Global financial stocks are down nearly 3.0% this year, while the broader MSCI World has gained 5.3%. US bank valuations have retreated as the Fed's appetite for interest rate rises evaporated. This has driven a compression in the price to book value to 1.3x, almost half the long-run average. Essentially, the financials appear cheap and the industrials appear expensive. The question to ask yourself, are bank valuations an opportunity or a value trap?
To answer this question, it is important to review our expectations and our long run success in predicting the future. If we cast our mind back to 2007-08, only months preceding the start of the Global Financial Crisis, investors had an expectation about the ability to source cheap money. The widely held consensus view, was that cheap and plentiful finance was a given. The analyst community would scold corporate managers for having a strong balance sheet, which they referred to as a 'lazy' balance sheet. The newspapers were littered with articles recommending individuals increase their portfolio gearing to amplify their returns. This is a crazy idea, irrespective of the time.
Let's roll forward to 2016, the widely held consensus view in the US is twofold. Firstly, that interest rates are not going up anytime soon and secondly, that inflation is dead and buried. You can form your own view as to which camp you sit in. However, before you do this, let us examine our ability to forecast and to do this we need to take a short stroll down memory lane.
The truth is, humans are notoriously bad at predicting the future. However, this doesn't stop the newspapers brimming with prognosticators who will give you their view on absolutely anything. Unfortunately, they are unaware of their own deficiencies. Investors can put themselves at a great advantage by acknowledging their inability to predict the future. As Socrates once said, I know one thing: That I know nothing.
If you approach investing with this in mind, suddenly you become very skeptical about the future and your ability to predict it. It is interesting to note, that although weather men are right just a small fraction of the time, they are actually aware of this fact. This makes them well calibrated. Analysts, on the other hand, are also right a fraction of the time, however, they believe that they are right the majority of the time. You can put this discrepancy down to a number of behavioral biases, primarily overconfidence. If you are interested in learning more about these biases, there are a number of good books that discuss this in further detail.
10 Year Bond Yield - Actual v Forecast - Figure A
It turns out that Economists ability to forecast interest rates is dreadful. The figure above shows the forecast line essentially just lagging the actual interest rate. Not only are they unable to get the level right - they cannot even get the direction right. Ok - so you don't think we are only picking on weathermen and economists, we include analysts forecast for the S&P 500. Again, it just tracks the actual results with a six-month lag!
S&P500 - Actual v Forecast - Figure B
So, if we know, as Socrates said, that we know nothing, perhaps it makes sense to buy uncertainty and to sell certainty. The financial markets eschew uncertainty. This is evidenced by global bank valuations trading at record lows, and global industrial valuations trading at record highs. As value investors, opportunities present themselves when people become overly bearish about the future prospects of certain sectors. We would argue that this is the case with bank valuations at present. Now, we don't profess to have any superior knowledge about the glide path of interest rates. However, we would argue that the market is providing an opportunity to those investors willing to take the opposing view.
As value investors, we need to hold non-consensus views and be correct to outperform the market. If investors do not hold non-consensus views, then they resign themselves to mediocre performance over the long term. This is the reason why the majority of investment managers fail to beat their given benchmark over time.
A successful investor by the name of Howard Marks became a billionaire by taking non-consensus positions. He understands that uncertainty provides opportunity. We would do well to follow his lead. At Swell, we are using the uncertainty in bank valuations to increase our weighting to Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM). The kicker for Wells Fargo, is that they are currently in the 'sin bin' for fraudulently establishing customer accounts without the customers' knowledge. The stock has retreated nearly 15% as a result. Whilst this is disappointing, we do not believe this has damaged their long-run competitive advantage.
Naturally, there are good reasons why bank valuations may stay cheap for a long time. However, as we have set out above, you wouldn't want to rely too heavily on your expectation for the path of future interest rates. So do you follow the herd into expensive industrial valuations? Do you join the bond refugees in expensive real estate and infrastructure stocks? Or do you take the long term approach and buy uncertainty. We have already answered this question; we will buy cheap uncertainty over expensive certainty every time.
A,B Source: Global Equity Strategy: The Folly of Forecasting: Ignore all Economists, Strategists and Analysts by James Montier. Reprinted in CFA Institute Program Curriculum, Volume 2, Reading 12, page 64 & 65.
Disclosure: I am/we are long WFC, JPM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.