Beware the Financials Value Trap

JPMorgan (JPM) CEO Jamie Dimon said on Monday that he anticipates a deep and protracted recession in the aftermath of the credit crisis. Investors should heed this warning and make sure they don’t fall victim to the value trap.

According to Dimon, the mortgage and corporate loan markets could see a bottom at the end of this year, but he believes that the full effects from de-leveraging and increasing loan loss reserves will eat away at profits of big banking institutions, including JP Morgan. This will be exacerbated by interest and fee revenue declines and increases in credit card business loss.

Many investors believe that the extreme sell-off in financial stocks presents an opportunity to buy when there is “blood in the streets,” but I would caution against doing so. The problem no longer lies in the solvency of these banking institutions; that risk was effectively mitigated through the socialization of Bear Stearns losses, and the promise for further bailouts. The risk for investors now lies in being caught in a value trap. See, the valuation metrics of these large banks reflect the operational profits of the past, not of the future. Yes, the price-to-earnings ratios are low, the dividend yields high, and the 52-week highs are enough to make a gambler salivate, but none of that matters.

When companies de-lever themselves, they reduce earnings power for future quarters. Bear Stearns (BSC) was leveraged 32-to-1, meaning for every $1 in assets they had, they had $32 in liabilities. When the good times were rolling, this leverage allowed the company to reap massive profits, resulting in inflated earnings and, subsequently, a higher stock price. It wasn’t just Bear Stearns that was highly leveraged; everyone was. Goldman Sachs (GS), the supposed poster-child of risk management, maintained a leverage ratio of more than 25-to-1. Indeed, you were laughed at if your ratio was less than 20-to-1.

The tables have turned and leverage ratios are now being reduced to high-single or low-double digits. I probably don’t need to state the obvious here, but I will anyway: Future earnings, based on lower leverage, will look nothing like past earnings, which were based on higher leverage. To mention nothing of huge write-downs, this fact in itself is a valid reason to be wary of valuing these companies.

Not only are companies de-levering, they’re also being prompted to increase loss reserves in order to stave off another Bear Stearns-esque catastrophe. Increased loan loss reserves mean less capital available to deploy and make a return on. This will hit earnings as well and quite possibly force a reduction in dividends paid.

You can bet that as earnings dwindle from these two factors, not to mention losses from bad loans, bank valuations will reset and we will all finally see how over-valued they still are. There are so many better plays out there, why fall victim to the value trap? ake it a very small portion of your portfolio.

Disclosure: Author has no positions in any of the companies mentioned.

Comments

[billddrummer:]

The writedowns already recognized, and the ones to come, represent unwinding of profits that wouldn't have been booked in the 2004-2006 years if valuations had been correct then.

I haven't done the research, but I'd be willing to bet that a large percentage of those profits were gains on unsold positions. When the derivative markets froze last summer, the game was up, and the only thing left to do was to back out the profits. Which reduces equity, and increases the leverage ratios.

There will be an end. But no one knows when.

2008 May 13 01:03 PM

[Ryan Freund:]

The last sentence of this document was butchered.... see the full version here:

freundinvesting.com/20.../

2008 May 13 01:49 PM

[Balance She...:]

Since assets - liabilites = equity, I think what you meant to say about Bear Stearns was:

"...for every $33 in assets they had, they had $32 in liabilities."

It doesn't sound nearly as dramatic, but it is accurate.

2008 May 13 02:34 PM

[helplessobs...:]

What kind of fools do the business schools turn out these days. Even utilities try to keep their leverage at no more than 50%. Who or what secures income streams for financial institutions?

2008 May 13 04:20 PM

[Ryan:]

who knows helpless... apparently they're too smart for their own good! it's very wise of you to see through it. i tip my cap to you.

2008 May 13 07:25 PM

[BlueOkie:]

Assets may be over or understated but liabilities rarely are.

2008 May 14 10:33 AM