"The reports of my death have been greatly exaggerated."
Mark Twain clearly wasn't referencing Citigroup Inc. (C) when he made this comment, but this famous American writer had lived through a variety of financial panics, and was familiar with the irrational swings that financial markets endure based on "group think" and speculation. Market participants regularly look at past price performance as being indicative of future results, and many analysts and portfolio managers find comfort in following the herd on the fashionable investments of the day, as opposed to venturing out on their own in the hopes of finding greener pastures. Citigroup, Bank of America Corp (BAC), American International Group Inc. (AIG), and Morgan Stanley (MS) all trade at significant discounts to tangible book value and are profitable businesses, yet few portfolio managers or analysts are willing to recommend or invest with conviction due to the belief that the stocks could go lower, which is essentially a bet on timing the market. The situation is reminiscent of when media stocks were out of favor in the early 1970s and Warren Buffett was able to establish a large stake in the Washington Post Co. (WPO), when the stock had a $100MM market cap and the company's net worth was around $400MM, when considering publicly available transactions for media assets. The common theme is that market participants obsessed with short-term problems cannot see the forest for the trees, and this herd-like mentality is what often creates below average investment returns. The bear argument for banks is well documented as expressed below:
1) The banks are social pariahs that only still exist because of taxpayer led bailouts.
2) Financial stocks have tremendous leverage and are inherently risky.
3) Regulatory changes have reduced leverage and, in turn, return on equity for the banks.
4) Europe is a disaster - which could severely impact financials.
5) There are a variety of lawsuits and expensive costs associated with servicing legacy problem assets, which are negatively impacting profitability.
6) You can't trust the accounting of financials.
Where others are transfixed on these negatives, I literally cannot buy enough of these tremendous franchises, which all have 200-300% appreciation potential over the next 5-10 years. While the stock market seems reasonably priced, especially given the fact that interest rates have likely already bottomed and profit margins for the S&P 500 are at all-time highs, and likely will revert closer to their historic mean, the financials offer a unique opportunity to make a tremendous amount of money within our estimation of "less risk" than many of the high flying stocks that dominate the positive headlines today. Because we have documented each of these banks in detail in the past and I'd suggest referring to those if you are curious about the individual business prospects, I'm going to address the bear arguments and show our expectations for Citigroup common stock even under extremely negative assumptions of future profitability and current book value.
First of all, it is obvious that the banks and their management teams have made varied mistakes that have damaged credibility and confidence. Recent examples of the "London Whale" and the Libor scandal are just the latest examples of greed and excessive risk taking. America was built on risk taking, and while that is no excuse for unethical behavior, it is also not new to Wall Street or Corporate America in general. Equity holders of all of these firms were virtually wiped out in a similar fashion to what would have occurred had they declared bankruptcy, and each company's management has been cleaned out considerably. There are a variety of industries, such as defense, solar, ethanol, etc., that are extremely reliant on government contracts or subsidies. I'm not interested in being a moral compass either way. But I am certainly of the belief that because financial regulation is a hot issue in an election year, the banks have been clouded to an extreme from negative publicity, that ultimately will dissipate over time, allowing investors to more clearly see the intrinsic value of these businesses. Cigarettes unquestionably cause cancer, yet market participants have been willing to bid shares of tobacco companies to extremely high levels based on their attractive dividend yields and cash flows, so ultimately I'm confident that the banks can eventually be forgiven by investors for whatever moral failings have occurred in the past.
Banks have always employed leverage and that does create additional risk. One of the benefits of the new regulation is the increased capital requirement on banks, which ultimately should reduce risk in the system. The large banks have virtually doubled their Tier 1 Capital and Tangible Common ratios since 2008. Leverage is down for all of the big banks, while deposits are up. Low net interest margins have caused banks to dramatically reduce their long-term debt, which is a higher cost funding source compared to deposits. Citigroup boasts a Tier 1 Capital Ratio of 14.4%, a Basel I Tier 1 Common ratio of 12.7%, and a projected Basel III Tier 1 Common Ratio of 7.9%. While this reduced leverage will indeed impact return on equity, it indubitably reduces the risks in the sector, which should give investors confidence that the banks can survive very difficult environments in the future. Both Wells Fargo (WFC) and JPMorgan Chase & Co. (JPM) have generated returns on tangible book of around 15% even in this weak macro-economic environment, and Citigroup's Citicorp division has done the same. As Citigroup continues to reduce Citi Holdings assets, the ROE of the firm as a whole should improve dramatically. I'd argue against financial stocks being inherently "riskier" than other stocks as the current price of these stocks hovers around 50% of tangible book, or liquidation value. We define risk as being the permanent loss of capital and at these prices I have less fear of Citigroup returning 10% on tangible book value, or being able to liquidate at prices approximating tangible book, than I do on Apple Inc. (AAPL) maintaining its record profit margins on the iPhone.
Europe is certainly a problem, but a very manageable one for the large U.S. banks. The exposure is quantifiable and the reality is that many European banks have already been recapitalized, or are likely to be recapitalized soon. The biggest problems were centered in Spain, which was the recipient of a huge capital influx to fix the banking sector in particular. There has been plenty of time to hedge positions and write down Greek bonds, so while the recession in Europe hurts revenue growth in that region and likely the capital markets in general, the risks can certainly be dealt with for the large banks. The table below highlights Citigroup's European exposure as listed in the latest quarterly release. As you can see, the net current funded exposure is $8.4 billion and only $0.9 billion in net current funded credit exposure pertains to Sovereign debt. These numbers should not strike fear in a company with $150 billion of tangible equity and earnings power of $10-$13 billion.
The banks have been riddled by lawsuits, fines and increased expenses to deal with loan servicing, compliance, and other problems that have impacted overall profitability. Bank of America, for instance, has about $3 billion in quarterly costs tied to mortgage servicing in excess of what would be needed on a normalized basis. While these issues have impacted financial results, the fact that these banks have been able to produce profits in spite of these costs highlights the underlying profitability of their respective banking operations. We are now about four years removed from the peak of the Financial Crisis, and I believe it is safe to say that the vast majority of payouts and lawsuits are now in the past. Credit metrics have been improving consistently for the last two years, and the loan underwriting on new production has been the strongest in at least a decade. As expenses come down, profits will go up, leading to substantial stock appreciation.
Accounting conspiracy theories are certainly in vogue and because one can't disprove a negative, arguing against these theories is largely a waste of time. Mark-to-market advocates were adamant that firms should remove their "toxic assets" in March of 2009, and many of the opaque securities from Bear Stearns and AIG were placed in the Maiden Lane portfolios held by the Federal Reserve. Shockingly, these "toxic securities" have posted staggering returns since March of 2009, as the intrinsic value of these securities were never nearly as low as the prices were at that time when illiquid markets were frozen. Accounting is far more of an art than a science, and the same questions could be made of a retailer or a consumer technology company's assessment of an inventory valuation, as can be made of a bank's Level III assets. Investors should always do their own research and crunch the numbers, but some solace could be provided that the following constituents are evaluating the banks:
2) Credit Ratings Agencies
4) Federal Reserve Bank of New York
5) U.S. Department of the Treasury
6) Federal Deposit Insurance Corporation
7) Office of the Special Inspector General for the Troubled Asset Relief Program
A key consideration for investors is that price is the single most significant determinant in the overall success of an investment. Therefore, let's assume that the bears are right on many points. Let's write down Citigroup's book value to equal its tangible book value, so we are giving no credit to the company for its nearly $34 billion of intangibles and goodwill, despite Citi's attractive positions in emerging markets, transaction services, etc. While I believe Citigroup will likely earn between 14-17% on tangible book value over the course of an economic cycle, let's assume that over the next decade, the company averages a return 10% on tangible book value each year. While that may be overly optimistic this year, it is likely overly pessimistic over the cycle, so hopefully it roughly balances out, erring on the conservative side. To make the calculation easier, we assume there are no dividends, stock buybacks, or share issuances.
As you can see the tangible book value would grow exponentially as the company retains earnings, and assuming that after 10 years Citigroup trades at 1 times tangible book value, the returns would be about 433% for an investor at current prices. Obviously, we believe the stock will likely appreciate far more quickly than that and dividends and stock buybacks next year will be a likely catalyst for this occurring. Dividends would reduce retained earnings, but would be extremely attractive for investors. Assuming a 50% payout on Year 3's net income would bring the dividend yield to greater than 10% based on the current share price. Some prominent analysts have built a career predicting a large bank would cut its dividend, so I wonder if it's equally prescient predicting that banks will likely be the sector with the highest dividend growth rates over the next decade. While dividends would decrease the benefits of compound interest exhibited in the table, I'm confident that any cash used could be invested in a more attractive fashion than the 10% return on tangible book that is being assumed in this calculation.
In the second table, for simplicity's sake, we assume a minimal annual share buyback of 2.5% of the common stock at prices equivalent to tangible book value. Therefore, we just reduced the share count by 2.5% per year, but kept the tangible book value numbers the same, only highlighting the impact on per share tangible book value. Virtually no business endeavor would be more attractive for the banks than aggressively buying back their own stock at currently available prices. Doing so would drastically increase tangible book and intrinsic value. Buying back stock at an average price of tangible book value would also be extremely beneficial and is easier to portray in this format than guesstimating how much they could buy back at various prices. I don't believe that the banks should pay any dividend until shares trade in excess of tangible book value, as buybacks are clearly the more attractive strategy.
As you can see, this strategy and these assumptions would lead to a tangible book value in year 10 of $173.10, which is roughly 577% higher than the current price of Citigroup stock. I would never invest based on assumptions on a spreadsheet, but the point of this exercise is to highlight the opportunity even in conditions that are far more bearish than I actually expect in terms of financial performance.
Notice that the banks don't need robust economic growth, or drastically improved net interest margins to be attractive for investors because the prices are so ridiculous. While market timers might think that they can pick the bottom, history has proven this attitude to be erroneous. Although current market dogma is to avoid financials in favor of high dividend payers (that also happen to pay out the majority of their earnings as dividends implying lower growth, and often higher debt to capital ratios), I'd suggest that the long-term investor establish positions in high quality financials trading between 50-65% of tangible book value. For those so inclined, in addition to buying stock, selling put options enables one to take advantage of the high implied volatility while allowing the investor to generate income and/or dollar cost average into a position. This strategy may not look intelligent over the next 3 to 9 months, but over 3-5 years I believe there is a high probability of explosive returns, while taking less risk than the overall market.