Jason Zweig writes the Intelligent Investor column for The Wall Street Journal. I’m sorry to say this week’s column is especially unintelligent.
When asked whether Graham would be buying financial stocks today, Zweig says no, and gives the following reason:
You cannot even pretend to be protected against loss while real estate prices - - the wobbly foundation for most financial stocks - - are still crumbling.
You can do more than pretend to be protected – and Graham would have. Crumbling real estate prices alone would not have deterred Graham. He liked to use long-term averages and estimates of what normal conditions would bring. He relied heavily on the past as an indicator of the future. Real estate prices will recover at some point. Even if they don’t anytime soon, land still has value and Graham would have done his best to conservatively estimate that value. He could’ve used estimates based on prices from many years ago, replacement costs, rents, or the value of unimproved land. Then he would have lopped off some of that price and – voila – there’s your margin of safety.
No. The crumbling real estate market wouldn’t have fazed Graham.
Graham wouldn’t have bought financial stocks for a very different reason: they simply aren’t cheap enough.
I know it’s hard to believe, but as Zweig points out, on average, financial stocks are still trading above book value.
Remember, 1.1 times book is still 110% of a bank’s equity. Graham bought net current asset value stocks at less than 67% of their net current asset value (NCAV).
A lot of people think NCAV stocks (or “net/nets”) are risky. Some may be. However, there was one study showing that net/nets sought bankruptcy protection less frequently than non-net/nets. That’s not as shocking as it sounds. Unlike low price to book stocks, low price to NCAV stocks have a built in tendency to be overcapitalized.
Because there’s no need to have a positive net current asset value at all. Many public companies don’t.
Take Anheuser-Busch. It has about $3.1 billion in book value and NEGATIVE $12.1 billion in net current asset value. Even if BUD’s stock price fell to two bucks a share tomorrow, it would not trade below its net current asset value, because it has no net current asset value. To have a net current asset value, the company would have to be overcapitalized.
Other companies, especially companies with very high inventory needs and rapidly declining sales, can trade below NCAV without actually having much financial wiggle room. However, most companies end up in NCAV territory with strong balance sheets and weak statements of income and cash flow.
The NCAV stocks that fail tend to do so in slow motion and through extreme pig-headedness. Had management wished to, they could have exited unprofitable businesses, stopped treating the company as their own personal piggy bank, or wound down the business at some point without ever facing insolvency. A bankrupt (former) NCAV stock is usually the direct result of a determined and dimwitted management.
I made this detour into the land of net/nets for a good reason. Graham liked to combine both safe and cheap. He didn’t necessarily look for a high-quality, low-price stock – he looked for businesses that could perform worse than expected and still see their share prices rise. When taken as a group, net/nets are both safe and cheap. Their current earnings and cash flow are usually very bad, their future prospects are usually abysmal – however, even the slightest improvement in their performance will lead to excellent results.
Graham was betting on stocks with extraordinarily low expectations; if he were betting on a horse race, the nearest equivalent would be betting that the worst horse in a race wouldn’t place dead last every time. He didn’t bet on long-shots (he wasn’t betting the horse to win), and he didn’t expect to make more than 50% from any one stock. But, he did expect to beat very low expectations.
The problem with financial stocks is that today’s expectations still aren’t as low as Graham liked. Buying a basket of bank stocks just above book value may be an excellent speculation, but it wasn’t Graham’s idea of an investment.
Given the right price, you could carry out an investment operation in financial stocks by relying on their past records (many banks have very long public histories) and diversifying. Zweig finally gets Graham right when he says:
If you are still tempted to bottom-fish for financial flounder, at least diversify.
Unfortunately, he goes on to say:
Consider Vanguard Financials or iShares Dow Jones U.S. Financial Sector. Each of these exchange-traded funds holds hundreds of financial and real-estate stocks.
You are to do no such thing. If you’re going to buy financials, don’t buy them indiscriminately above book value. You need a margin of safety – and you can't diversify your way to safety. That means you either have to buy banks that are a cut above the rest or you have to buy banks well below book value.
An example of a bank that’s a cut above (from a Grahamian safety perspective) is Valley National (VLY).
Unfortunately, it ain’t cheap. I nearly posted on Valley recently when the company’s declining stock price brought its dividend yield over 5% and its price-to-book ratio under two. Of course, that means the company (briefly) traded at just under 200% of its book value – not exactly Ben Graham cheap.
And that’s the problem. Many of the banks trading below book value don’t have long histories of safety, solidity, and reliability. While many of the banks that do have such records (the kind of records Graham would look for) aren’t trading anywhere near Ben Graham bargain territory.
If financial stocks fell another 40%, Graham would consider buying a basket regardless of the economic climate. Even if we’re heading into a depression, buying the 20 best financial stocks at 2/3 of book value would be intelligent investing. However, even if we’re heading into the broad, sunlit uplands of permanent peace and prosperity, buying a hodge-podge of financial stocks at 110% of book is unthinking investing.
Graham wouldn’t do it and you shouldn’t either.
So Zweig gets the answer right: No. If Ben Graham were alive today he wouldn’t be buying bank stocks.
However, Zweig’s reasoning is all wrong. Graham wouldn’t be deterred by real estate prices; he’d be deterred by stock prices. Bank stocks just aren’t cheap enough to provide a margin of safety – unless you’re sure most banks are worth much more than book – and Ben Graham wouldn’t be.
Zweig concludes with this indulgent advice:
Whatever you do, use only the money you were salting away for that trip to Las Vegas.
Invest or don’t invest. But, don’t play games. Don’t dip a toe in the water. Don’t fool yourself into thinking you’re being prudent when you’re simply being indecisive. It’s one thing to make a single bad investment; it’s quite another to indulge yourself in a bout of sloppy thinking and indecisive decision making. Better to burn the money now than lose it in a way that will undermine your confidence in yourself or the seriousness with which you approach your investments.
Here is the matter before you: Is an adequate margin of safety provided by the purchase of a basket of bank stocks at an average of 110% of book value?
Yes? No? Maybe?
If yes, then invest.
If anything else, then forget about bank stocks altogether.