Yes, Financial Companies Can Be Analyzed 32 comments
Tom Brown
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“Is it Time to Tiptoe Back into Financial Stocks?,” Jason Zweig asks in Saturday’s Wall Street Journal. He argues that Ben Graham’s answer to the question, were Graham still around to consider the matter, would be “no.” “When bankers themselves have no clue what their assets are worth,” Zweig writes, “there is no way most outsiders can determine which stocks are undervalued and which cannot be valued.”
Inasmuch as Zweig literally wrote the book on Ben Graham, you’d think his take would be definitive. But I don’t buy it—both as a matter of analysis and a matter of history.
Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets--particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.
Interestingly, Zweig’s argument is the same one used by some analysts at the bottom of the last bear market for banks. Just days before Wells Fargo bottomed in 1991, George Salem, the chronic bear of the moment, told the Wall Street Journal that (if I recall the phrase accurately) even Mark Spitz can’t swim against the tide in a hurricane. At the time, the U.S. commercial real estate markets were in the midst of a nasty downturn: most geographic markets were overbuilt, absorption rates were low, and prices were falling. Of the top 50 banks, Wells Fargo (WFC) had the largest ratio of commercial real estate loans to total loans.
If Zweig were writing back then, he’d have agreed with Salem and would have warned readers to stay away. There was no way, he’d have argued, to predict the level of losses Wells Fargo would suffer.
Literally, of course, Zweig would have been right. No one, inside or outside the company, could accurately predict what Wells’s ultimate losses would be. But what they could do—and what financial services investors can do now, regarding the banks in general--is make reasonable estimates of ranges of losses, and estimate companies’ future earnings power, then compare that to their market values.
How ironic is it that one such investor that did that back in 1991 was Warren Buffett himself, who, despite the uncertainty and worry about hurricane-force winds, began purchasing Wells Fargo’s stock in December 1991. Those purchases, in hindsight, turned out to be close to the absolute bottom for the stock.
I’ve known Jason Zweig for almost two decades; I like him and have a high regard for his work. I spent 45 minutes on the phone with him as he prepared this article in particular. But for him to claim Ben Graham would not buy financials today contradicts Graham’s analytical discipline--and is inconsistent with the past behavior of the best Ben Graham student of all time!
Zweig: “To see why I think Graham would sit on his hands, you need to understand his crucial distinction between investment and speculation. ‘An investment operation,’ he wrote in his first book, Security Analysis, ‘is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.’"
TKB: Many financial services companies now provide highly detailed disclosure of their asset positions. Investors willing to do the analysis can come up with range of loss estimates in order to get comfortable with the promise of “safety of principal” of the potential investment. They can also forecast the return the companies can earn on their estimated equity once the problems pass, in order to make a reasonable estimate of potential returns.
This is not the first downcycle in credit. Each prior one has provided a raft of investment opportunities. While this cycle has its differences from past ones, it has many more similarities.
Zweig: “You cannot even pretend to be protected against loss while real estate prices--the wobbly foundation for most financial stocks--are still crumbling.”
TKB: Of course lenders are going to suffer more losses--but that’s not the debate. Investors can make their own forecast as to the magnitude of future declines in real estate values and then extrapolate their effect on the specific exposures of financial services companies.
Last cycle, commercial real estate loan values kept falling, and nonperforming assets and losses kept rising long after the stocks began to recover. Losses and nonperformers will be lagging indicators this cycle, as well.
Zweig: “Each quarter, the banks set aside in reserve against losses on their loan portfolios and say they believe those reserves should be adequate. The next quarter, they find out they were wrong.”
TKB: Whoa! This is terribly misleading; I’m surprised Jason Zweig wrote it. I’ll spare you the details of the minutiae of reserve accounting. Suffice it to say, though, that managements have very little discretion. Rather, reserves are built, held constant, and reduced largely via formula, based on what happened during the quarter. Auditors do not permit (and investors would not want) managements to have broad discretion over the size of reserves. There is nothing significantly different about how reserves are being managed this cycle compared to that last one. And the result will be the same: when the credit problems finally start to shrink, it will be clear reserves were overbuilt, and earnings unnecessarily depressed.
Zweig: “I’m not saying there is no money to be made on financials in the next couple of years. But the potential for further losses is at least as great as the odds of big gains.”
TKB: Here Zweig unfortunately falls into the sell-sider’s standard waffle. Usually it goes, “I see big gains ahead for financials but worry about the near term downside.”
True value investors, by contrast, tend not to worry what might happen in the interim. Instead, they come up with their best estimate of a financial company’s intrinsic value by estimating the magnitude of likely losses along with its “normalized” earnings level two or three years out. They then compare that estimate of intrinsic value with the stock’s price today. Zweig says such estimates are impossible. I disagree. Having spent the bulk of my waking hours lately going through this very process, I believe many financial services stocks are significantly undervalued.
Zweig: “If you are still tempted to bottom-fish for financial flounder, at least diversify. . . Whatever you do, use only the money you were saving away for that trip to Las Vegas.”
TKB: Was Warren Buffett using his Vegas money to buy Wells Fargo’s stock back in late 1991? I don’t think so! To say these companies are too risky because they can’t be analyzed is just a way of saying, “I don’t want to do the analysis” or “I am incapable of doing the analysis.”
What do you think?
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This article has 32 comments:
Good column, and there is a good chance you are right - I am still building my circle of competence in this area before I dive in.
en.wikipedia.org/wiki/...
Remember that the Warren Buffett whom Tom refers to called derivatives (especially credit derivatives) "financial weapons of mass destruction" back in 2002, and boy was Buffett correct!
Also, I agree with Tom Brown that Graham would not have shied away from trying to analyze the current situation. There are still many great financial firms to invest in but not that many here in the U.S. (although there are a few).
Tom Brown, manager of a primarily "long only" bank/credit hedge fund is once again doing anything he can to rationalize the financial industry.
I am sure Tom's hedge fund is down massively over the past few years.
I have read many articles on his web site where he defends many companies that regardless if he, in theory is "right", the market has taken those stocks down 80% or more.
I personally see no reason to rush into financials. If you were not invested in them in the first place, you are doing fine anyway and you lost nothing.
For those that cannot sleep at night thinking that if they miss the exact bottom, they are going to miss the boat, here is the word that describes you best: gambler.
So what if you miss the first 30% on the upside. If everything Tom and other bulls say is true then you will still make another few 100% over time anyway.
As this current sell off, once again in financials shows, a true bottom will be put in when the credit crisis is no longer front page news and everything related to financial companies has been left for dead.
A bottom will not be put in while there are way to many people "looking" for a bottom, and while the media continues to yell buy, buy, buy all the way down.
I am not going to argue about the relative value of the financial sector ,but the risk in that sector these levels appears to be fairly minimal -unless of course one believes that the Administration ,the FED and the Treasury will allow a mega financial and economic failure.I do not.
If you're a bank, and you don't have any money to lend, and folks are not paying you back money that they owe you, then you will go out of business. It's that simple.
How can you say these banks are over-reserved when we now see banks in the Pacific rim writing CDO's & SIV's down to 10 cents on the dollar?
Merrill is selling $31bb in face value for 6bb? This will ripple thru fantasyland pretty quick now that we know where the marks should be.
When these long only financial apologists finally give up and stop calling the bottom, and CEO's stop lying about their need not to raise more capital, I will start buying.
disc" Long SKF
On the other hand, we do have some speculative financial investments available: will WM and WB pull through? Total guesswork. What will happen to equity-holders of FNM and FRE? Depends on unknown information. What will C have to do to survive? Could be anything. If you think about C for 5 minutes and decide "eh, they're not going out of business - might even go back up some time!" then you are speculating. If you read the WFC reports and see that they're earning through this crisis and laying the groundwork for a return to better profits, you might think that they're undervalued by enough to give you a margin of safety for investing. Certainly you had the margin of safety before 2Q earnings, but now that they've put out some (largely forseeable) good news it's reduced by the higher share price. If WFC at today's prices isn't an investment, what is? Almost everything depends on oil, housing, credit, and currency, and with all 4 moving all over the place it's hard to predict the near term future. All you can do is look for long-term values based on current prices.
Also, I agree with Jimmy Lathrop that the financials cannot make a convincing long term bottom until there is clearer evidence that national home prices have begun to stabilize.
Second, I am currently reading "The Intelligent Investor" by Benjamin Graham with updated commentary by Jason Zweig and I have to say that thus far I have found Mr. Zweig to be very self-important (putting his contributions in capitals in the index of the book) and his contributions to be exhibiting an incomplete understanding of Mr. Graham's techniques and arguments (for a prime example, see his embarrassingly incomplete Michael Jordan analogy at the end of the third chapter).
I must admit that I have not had a lot of exposure to Mr. Zweig's work, and his resume is very impressive, so he must be worth his salt, but based on what I have seen I really do not feel that his analysis carries much weight.
Additionally I would tend to agree with the author of this article, to a limited extent. There are a very few financial institutions that I would be interested in investing in if I had a longer investment horizon (Goldman Sachs is the only one I would definitely invest in and sleep soundly holding), but also agree with Zweig. I feel that it really isn't possible to analyze how far the housing market is going to fall and how many credit-worthy people are going to be affected by this slump. As a result, it is very hard to tell how low various grades of investment securities will fall before they recover. With mark to market accounting, even if they will ultimately be written back up, a precipitous decline may force a financial institution to raise capital where it would not be necessary without such accounting practices. I was surprised by Amex saying that the current crisis was even affecting some of their "super-prime" customers. To be perfectly honest, I don't feel that even sophisticated investors have the time nor the ability to value financial institutions. I feel that only the very best analysts can get a rough estimation of the true value of financial stocks, and oftentimes their compensation structure is such that we may not even get the true result of their analysis...
Do you buy the banks? Which ones and why? Residential real estate will keep falling for a few years. These banks will keep going broke and keep taking write downs. Now is not the time to be a hero. At some point the financials will be up 100% from their lows.
Who can pick the bottom? No one. Buy UYG when things turn. For now, stay away.
Mr Brown wrote: "I’ll spare you the details of the minutiae of reserve accounting. Suffice it to say, though, that managements have very little discretion... Auditors do not permit (and investors would not want) managements to have broad discretion over the size of reserves."
That makes me think there is an aspect of banking regulations that more or less ties the hands of management teams in establishing reserves. That would be news to me, it would be highly relevant to this debate, and I would like Mr Brown to address this further (if he has made it through the endless comments of drivel).
We are all familiar with Wall Street show horses. Take time to discover the Main Street work horses.
64.233.169.104/search?...
I assume that this is still the case today.
Calling a bottom is not what Brown has done and is absolutely not what Graham would ever do. Value investing is long term and not about market timing.
That being said, Brown claims that "investors willing to do the analysis can come up with range of loss estimates" for banks. As someone mentioned above, these level three assets like CDOs that ML has just written down again are exceedingly complex and require models put together by teams of PhDs. An individual investor will never be able to come up with this "range of loss estimates." If you can pick up Merrill's SEC filings from three months ago and estimate its $5b writedown, please give me the name of your hedge fund so I can invest!
That being said, I do agree that financials as an industry are now undervalued. However, Brown's approach of doing due diligence and picking the "best" of the pack exposes the individual investor to too much idiosyncratic risk -- no individual investor can pick out the next Bear Sterns or even Freddie or Fannie.
I think the best move for an investor with a three year horizon is to make a diversified bet on financials with 10 names in his portfolio. That way, even if one crashes and burns, he will still be able to benefit from the underlying valuations long term.
Sure they can gamble with your money. When they lose they just get more free money from the fed or big deal go bankrupt. The management has made a killing during the boom years anyway and the government will pay back most depositors, running up more debt. What a system.
www.reuters.com/articl...
How would Ben Graham have analyzed MER after their earnings call and before this sandbag. Seriously, you have no idea what you're talking about ...
And for many of them, 'investing' is confined to taking the easy way out - just bad mouth everything and generalise a negative point - the shorts just love to do this - I've never seen them polite on anything they love to short. Of course, the difficult way is to analyse and pour over (just like what Ben Graham adn Tom is suggesting) - that is much harder work and involves more conviction.