“Sometimes, what matters is not so much how low the odds are that circumstances would turn quite negative, what matters more is what the consequences would be if that happens” Jean Marie Eveillard
Financial bulls (Pzena, Miller, etc.) and bears (Romick, Tilson, etc.) make compelling cases. One side argues that financials are a coiled spring ready to explode. The other argues that the spring is broken.
In a recent quarterly report Pzena wrote:
A new fear has permeated conventional investment thinking: the massive leveraging-up of the recent past has gone too far and its unwinding will permanently hobble the global financial system. This view sees Bear Stearns as just one casualty in a gathering wave that has already claimed many U.S. subprime mortgage originators along with several non-U.S. financial institutions and will cause countless others to fail. And it sees the earnings power of those that survive as being permanently impaired.
The obvious question then is, which scenario is more logical: the extreme outlook described above, given the long period of easy credit extended to unqualified individuals? Or the scenario of a typical credit cycle that will work its way out as other post- excess crises have, and without impairing the long-term ROEs of the survivors? We believe the latter.
Steven Romick of First Pacific Advisors offers some alternative insight.
I’m more concerned about what I don’t see. Why is it that we are not being told about or seeing another bidder for Bear Stearns other than JPMorganChase? Might JPMorganChase be playing defense so as to protect its $91.7 trillion dollar derivative exposure (according to September 2007 Office of the Comptroller of the Currency data) that is supported by just $123 billion of equity? How much counter party exposure did JPMorganChase have to Bear Stearns?
Within the greater derivatives market, there is a segment, referred to as credit default swaps (CDS), which has grown from $900 billion in 2001, to $45.5 trillion in 2007.
In our opinion, a new financial system is in the process of being created. This is the beginning of a new era. Some may refer to it as Pre-Bear Stearns and Post-Bear Stearns. It is inconceivable to us that the Fed can place its balance sheet at greater risk without having some type of regulatory authority over those financial institutions that now have access to its liquidity services. In essence, new and increased levels of regulations are a likely outcome from this series of events
(In a recent Value Investor Insight Interview he added)
We believe in reversion to the mean, so it can make a lot of sense to invest in a distressed sector when you find good businesses whose public shares trade inexpensively relative to their earnings in a more normal environment. But that strategy lately has helped lead many excellent investors to put capital to work too early in financials. Our basic feeling is that margins and returns on capital generated by financial institutions in the decade through 2006 were unrealistically high. Normal profitability and valuation multiples are not going to be what they were during that time, given more regulatory oversight, less leverage (and thus capital to lend), higher funding costs, stricter underwriting standards, less demand and less esoteric and excessively profitable products. (emphasis added)
Can history be a guide?
During the great depression, which was the last credit bust witnessed in the west, the price to book of the financials fell from 2x to 0.5x. The following chart from James Montier shows that during the great depression the book value of financial stocks halved. Thus far in this financial crisis we are down a mere 6%.
Before investing - we have some simple questions for readers to ask themselves.
Can you measure the risk of the financials? Do you understand the derivative exposures? It seems almost a certainty that regulatory changes will be coming ( increased capital ratio requirements, perhaps costly oversight, etc) - how will these affect profitability? Perhaps more important in today’s operating environment - do you trust the person running the company?
I can’t answer those questions with very many financial companies. There are, however, some interesting financial companies to keep in mind as this mess plays out.
In a recent note to shareholders Mark Sellers said this of Fairfax Financial (FFH):
The company’s intrinsic value goes up when the market falls. The great thing about this situation is that it isn’t priced into the stock, so we get a free put option on the market and an undervalued stock at the same time.
Berkshire Hathaway (BRK.A), of course, is very well positioned for this environment and so are some of their financial holdings. It’s not a coincidence that the two banks Berkshire has been buying recently are relatively unscathed by the financial mess. More than just protecting existing wealth - they are both capitalizing on this environment to grow intrinsic value.
A lot of people put JPMorgan (JPM) up there with Wells Fargo (WFC) and U.S. Bancorp (USB). I think this is largely because all three banks have tier one capital ratio’s over 8%. At a time when most banks are struggling these three - with plenty of liquidity to opportunistically expand - stand out. However, not all banks are created equally.
I love Jamie Dimon - he’s the guy that wrote the best shareholder letter ever. I think he’s one of the smartest, honest, and capable people around. That doesn’t mean I’ll invest in JPM right now. I doubt even they understand the large, complex, derivatives book embedded in their reports. I don’t understand their risks and if i can’t measure their risks - I can’t ensure that I have a margin of safety. (JPM does a lot of things right - perhaps i’ll leave that for another post.)
If Buffett’s prediction that derivatives are the ‘financial weapons of mass destruction’ comes true - JPM is not a company you’d want to own. If Buffett’s wrong - or JPM really does understand their derivative book, we could see a massive upside to shares from these prices.
As the opening quote to this post highlights: expected value matters more than simple probability. The probability of something going wrong in the JPM derivatives book might be low, however, the expected value of that problem could destroy the company.
You only learn who has been swimming naked when the tide goes out — and what we are witnessing at some of our largest financial institutions is an ugly sight. Warren Buffett
For the most part we prefer to sit on the sidelines and watch. As Yogi Berra said “You can observe a lot just by watching.” With that in mind, we’ll be keeping a close eye on Buffett.