Our Advice? Buy the Financials Now

Aug.22.08 | About: Financial Select (XLF)

I went on Neil Cavuto’s show on the Fox Business Channel Tuesday night to discuss why I’m so bullish on the financials. Ironically, I found myself explaining that in the near term, my expectations for the group aren’t all that different from the bears’. Yes, there will be more loan losses, asset sales at depressed prices, and further negative asset marks. Credit is still deteriorating.

All of which comes more or less straight out of Nouriel Roubini’s screenplay. The main difference between the Roubinis of the world and me, from what I can tell, is that I believe once all the sales, marks, and losses are done, over 95% of the companies in the industry will have survived and will have surprisingly robust business outlooks. The survivors will have fully recovered in three years.

What’s more, I believe the stocks should be bought now; investors who wait for signs of major fundamental improvement will end up missing the boat. There is, first of all, the matter of the stocks’ valuations. In instance after instance, they are compelling. Earlier this week, for example,  I posted an article here that laid out how MBIA’s (NYSE:MBI) adjusted book value—that is, its book value adjusted to include items that will almost certainly find their way into the company’s equity account but haven’t yet—adds up to $39.63 per share. Yet MBIA’s price lately comes to $10.75 per share—which means that in its current, severely beaten-down state, the stock trades at 27% of adjusted book. I will grant you that in the near term, the company might take some actions that could modestly erode its book value. But you’ll have a hard time denying that at 27% of book, the stock is discounting a level of losses and impairments that are highly unlikely to occur.

MBIA’s valuation is just one of the more notable examples of the valuation extremes that have overtaken the financial sector. Most “controversial” financial services companies are trading at only 20% to 50% of their normalized valuations. I expect the companies to regain those valuations within three years. For investors, that means doubles, triples, and quadruples over that time period.

In the meantime, signs have begun to appear that hint the beginnings of the end of the credit crunch might have commenced. As we’ve discussed here before, for example, the inflow of new bad subprime mortgage loans has fallen considerably in recent months. That’s good: fewer new delinquencies now means fewer foreclosures several months from now. And the rate at which delinquent loans are moving from early-stage buckets to later-stage ones has declined. More generally, on their second-quarter earnings calls a number of banks indicated they’re seeing a slowdown in the rate of new problem loans, as well.

Does that mean the industry’s credit problems are on the verge of healing? Of course not, things are getting worse, not better. But the second derivative of deterioration—that is, the rate things are getting worse—has begun to improve. That’s key. As I’ve noted, investors who won’t buy the stocks until they see an absolute decline in credit problems will miss the bulk of the stocks’ coming move higher.

We’re even seeing improvement in the main cause of the whole mess: the collapse in home prices. Thisitem didn’t get much attention, but on Tuesday RealtyTrac announced that for the first time in 33 months, home sales in Southern California actually rose. That’s very good news, since it implies banks have finally found a clearing price at which they can dispose of their repossessed properties. The sooner banks REO clears the market, the sooner the housing market can return to normalcy. Will that happen overnight? Nope. But at least the process seems to be in place for it to happen eventually.

Once the credit crunch does end, meanwhile, the outlook for the financials should be pretty darn good. Skeptics complain that the deleveraging the industry is going through means that returns must fall permanently. That’s crazy. Remember, companies are deleveraging—that is, withdrawing capacity--en masse. Lower capacity means higher returns. As Rich Pzena has pointed out, to say that the financials’ deleveraging must mean lower returns on lending is like saying a shut-in of capacity by the oil industry must mean lower oil prices. That makes no sense. In the meantime, demand for credit shows no signs of easing.

As I say, investors who wait for an all-clear signal will have missed most of the coming move higher. The stock market moves on what it expects to happen in the future—sometimes well into the future, not on what it sees happening right now. There is no doubt that the financial services industry is currently in a world of hurt. Prices of financial services companies reflect that. The question now is, will the industry ever recover and, when? My answers: “Yes” and “Eventually.” Given the stocks’ valuations, and the first glimmerings of fundamental improvement that are appearing, that’s all you need to know.

Tom Brown is head of Bankstocks.com