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Understanding the value of a bank is beyond human comprehension. There is too much uncertainty from legal risks, the implementation of new regulations, and danger lurking in opaque accounting. Even if the economics of banking is somehow certain (it isn't) or if banks could be accurately valued without error (they can't because they are extremely levered), external shocks make them highly speculative.

Investors should either stay away from banks, or pick up the cheapest ones as small, low cost, speculative bets.

Industry Wide Legal Threats

The latest tremor to shock financial companies came in the form of a class action lawsuit filed against twelve different banks which allegedly profited by colluding to fix LIBOR. Plaintiffs include the following banks from the United States, Canada, and Europe: JPMorgan Chase (NYSE:JPM), UBS (NYSE:UBS), Bank of America (NYSE:BAC), Citigroup (NYSE:C), Barclays Bank (NYSE:BCS), Royal Bank of Scotland (NYSE:RBS), HSBC Holdings (HBC), Lloyds Banking Group (NYSE:LYG), Rabobank, Credit Suisse , Deutsche Bank (NYSE:DB), and Royal Bank of Canada (NYSE:RY).

LIBOR is the London interbank offered rate, which is widely used as a benchmark for variable rate lending rates such as variable rate mortgages. Substantial increases from a market value could have increased interest payments due on over $300 trillion of LIBOR-based debt securities like adjustable rate mortgages.

That's right: the often pitied American homeowner is a defendant. A case like this is a lawyer's dream: the defendants are lovable and down-on-their-luck home owners while the plaintiffs appear to laypeople as cold, unfeeling financial goliaths who supposedly exploit the little guy. This case almost wins itself!

More importantly for lawyers, these plaintiffs are loaded. Even better, the complexity of this case will provide years of appeals and legal maneuvering. Imagine the fees you could bill on this one!

Unpredictable but Par Course

Bank shareholders should have learned by now that news like this will surface over and over again. It's just the nature of the beast. The likelihood of more allegations and legal issues coming to light is roughly the same as it was before. As an investor, there is no reason to punish financial stocks that got caught in this particular lawsuit since there is no way to know who will get caught in the next lawsuit.

If you don't believe me, you don't have to take my word for it. Remember way, way back in ancient history when JPMorgan was considered safe? That was 2012. Today, we think about JPMorgan very differently. The bank is being investigated by a U.S. Senate panel led by Carl Levin regarding its $7 billion trading loss. So far this panel has extensively questioned executives from many banks, including HSBC and Goldman Sachs (NYSE:GS). Unidentified sources have stated that Levin's Permanent Subcommittee on Investigations is looking for testimony from people who worked in JPMorgan's investment office. The London branch of this office lost almost $6 billion earlier this year on failed derivative positions, an unexpected loss, which shook the markets and caused JPM shares to plunge.

The inquiry is challenging JPMorgan's version of events that led to this huge loss, and JPMorgan has stated publicly that its own internal review has found that traders may have tried to hide the full amount of losses on their transactions.

In May 2012, Ina Drew, JPMorgan's chief investment officer resigned, and then offered to pay back part of the compensation she had earned with the company. Jamie Dimon, the company's chief executive officer has recently overhauled the division and replaced many executives. The bank has stated that Craig Delany is now its new chief investment officer and will report directly to the new co-chief operating officer Matthew Zames. An internal memo stated that Delany will now manage the bank's mortgage servicing rights. The bank has also stated that the three London managers and traders who were responsible for the bad trades are not with the firm any longer, and the bank will attempt to recoup their pay. Levin's senate panel is known to be extremely thorough in their investigations and will often spend years checking documents, interviewing witnesses, and issuing subpoenas. The same panel investigated Wall Street for two years after the 2008 financial crisis, which resulted in a report that was over 600 pages in length and put much of the blame for the crisis on large banks.

Cheap Bets

Assuming investors are capable of learning, they can react in one of two ways to the conundrum of investing in financial companies. One defensible way to act on this knowledge is to abstain from investing in financials. Another way is to keep investments in financial companies small, and only when they are trading at compelling discounts, which can justify taking on risks.

Consider the following valuations of bank stocks that are plaintiffs in the LIBOR class action lawsuit:

Ticker

Company

Country

P/E

P/S

P/B

P/FCF

[[BAC

Bank of America

USA

10.29

1.68

0.43

7.21

[[BCS

Barclays

UK

19.09

1.4

0.55

1.04

DB

Deutsche Bank

Germany

11.83

1

0.59

2.45

C

Citigroup

USA

11.14

1.6

0.61

2.8

LYG

Lloyds Banking

UK

1.15

0.64

JPM

JPMorgan Chase

USA

9.13

2.84

0.82

CS

Credit Suisse

Switzerland

57.71

1.31

0.83

1.02

UBS

UBS

Switzerland

18.61

2.83

0.86

0.57

HBC

HSBC Holdings

UK

11.57

2.96

1.08

WFC

Wells Fargo

USA

10.84

3.73

1.18

RY

Royal Bank of Canada

Canada

12.26

4.04

1.95

RBS

Royal Bank of Scotland

UK

1.5

2.2

Wells Fargo was added as a contrast to this list since it is a bank that is considered "safe."

The valuation differences that exist in the news can be exploited to make smart bets on banks that are currently considered scandalous while avoiding paying a premium for the illusion of safety in other bank stocks. Bank of America, Barclays, and Deutsche Bank are trading at price-to-sales and price-to-book multiples that are near or under one-half of those of Wells Fargo. These three companies are also all cash flow positive.

If an investor seeks exposure to financial companies, she should accept that unpredictable risks and huge losses come with the territory. At the very least, Bank of America, Barclays and Deutsche Bank make for cheap speculation.

Source: Banking 101: How To Play This Risky Sector For Profits