The crisis among financials in general and banks in particular is one of the worst-kept secrets around. Less clear, however, is an appropriate investment strategy. Market veterans have seen many groups over the years recover from many crises and know the time to buy is when things still look bleak. But they also know how painful it can be to jump in too quickly. Lately, buying interest in banks has picked up, leading one to wonder if now is the time to get in.
Light at the end of the tunnel?
Notwithstanding all the noise about securitization, structured derivatives, aggressive hedge funds, and so forth, the nature of the U.S. financial crisis is actually quite easy to understand: too many companies got too enamored with growth and too cavalier about risk and loaned too much money to borrowers who couldn't repay and supported those loans with security interests in assets whose so-called values proved unsustainable.
Sub-prime mortgages are an old story, and by now, it looks like the world at large is well aware of problems with other categories of lending. Throughout the financial sector we've seen write-offs galore, shotgun mergers (Will Lehman Brothers (LEH)be next?) , and the announcement of a sort-of nationalization of Fannie Mae (FNM) and Freddie Mac (FRE) which suggests that right or wrong, for better or worse, Washington is determined to avoid letting the whole thing go completely down the drain.
All this raises the classic investment question: whether enough bad news is already out there to justify buying in anticipation of the next upcycle. Judging by the performance of two bank-oriented ETFs, SPDR KBW Bank ETF (KBE) and SPDR KBW Regional Banking ETF (KRE), it looks like many are answering in the affirmative. KBE, focusing on larger money center banks, after having fallen 52.55 percent from its 2/20/07 peak to its 7/15/08 trough, closed yesterday 57.8 percent above its bottom. KBR, the regional offering, moved pretty much in lockstep, falling 57.50 percent from peak to trough and bounding 52.38 percent from the low.
I'm not such a banking expert as to suggest I can predict if any more shoes are yet to drop, or if so, how many. (I'm not sure that's such a handicap considering how many more knowledgeable people failed to call the top.) But based on some research conducted on Portfolio123.com, I am able to discern a significant and potentially actionable change in Wall Street's approach toward bank stocks.
Conservative criteria for ranking bank stocks
Assuming I'm right in assuming that over-aggressiveness has been at the root of the problems seen in banking, it would seem possible to construct a ranking system designed to favor conservative (relatively speaking) banks. I would expect such a system to have done a poor job in picking winners during the recent heyday, when profit maximization was the mantra and risk was on the back burner, but to have performed much better more recently, as things came apart.
Here are the factors I used:
- Trailing 12 month growth in Interest Income: For banks, this is the equivalent of sales growth. Usually models incorporating sales growth equate higher growth to higher desirability. This model does the reverse, it favors lower levels of growth. That's consistent with the notion that much of the trouble we've seen relates to the aggressive pursuit of more and more growth. Standing alone, this would not appeal to even conservative investors, who may frown on aggressiveness, but don't want the other extreme either. But here, lesser growth does not stand alone . . .
- Trailing 12 Month Lending Margin: This is net interest income divided by interest income. The difference between the two is interest on deposits, borrowings and securities held. Arguably, the conservative investor would be more interested in seeing the margin after deduction for the loan loss provision, but I elected not to do that here, since the latter item is likely to surge suddenly nowadays, making it difficult to draw conclusions from past histories of moderate results. I'd rather, instead, model an overall conservative mindset, one that would, hopefully, make the bank less prone to future jolts in the loan loss provision. Unlike the case with income growth, with margin, higher tallies equate to more desirability. Putting this factor together with the first, I'm more interested in banks that lean toward slower but profitable growth, as opposed to those who slash margins to "buy" lending share.
- Equity Multiplier: This is total assets divided by equity. The model favors lesser tallies, which signify lesser tendency to use leverage. This is viewed relative only to other banks. (Even the most conservative banks normally work with more leverage than the typical industrial firm.)
- Trailing 12 Month Return on Assets: This is a very standard measure of overall corporate profitability, and consistent with normal usage, higher tallies are favored here. For industrials, I'd be more likely to use Return on Equity of Return on Investment. But for banks, it's more useful to look at the entire asset base, especially since this model includes the equity multiplier and, hence, is not ignoring the issue of leverage.
The factors were equally weighted and were applied to banks whose shares are included in the Russell 2000 index, a generally less famous/infamous group that seems more likely to trade on the basis of reported fundamentals rather than headlines, gossip, emotion, and so forth.
Back-testing the system
Figure 1 shows the results of a Portfolio123.com back-test focusing on 3/31/01 through 12/31/06, when return seemed to have been exalted over risk. The left-most red bar represents the annualized performance of the S&P 500. The second, blue, bar represents the banks rated in the bottom 10 percent, The right-most green bar depicts the annualized performance of the banks stocks rated in the top 10 percent.
Figure 1: 3/31/01 - 12/31/06
The results show that in the recent heyday of banking, a model geared toward conservatism would have been essentially useless in helping to identify potential stock market winners. If anything, there's was modest tendency for stocks with lower ratings to have performed better, suggesting that the Street, to the extent it considered risk at all, was perfectly content to see it dialed up. This is consistent with my initial expectation.
Figure 2 picks up the story as we move toward the present, the period when risk re-asserted itself in an often-painful manner.
Figure 2: 1/1/07 - 9/9/08
What a difference a time of reckoning makes. The ten groups aren't in perfect performance order, but it's clear that during this time period, the model is providing us with useful information. As we know, the market as a whole is down and the overall bank group fell further. But now, it's clear that investors who want to own banks are identifying aggressive strategies and running in the other direction.
Figure 3 takes a closer look at a more recent slice of time and continues to show that banks have underperformed a weak market but that within the group, investors are emphasizing conservatism, and now, to a slightly greater degree than we saw in Figure 2.
Figure 3: 7/31/08 - 9/9/08
Interpreting the results
One way we could react to a model like this is to buy highly rated bank stocks hoping they'll continue to rally but expecting that if more bad times lie ahead, as would seem likely if we get more Lehman-like news, the stocks we own would suffer less.
We might also view a model like this as providing something of a sector signal.
It would be nice to think that bankers and investors have learned their lesson and will be more prudent in the future. Realistically, though, I wouldn't bet the farm on that. This isn't the first time over-aggressiveness got banks into trouble, and absent very substantial new federal legislation (a comprehensive scheme of day-to-day business regulation, as opposed to one-off crisis remedies), it probably won't be the last. If that's so, it seems reasonable to assume this model will cease to identify better performing bank stocks once investors start looking past the crisis. In that case, when the lesser-rated stocks outperform (or even improve substantially relative to) higher-ranked stocks, one might take that as a signal that the bank group as a whole is more buyable.
The latter interpretation would suggest that what we saw with the aforementioned bank ETFs was more in the nature of the dead-cat bounce. Unless you are willing to assume we're in a new era where conservatism will prevail even in better times (an assumption I'm not yet ready to make), we'd have to expect a sustainable upturn to incorporate more willingness on the part of investors to own the aggressive banks.
Here, in Tables 1 and 2 respectively, are the current listings of high- and low-rated Russell 2000 bank stocks.
Disclaimer: The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of Portfolio123.com, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.