General Electric (GE) is an incredibly complicated conglomerate which is too hard for mere mortals to manage or comprehend. In this sense, it resembles many financial stocks which also lack transparency. It is also like a lot of financial stocks based on its finance unit, creatively named GE Finance.
Investors who are looking to gamble should require that GE trades at valuations as low as equally-puzzling financial stocks. Investors who sagaciously don't want to gamble should look elsewhere for stock investments.
Segment Losses and Cuts
General Electric has been forced to shrink its finance unit as a result of the financial crisis and its roughly $32 billion in credit losses. GE's Chief Executive Officer Jeffery Immelt pledged to shrink GE Capital after Lehman Brothers Holdings collapsed.
GE's quarterly sales and demand have fallen short of the projected and this is expected to reflect in lower than expected full year revenues. The drops are attributed to reduced demand in the aviation and health care sections. The financial crisis has seen airlines overlook non-essential repairs and this has left GE grappling with markets for slow moving products like jet engines and healthcare imaging. The U.S health-care policy discussion has also negatively affected demand of the latter.
Sanford C. Bernstein's analyst Steven Wonker who stated that the drops had been anticipated admitted to uncertainties. According to Wonker, "We did expect some messiness to the numbers but we thought GE would find a way to pull out all stops and beat estimates."
As GE's Chief financial Officer Keith Sherin indicated, investors and observers however have no cause to worry. According to Sherin, "The lower-than-expected sales and reduced outlook shouldn't obscure GE's strong operating performance."
Bid Rigging at GE Finance and Banks
Three former bankers with General Electric have been sentenced to jail for 3-4 years each on cases of fraud against cities as well as the Internal Revenue Service. The fraud case involves a scheme in bid rigging using municipal bonds. The former General Electric employees, Steve Goldberg, Dominick Carollo, and Peter Grimm were also fined for their involvement in the crime: Carollo and Grimm were each made to pay $50,000, while Goldberg was fined $90,000.
Despite the three bankers' plea for leniency, the judge in the case still handed down the prison sentence in addition to the fine. They had already been found guilty of fraud earlier in 2012 upon the decision of a federal jury. The three manipulated auctions for investment contracts for municipal bonds and, according to government record, gave kickbacks to brokers from 1999 to 2006. These brokers had been hired by the local government, and the bid rigging was meant to increase profits for the three, via higher bids and winning auctions.
This case is only one among many other investigations by federal prosecutors into the municipal bond market, now worth an estimated $3.7 trillion. Corporations such as Bank of America (BAC), Wells Fargo (WFC), and JPMorgan Chase (JPM) are already part of the investigation and have together paid over $600 million in penalties.
Another Day, Another Scandal
This should come as no surprise given the various legal struggles which have embroiled financial companies.
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, UBS (UBS), Bank of America , Citigroup (C), Barclays Bank (BCS), Royal Bank of Scotland (RBS), HSBC Holdings (HBC), Lloyds Banking Group (LYG), Rabobank, Credit Suisse , Deutsche Bank (DB), and Royal Bank of Canada (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.
Unpredictable but Par Course
Bank shareholders should have learned by now that news like this will surface over and over again. 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.
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 (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.
Looking for Cheap Bets
Financial companies are not transparent: they are black boxes with incalculable risks. Mark-to-model accounting and high-failure modification programs cast dispersions on the valuations of bank assets. Similarly, even the smartest investors can become confused by General Electric.
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 stocks that are plaintiffs in the LIBOR class action lawsuit and/or implicated in bid-rigging:
Bank of America
Royal Bank of Scotland
The valuation differences that exist in the news can be exploited to make smart bets on stocks that are currently considered scandalous while avoiding paying a premium for the illusion of safety in their peers. Most of these bank stocks trade at cheaper price-to-book ratios than General Electric. Some of them trade at cheaper price-to-sales ratios or cheaper price-to-earnings ratios. Deutsche Bank is cheaper than General Electric on the basis of all four listed price ratios.
If an investor seeks exposure to financial companies, they should accept that unpredictable risks and huge losses come with the territory. At the very least, investors should consider cheaper firms on this list before considering betting on General Electric.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.