Too Big To Value

Includes: BAC, C, GS, JPM, MS, WFC
by: The Sociology of Finance

Few people have the ability to value the common stock of megabanks. Each bank has hundreds of subsidiaries and thousands (perhaps millions) of trading positions. The value of each position is marked according to what management says it is worth, which is problematic in two ways: 1.) This is often just a guess 2.) Management has incentives to fudge the numbers. This became all too apparent in recent congressional hearings, in which JPMorgan (NYSE:JPM) executives admitted that the company moved the valuation goal posts to hide trading losses during the London Whale fiasco.

That megabank executives can cook their books with impunity is troubling, but as a potential megabank investor, I'm worried even more about the first problem: the people running the show are not as smart as they would like us to believe. Bank executives, Wall Street analysts, regulators, and professional investors all have partial information about these sprawling financial empires, but their understanding of how all the pieces fit together is actually pretty tenuous.

We all know this to be true, but sometimes the most obvious investment truths are hiding in plain sight. After all, who would really be shocked if they opened the newspaper sometime in the next year to find that one of the megabanks just vaporized $10 Billion in shareholder wealth on "hedges"? Or that common stock holders in one of the megabanks would be totally wiped out in the next five years?

I am writing this because there is a growing chorus of articles on SA trumpeting megabanks as value investments. Evidence cited in favor of this perspective usually includes valuation metrics such as P/E, P/B, and macro factors like the improving economy. While there are many bargains in the financial sector right now, investors should draw a distinction between financial companies that can and cannot be valued. Megabanks cannot be valued because opacity is their business model. From byzantine corporate structures to flawed public disclosures to exploiting information asymmetries in dark markets, these banks cannot operate in an environment of real transparency.

Even the information that megabanks do release to the public is impossible to fully process. Here's the disclosures the big banks made in the last year compared to other corporate giants:


Pages in 10-K filing

Number of additional exhibits

JPMorgan Chase (JPM)



Bank of America (NYSE:BAC)



Wells Fargo (NYSE:WFC)



Citigroup (NYSE:C)



Goldman Sachs (NYSE:GS)



Morgan Stanley (NYSE:MS)






Exxon Mobil (NYSE:XOM)



Berkshire Hathaway (NYSE:BRK.B)



Including all the footnotes, appendices, and exhibits in the page total easily doubles or triples the size of the main 10-k documents. How many people have read these things cover-to-cover, much less really understood them? The problem is that investors just do not know which buried footnote foreshadows the next blowup, or which numbers are simply make-believe. Management may not know either.

I am not arguing in principle against investing in complex companies or companies with uncertain futures. Apple has an uncertain future because its product cycle is short and it is hard to know where its industry will be in five years. Exxon Mobil has an uncertain future because its business is sensitive to commodity prices and is exposed to environmental disaster risk. Berkshire Hathaway is complicated because its portfolio includes dozens of operating companies.

What makes these companies different than megabanks, however, is that important information about the company's sales, balance sheet, profits and so on is basically knowable. Investors can learn about the company in its filings, research broader industry trends, and then assign the company's stock a value. The problem with the megabanks is that they are totally opaque and the range of possible stock values therefore needs to include $0.

This fact was all too clear in 2008, but is being forgotten. In the rush to celebrate improving quarterly numbers, many are forgetting that most of these banks were still reporting profits when they were days from bankruptcy. There is a reason why no other industry or business model works this way.

Avoid the Megabanks

As far as I am concerned, if it is impossible to come up with some sort of concrete value for a company, its common stock cannot be a good investment. Maybe megabank stock prices will go up or go down, but such gains or losses would be entirely speculative. If your last name is Buffett and/or you can get a sweet deal on preferred stock, then maybe an investment makes sense. But if most investors are honest with themselves and their valuation abilities, buying megabank stocks is like playing a slot machine: you insert your money into a big flashy device, and hope the machine spits out more than you put in. Why do you think this will happen? The machine has a sign on it that says you can win big, and you see others around you winning.

Perhaps investors could put an opacity discount on megabanks and go from there, but the problem is that we have no idea how big that discount should be. Just like bank liquidity, opacity won't be an issue until it suddenly is. By avoiding megabank stocks, you may miss out on some big run-ups, but doing so can go a long way towards reducing portfolio risk. Whenever investors are tempted to buy stock that seems cheap in a company they don't fully understand, they should look into a mirror and repeat: "Keep it simple, stupid!"

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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