Twenty-eight months into the bull market that started in March of 2009, the S&P 500 has risen by 97%. Believe it or not—and this might come as a surprise to some of you—the financial stocks have actually participated in the rise! The S&P Financials are up by 149% from their lows, while the KBW Bank Index is up by 161%.
Yet despite that outperformance, the financials don’t have a lot of fans among investors. Take a look at the holdings of the 25 largest U.S. equity mutual fund managers. Almost all of them are underweight financials, particularly the banks. And more recently, the financials and the banks have both lagged. The financials have pulled back by 14% from their recent high while the banks are off by 21%, compared to just a 4% pullback in the S&P 500.
I mention all this to provide some context for the view I’ve had of the stock market (and the financials in particular) for some time: the bull market in stocks still has a long way to run. Banks, I believe, will be at the forefront.
In the last month, I’ve had the chance to sit down and talk about the financials with two of the greatest investors of our lifetime: Bill Miller of Legg Mason and Chris Davis at the Davis Funds. Both are of course long-term, value investors—and both are very positive on the group.
Let’s focus on the banks, first. I’ve said for some time that the bank stock bull market would have three legs. The first lasted a year, and reflected investor recognition that the banking system wasn’t going to collapse, after all. The second, which we’re in now, would be driven by a return to normalized earnings and valuations. The third leg of the rise will be driven by the deployment of banks’ excess capital.
As I say, we’re in the middle of the second leg now. Sure enough, the early second-quarter reports that have come out have shown that the banking industry’s earnings are recovering strongly, as credit problems ease and economic activity picks up generally. Yet earnings recovery or not, the valuations of many banks, especially the ones that were most stressed by credit, haven’t expanded much from where they were at the depths of the crunch.
So the most attractive opportunity I see in the group today is in what I’ll call “credit-recovery” banks. These are the banks that had severe credit issues that are being steadily fixed. My favorites are companies in the $1 billion to $30 billion asset size where we’ve done extensive work on credit, and have confidence that recoveries are real and durable. Among our favorites (both of which we own, by the way) are Citizens Republic (CRBCD) and Mercantile Bank (MBWM). Both should report strong recovery earnings over the next two weeks. What’s more, in coming quarters they should recover huge deferred tax assets, which will significantly boost their GAAP tangible book values, as they demonstrate sustainable profitability.
Among the big banks, meanwhile, one name among our positions deserves a mention: Bank of America (BAC). Longtime readers know that I haven’t had a lot of good things to say about BofA for, oh, the past 20 years or so. Even now, no one will confuse BofA with a growth company. But the stock has gotten hammered so badly that BofA’s franchise is worth considerably more than the company’s current market value.
To see what I mean, take a look at one quick-and-dirty bank valuation measure: market cap plus preferred as a percentage of assets. Among the big banks, BofA is at the bottom of the heap:
On other standard valuation measures, BofA sticks out as well. The stock trades at 5 times its normalized earnings, and 76% of its tangible book value. There’s no doubt, then, that investors aren’t optimistic about the company’s long-term earnings outlook.
Those doubts notwithstanding, the fact is that the company faces only one major—and well-known— problem: its credit and legal exposure to future residential mortgage loan losses. I won’t go into a detailed discussion here of why I believe future losses from litigation not already taken or reserved for are manageable (they’ll be under $10 billion I believe). But if you want to read some great research on the topic, take a look at the work that’s been done by John McDonald of Sanford Bernstein.
If you can get comfortable with BofA’s future residential mortgage loan costs, the company has a lot of things going for it that investors don’t seem to be properly appreciating.
- Powerful pre-tax, pre-provision earnings. BofA currently earns close to $40 billion a year pre-tax, pre-provision, and pre-mortgage litigation costs. This is the fuel that will enable the company to burn through future mortgage related expenses.
- BofA has already put aside huge reserves for mortgage losses and related litigation costs. The company has a $ 40 billion loan loss reserve and several billion dollars worth of litigation reserves. The former is already coming down, and that will continue for several quarters, which should in turn drive higher earnings. The latter will come down when the end of the mortgage mess is in sight.
- Credit is improving. Commercial and consumer credit, ex-residential mortgage loans, is clearly getting better. This trend should continue. Even mortgage delinquencies appear to have peaked.
- BofA’s net interest margin is set to improve. No other bank I know of has as high a percentage of its funding mix be long-term debt. This debt should decline all year, which would help the company’s margin this year and next.
- Bank of America has an efficiency plan in place. After credit improvement, BofA’s highest priority is better cost efficiency—and the company has put in place a major initiative to achieve it. The positive impact from this effort will be seen in coming quarters.
BofA of course has some challenging longer-term problems. I am not suggesting otherwise. What I am suggesting, though, is that the negatives are well-reflected in the company’s valuation, while the positives (and there are more than a few) are not.
Catalyst?
“So what’s the catalyst?” for bank stocks overall, or Bank of America in particular, investors will often ask. Usually I answer, “Who knows?” It’s hard enough to find attractive investment opportunities. Predicting what will make them go up is impossible. For value investors like Bill Miller and Chris Davis, the catalyst is simply BofA’s incredibly favorable risk/reward profile. Some day down the road—who knows when?--some relatively insignificant event will occur that will cause investor sentiment to slowly begin to change, and BofA’s valuation will at last start to edge higher. Smart value investors don’t wait for that unpredictable moment.
Banks vs. Tech
Investor sentiment toward the banks today versus the tech companies reminds me of 1999. It’s crazy! Either banks are undervalued or certain tech stocks are overvalued, or both.
Let’s take one example. Fifth Third (FITB) has a market cap of $11 billion, while LinkedIn (LNKD) has a market cap of $10.4 billion. Fifth Third trades at 1.5 times its revenues, while LinkedIn trades at 43 times revenues. When Fifth Third reports its earnings—yes, earnings--this week, they’ll be higher than the revenues LinkedIn is apt to generate for the entire year! In fact, Fifth Third will pay out more cash in dividends to shareholders this year than LinkedIn’s revenues will be for all of 2011!
Just like in 1999, the valuation disparities that exist today between the banks and some tech companies (either public or soon-to-be-public) likely are not sustainable. And just like in 1999, I can’t tell you when the mismatch will end, but it will, that’s for certain. In the meantime, I like the investment risk/reward tradeoff today much better owning bank stocks—even one I haven’t liked for decades, Bank of America.
