Two months ago I wrote this piece on selling most of my REITs to buy banks. Except for the idea swapping Realty Income (O) for Wells Fargo (WFC), it was about as timely a sector call as I have ever executed or suggested. Even the WFC for O swap, ironically, did quite well with WFC down about 6% and O down about 12% since the article, evidence that valuation and powerful sector influences can overwhelm almost anything particular to a stock.
For full disclosure, I bagged my large Wells Fargo position as described in this article this article. I kept only reduced positions in two health care REITs, but the major thing I did was to materially ramp up positions in Citigroup (NYSE:C) and Bank of America (NYSE:BAC).
My thinking then was that the bond proxy trade had pretty much reached its limits, making all defensive areas of the market wildly overpriced. Seeking Alpha articles served as a helpful contrarian indicator. I would estimate that at least half of SA articles over the past year had featured desperate efforts to generate income (many of the rest being about wildly overpriced growth stocks). It made sense to look for market sectors dwelling in the dungeon: thus, banks.
This piece is a focused statement of the investment thesis for Citi and BAC: five reasons, four risks, and the perspective of three time frames. I am happy when I can find several considered and solid arguments for buying a stock (not one reason and several weak reinforcements), especially when any one could potentially stand on its own merits. I also like to consider a potential purchase on multiple time frames, from looking backward at charts over various periods to considering future opportunities and risks over the short, intermediate, and long term.
The following are my thoughts on C and BAC. Their operating prospects have been well-examined in many SA articles, so I will stick to presenting the investment thesis.
The Five Reasons To Buy Citigroup and Bank Of America
1. They are statistically cheap.
Banks are one of the few statistically cheap sectors of the market (housing and energy being the others, one of which I like, one of which I don't, neither of which offer the same diversity of arguments as the "bad banks").
By statistical, I mean the kind of cheap suggested in the bible of statistically driven investing, David Dreman's 1979 book Contrarian Investment Strategy. Dreman used quintiles and simply advocated buying the market's cheapest quintile by price to earnings, book value, or sales. Period. He suggested a strategy in which you don't even look at the individual companies. Trying to analyze individual companies undercuts the statistical approach.
Dreman presented quantitative tables demonstrating that the cheapest quintile of the market beats all others over all but the shortest time frames. The most expensive quintile, overly loved, trails all others in returns. I don't use his principles quite that rigidly, but my overall portfolio PE, just to suggest my approach, is currently around 12 or 13, barely over half the market PE.
REITs seemed priced as that kind of value when I bought them in late summer 2014 but (with two health care exceptions) wildly overpriced by July 30. Banks with a PE lower than 10 and selling well below tangible book value are now, in my opinion, statistically cheap. They are cheap in the current overpriced market and probably cheap in any market. They are also cheap even when compared to the modest historic valuation of major banks.
The statistical approach seems to work well in all market conditions. In the aggregate, the prospects of the cheaper quintile of stocks and sectors are rarely as bad as the accepted story line, while the future of expensive stocks is rarely as good as the accepted story line.
Whether the immediate future is a reinvigorated bull market or a bear market, being statistically cheap makes relatively good performance more probable. For that reason the time frame for buying statistical cheapness is: ALWAYS.
2. The bad banks have been scourged.
The largest banks have had the fear of God put into them. That's both the regulatory god and the market god. Click Citi and BAC and look at their market charts over the longest interval (kudos to SA, by the way, for the new and useful advanced charts). Both C and BAC look like popped balloons with an L-shaped recovery. Only by gradually shortening the time period is it possible to see the market's slow movement toward a better view of them. BAC CEO Brian Moynihan recently said "that war is over," referring to the struggles with historic losses and regulatory sanctions (see this piece) and the gradual improvement of BAC results makes me inclined to accept his view. Both BAC and Citi are just now beginning to emerge from a terrible dark age.
Most sinners, of course, backslide into their old ways, but not immediately. Severe punishment is a good vaccination against recidivism. Citi and BAC were both punished severely. The time frame within which investors can probably depend upon good behavior from the managements of "scourged" banks is probably SHORT TO INTERMEDIATE TERM.
3. The arithmetic of capital return is an automatic tail wind.
Because they are cheap, capital return (recently granted by the Fed) provides a fantastic opportunity for financial engineering. BAC trades at about .97 of tangible book, Citi at about .75. That means that both - much more C than BAC - can buy back shares accretively within the large amount of capital return allowed as of this year. Although paying dividends seems far less efficient to me, they can each increase their dividends substantially every year without increasing the actual amount of cash-out-the-door. Earnings per share should also rise without an increase in aggregate earnings. In a way the investor might almost wish that the stock price remain static over a few more modestly profitable years - Buffett often says something like this in the case of IBM.
However, the ability to do this for a long time may diminish gradually for a reason that has its own upside - a rising stock price. The time frame over which simple arithmetic works powerfully in the area of capital return is SHORT for BAC and INTERMEDIATE for Citi.
Unless, that is, they fall back to a price further below TBV. The prospect that buybacks may enhance return in a more modest way may be substantially longer - until the shares get overpriced. Most investors are happy to worry about that in the future. Barring that, the arithmetic of buybacks might be LONG TERM.
4. The price action on their charts looks great.
Both Citi and BAC appear to be breaking out. You can see this easily by, again, referring to the new improved SA charts. Both stocks have recently broken above important intermediate-term highs and/or downward sloping lines connecting recent market tops. Better yet, they have recently finished testing their breakout points - see BAC for a classic retest, coming within a few pennies of its breakout at 15 only to turn around and head up again. This is a classic technical analysis buy point.
Do not think that I am a huge believer in technical analysis. Buffett can't make sense of it, and I share much of his view. Its only virtue is that simple use of it often helps with the timing of otherwise well-grounded buy (or sell) decisions.
A modern improvement in the value studies of David Dreman can be found in the work of James O'Shaughnessy, who argues in several seminal books that a better approach than pure value is to select from among the cheapest stocks those with the highest price momentum over various intervals. This, he speculates, may help avoid value traps with permanently broken business models.
Technical analysis accords with the O/Shaughnessy model. It helps if a very cheap stock or sector (like the banks) shows strength by breaking above recent highs. It's as simple as that. I often violate the rule of waiting for a breakout if I have strong conviction about my other reasons - I did this at the time of my July 30 piece - but I am happiest when my positive view of an unpopular sector begins to be validated promptly and never looks back.
Technical analysis of this sort, I should say, is largely SHORT TERM, although I occasionally cast a glance at longer term charts. Technical breakdowns on charts are also a good prompt to reconsideration of a position, and failure of a breakout is one of the more negative chart patterns. Unless I have exceptional conviction I sell when a position is down much more than 7% and share the red ink with the IRS. You can always buy again in a month.
One thing about the present breakout of the banks: they are trading like helium balloons right now, although so far not much noticed. As I write this Citi and BAC are extending breakout highs strongly. If taking this short-term part of the thesis into account, you might wish to act promptly. They may zoom toward last year's highs.
5. A resumption of more normal rates and economic growth will greatly benefit these banks.
Note that I say normalization not a short-term Fed move to increase the Fed funds rate. To my mind, such a rate increase is neither here nor there. It matters only as part of an overall improvement in growth and business lending, with rates naturally rising and yield curve steepening. It is the steeper yield curve, not higher rates per se, that really supercharge bank earnings. More business loan demand doesn't hurt either.
Improvement in the economy with rising rates is the LONG TERM argument for the banks.
What Makes This Thesis Wrong?
1. The short term technical argument for buying might be undercut if, say, BAC traded back down under 15 or Citi broke back under various resistance points or downwardly sloping lines. Since their short term momentum is the least important rationale for buying, and because the longer term rationale is strong, it would not bother me greatly. Time frame: SHORT TERM.
2. The banks might get into trouble despite having been punished so recently - something like revelations that cross-selling abuses were across the board or particular to one or both of these banks. Or Hillary, after the election, might surprise me by taking strong measures to break up or otherwise cripple large banks. This strikes me as unlikely, because of the importance of the banks to the U.S. economy, but you never know. An INTERMEDIATE TERM risk.
3. The economy might continue to muddle along weakly, deteriorate, or even fall into recession. Slow growth and a flatter yield curve would make life difficult for the big banks for a period of time. My overall sense of the most probable future tilts toward a strengthening recovery, but my conviction about this is not high. I do have high conviction that the next recession and bear market will not be as draconic as the last two. The market will probably tumble within a year or two because it is significantly overpriced, but I also think that cheap stocks will do much better than the market as a whole. Recessions happen, but they also come to an end. The risk of recession is in the INTERMEDIATE to LONG TERM.
4. One of the potential problems which bears watching involves fintech entities which challenge all or part of the current banking model. One of the defenses, strangely enough, is the very regulation which often punishes and constrains their actions. Because of that regulation there is general faith that banks will be held to account and forced to make good on most of their commitments to customers.
Banks are unlikely to disappear, but they may look very different in ten years than they do at present. One has only to look back ten years at the emergence of payment processing alternatives to understood ways in which the banking franchise might be chipped away at. At best they will use their superior resources to overcome or buy out rivals. The failure of Wells Fargo management to recognize the threat posed by corruption of the cross-selling model does not speak well of bank management ability to grasp and deal with future problems.
Minimally, banks are likely to feel pricing pressure in many areas of their business. Radical disruption of business models is a theme of our time. The odds historically favor the incumbent, but one can't quite rule out major changes in the way financial business is conducted. Time frame: VERY LONG TERM.
Conclusion
Citigroup and Bank of America are well positioned to do well under various market conditions. In a sense, their performance has been so bad that it is good, putting current management on constant alert and enabling the arithmetic of easy financial engineering to work powerfully because of their low prices. Their low price to earnings, book value, and sales also places them among the cheapest quintile of all stockss. The cheapest quintile is historically the counterintuitive winner over most extended periods and likely to outperform if an overpriced market undergoes a major correction. These banks are also one of the major winners if the economy resumes even moderately stronger growth and the yield curve steepens.
