Shockingly, financials (as represented by the XLF ETF) are valued lower today than they were in the fourth quarter of 2009, a time when asset quality was unknown and the very survival of the financial system was in doubt. This makes no logical sense.
The current fear, caused by the emotional scars inflicted on investors who lived through a life?altering crisis in 2008-2009, is creating a wonderful opportunity for the rational investor.
[For the bulk of this article when I refer to financials broadly, I am referring to primarily U.S. money?center banks and investment banks—the classic candidates for SIFI classification (Systemically Important Financial Institutions). Many other areas within financials are arguably materially cheaper but have their own unique metrics and characteristics.]
Why bullish? First and foremost prices are low—in several cases irreplaceable franchises are trading below tangible book, e.g. Bank of America, Citigroup and Morgan Stanley.
Tangible book value is realistically considered the liquidation value for a financial institution. When Mr. Market prices a bank below TBV, it means one of three things: 1) that the franchise has negative ongoing value, 2) that the TBV is wrong/misstated or 3) that Mr. Market (our manic-depressive friend) is so scared that he is giving the rational investor a gift. It is my opinion that this last condition holds true today.
In early 2009, it was unclear if the financial system was going to survive. No one knew what any of the assets on banks’ books were actually worth and panic reigned. The prices of financial stocks reflected all of that uncertainty and stocks of leading financial institutions were tremendous buys. Bank of America traded under $3/share, Wells Fargo traded under $10, Goldman Sachs touched $48 and Citigroup printed $9.70 (split adjusted).
Those prices represented a once-in-a-generation opportunity to compound wealth. But there was real (if remote) risk of losing everything. Today the risk of total loss in these same institutions is virtually nil.
Capital levels have gone from low to high by any historical measure. Core earnings are intact and robust. The competitive landscape is dramatically diminished (think of all the institutions that are gone, not to mention the virtual elimination of shadow banking). Balance sheets have had two-plus years of scrubbing by regulators and auditors as well as two-plus years of burn?down and seasoning of poorly underwritten legacy assets. At this point, balance sheets are cleaner than they have been in many years.
So while the dramatic multi-bagger upside that occurred post March 2009 may not be available today, the current risk is also commensurately less. I would posit that the opportunity (viewed with at least a one- to two-year investment horizon) is nearly as compelling on a risk/reward basis.
I am further comforted that, while clearly in the minority, I am not alone in this view. Certain investors with superlative long?term track records have had notable drawdowns recently due to their investments in financials. Two that immediately come to mind are Bruce Berkowitz and John Paulson.
Still, there are reasons to be fearful, and it is important to address them. So as Charlie Munger likes to do, let’s invert these arguments and see what we get.
Is Greece really the next Lehman?
Fear #1: Greece. Greek default is going to lead to a Lehman?like contagion!
Response: I just do not see how that is possible. However, just last week I had conversations with two different macro PMs that I have known for years. The conversations went something like this:
“Greece is going to be bigger than Lehman!” said my friend.
“How?” I said. “Their total debt outstanding is only roughly 250 billion euros. Even haircutting that 50 percent is only 125 billion euros, and the global banking system’s annual earnings are many multiples of a number like that.”
"...but the contagion!...“ my friend said.
“OK, all the PIGS together have about 1.3 trillion euros of debt. If you haircut Greece’s debt 50 percent and the rest of the PIGS 20 percent, you get about 400 billion euros of loss. Still sounds manageable.”
“Yeah, but the CONTAGION!!”
The fear argument is hard to counter. But the reality is that many countries have restructured debt in the past without sinking the global economy. Greece’s restructuring has been telegraphed for over a year so would not be a surprise/shock to the system. By comparison, the debt crisis of 2008-2009 has been estimated at $2 trillion globally and was an unanticipated broadside to the financial system
Fear #2: Regulation. Regulation is going to stifle banks’ ability to make any money.
Response: Impossible. Even a worst?case scenario result in which the financial industry is highly regulated (think utilities) would not be so bad. In this situation an investor should expect a 10 percent ROE and a smoother earnings stream. It is possible that SIFI capital requirements and regulation could materially dampen returns. However, they should also smooth those returns. The capitalization requirements and the implicit government backing may eventually lead to a premium multiple (relative to history).
Fear #3: Housing. Housing will have a double dip and crater bank balance sheets with another wave of defaults.
Response: Not a chance. Affordability is currently at or near record levels. Pre?2008 loans have seasoned. All of the pretender/faker loans and "jingle mail" have been worked through. Loans since 2008 are very conservatively underwritten. According to mortgage insurers and underwriters, the only way to spike defaults is to spike unemployment to a new high. This plays well into the next fear.
Fear #4: The Fed is out of bullets. The Fed is now impotent and will watch idly by as the economy craters.
Response: This is crazy. As a student of the Great Depression, Big Ben understands the pernicious consequences of deflation and contraction very well. As he has articulated in his past criticisms of the BOJ, there are many weapons for a central bank to use against this type of outcome. In the end, inflation/deflation is a monetary phenomenon.
Given the recent crisis, the Fed is on the equivalent of "code red." If the economy starts to actually contract, we can expect QE3-QE10 and even more aggressive purchases of higher risk assets. The Fed’s vice chairman, Bill Dudley (a colleague of mine from my Goldman Sachs days) is fully on board with this view as well.
Fear #5: Obama. Obama and the Democrats are going to sink the economy.
Response: I do NOT like the way Obama handled the General Motors restructuring or the oil?permitting situation in the Gulf or the recent FLRB blocking of the Boeing plant in South Carolina. He clearly is not sensitive to business having never been a businessman. However, with Nancy Pelosi gone from power, a split Congress and an upcoming re?election campaign, the President has every incentive to migrate more to the center. That means becoming incrementally more pro?business.
Whew…. While all of these fears have merit, current stock prices for financials discount severe outcomes that will almost surely not occur. Therein lies the opportunity.
To understand just how depressed sentiment has become, one need look no further than the Michigan Consumer Sentiment numbers. Levels today remain lower than at any time since the depths of the 2008-2009 crisis—lower than the 2002 recession, the 1998 crisis and any time in the 1990s. Thus it is no surprise that investors today are running away from double?digit earnings yields and sprinting towards miniscule yields in “safe” treasuries.
Interestingly, the opposite was true in 2000. Stocks in general traded at astronomical multiples to low-quality earnings, and treasuries were at 6 percent with an inverted yield curve. Now earnings are much higher quality after the last decade?plus of cleansing (driven by newfound conservatism in management, auditors/accountants, and regulators). Yet, investors are over?weighted in cash and fleeing to the safety of treasuries.
In the end, this is pretty simple and I am reminded of two adages: "Don’t fight the Fed" and from Warren Buffet, "be fearful when others are greedy and greedy when others are fearful." Clearly this is a time to be greedy.
Disclosure: At the time of publication, accounts that Mr. Helmers oversees hold positions in the securities referenced in this article.
John Helmers has been active in the markets since the late 1970s. He has had stints trading or managing money for JP Morgan, Goldman Sachs, Tudor Investment Corp and Citadel. He currently is the principal of a private investment firm, Swiftwater Capital.