Similarly to 2011 during the European Crisis, banks have sold off aggressively across the globe during this global bear market. Financials in general are often viewed as a proxy for investor confidence. Due to the absolutely traumatizing experience that bank shareholders’ experienced in 2008, it is very easy to cause panic in the sector over the short-term, which can be frustrating but that also opens up some of the best investment opportunities if you know what you are doing.
In 2008, we faced the biggest recession since the Great Depression. Housing plummeted. That is the biggest issue that occurred! There was a pervasive belief that housing prices only went up, which seems crazy but we all remember how people talked about things back then. Now, there were other elements that compounded the problems. Mortgage debt was by far the biggest exposure for banks and this was further exasperated via exotic structures such as collateralized debt obligations (CDO) and off-balance sheet assets called structured investment vehicles (SIV). This enhanced the leverage that the banks had and when you are dealing with rapidly declining assets on the biggest portion of your balance sheet, with leverage, you have a recipe for major problems. In 2008, banks had less than half the capital that they have now. For companies such as Citigroup or Bank of America, this equates to many tens of billions of dollars. In addition, liquidity is more than double what it was then. Companies such as Lehman Brothers and AIG that lacked deposit bases’, went bankrupt or basically went bankrupt via liquidity squeezes more than anything. Bank of America for instance, can now fund itself for over 3 years without accessing capital markets if it wanted to. Liquidity is not an issue.
In the beginning of 2009, members of Congress strongly advised FASB, the federal accounting board, to put an end to mark to market pricing on loans. This change basically marked the bottom of the stock market and led to a massive rally in the banks. There are opaque derivatives called credit default swaps that can be bought to insure against default on a company, securities, or CDOs etc. These swaps are done over the counter (OTC), which means that liquidity is very low and often these are very small markets. Short sellers could aggressively buy credit default swaps on banks, jacking up prices and spreads on their debt, while also shorting their stocks. This created the sense that the companies weren’t credit worthy and greatly exasperated the situation. It also artificially depressed loan values on mortgage backed securities to levels far below the discounted cash flow levels, or intrinsic value of the securities. Combined, these factors forced the banks’ to take much larger losses than what they would have taken, and made them raise capital at depressed levels. Once mark to market accounting was eliminated on loans, banks were able to mark the assets at their true market prices based on future cash flows, as opposed to some artificial figure based on a credit default spread. This stopped the negative feedback loop, which caused the massive dilution and poured gasoline on an already explosive fire.
I realize that this is very complicated, but the issue is important to understand. Now banks have more capital than they have ever had. They no longer have the SIV exposures. Underwriting quality has been far greater and there has been virtually no market for CDOs or other synthetic securities. Real estate and consumer credit, which are the most important areas for the banks are stronger than they have been in many years. Energy and mining exposures are the key trouble areas for the banks, but for the big banks’, these loans only account for about 2-3% of total loans. Assuming the worst case scenario possible, we are talking about a 5-10% hit to earnings per share based on these problem loans. As I’ve mentioned before, many are investment grade, almost all are asset backed and are senior to bonds in the capital structure, meaning that even in a bankruptcy the loan might still be good. Sure if there is a major recession and the yield curve stays flat, earnings might be down a little more than 5%, but we are still talking about a trough P/E ratio of about 7 that is insane, considering the earnings potential of these businesses.
Now in this market panic, just about all stocks are down big. Whether it is Apple, or Disney, or Netflix, the selloff has been severe. Banks have been no exception. Similar to 2008 and 2011, credit default swaps are being bought jacking up prices in these illiquid markets. This can cause the bonds of banks to sell off, as was the case for some of the European banks, which are viewed to be less strong relative to the U.S. banks. For a company that needs immediate access to capital markets, this can be problematic as it raises the cost of funds. That is where the increased capital and liquidity come into play. Now let’s say a bank’s senior bonds sell off to 90 cents on the dollar, which would be very concerning as it implies that market participants believe the bank might have major issues. If the company is well capitalized and extremely liquid like all of the big U.S. banks and most of the European ones, the bank can buy back the debt and pocket the discount as a profit, bolstering earnings! That eliminates the discount and will also reduce credit default swaps pricing, reducing the pressure put on by short-sellers.
This is what Jefferies did when short-sellers spread rumors about its financial health in 2011 and the stock plummeted. Their management team was very smart and bought back debt at a discount and the stocks and bonds rallied making us a great profit, as we bought the debt and equity too. The big U.S. banks’ are far stronger than Jefferies or any of the European banks that are also now deploying these same tactics. These stock declines happen in a bear market and they are to be expected once every 5 years or so. This is why the fundamentals matter. You can’t liquidate Citigroup for less than $60 per share, or Bank of America for less than $20. These companies have the capacity to continue generating strong profits even in this adverse scenario. Higher interest rates don’t look like they are happening this year. Let me release some breaking news, interest rates have been quite low for some time and the banks have still been making a ton of money!
I don’t know when the panic will end but I do know that it will and that we are right. This is one of the best buying opportunities I’ve seen since 2009. I’ve seen nothing that has changed my opinion and believe me I’m constantly researching and looking at the data. When confidence returns, so will the stock prices. At these discounts to tangible book value, the companies could earn paltry returns on equity and still raise their dividends to yields, which could be 4-5% conservatively. Most likely though, they will do the smartest thing and buy back stock aggressively. Management in most of our financial stocks have been big insider buyers of late. For an example of what I mean, let’s look at Citigroup which trades around $37 and earned $5.40 per share in 2015, which is still way less than its $7-8 of earnings per share potential. Let’s say the company decided to pay a dividend of 50% of its earnings, which would be $2.70 per share. This isn’t unrealistic because the bank is already overly capitalized. That would result in a yield of around 7.2% even though we are talking about trough earnings. The other alternative is the company can buy back its stock, which will dramatically increase the per share intrinsic value. Basically think of it as Citigroup buying dollars for 60 cents and the dollar is accruing interest. The price is volatility, as we have seen that 60 cent dollar can still go to 50 or 40 cents in the short-term.
A couple very intelligent clients have asked me, “Tim, if the value is so good, how do the stocks get so cheap.” The answer is as follows. In the short-term, the market is simply a popularity contest based largely on emotion. The majority of trading is done via algorithms and ETFs, where valuation is not important. This can drive prices very far and very fast. It is simply volatility. It is not fun, but nor is it something to be scared of as a long-term investor. It is an inevitability when you buy common stocks, as even fortress companies such as Berkshire Hathaway have sold off by over 50% on several occasions over the years. As earnings come out, dividends and stock buybacks are raised and market conditions normalize, stock prices will once again converge with intrinsic value. It might just take a few months, or it might take a few years. The timing is difficult to predict but there are clear catalysts for the financials that we own in that they are overly capitalized and can aggressively buy back stock at huge discounts, which will create enormous book value growth. There is no doubt that fear rules in the current environment. As FDR said, “the only thing to fear is fear itself.” In my roughly 15 years working in finance beginning in college, I’ve worked with many thousands of clients; I can’t name one that made the right decision by panicking and giving in to emotion. There are people that have gotten out before the selloff got worse, but then didn’t get back in until the market had rallied to much higher levels, but even those stories are rare. Imagine getting out now and then the market rallies a few percentage points. Is that a suckers rally or is it the start of the big rally? How do you know? Most people just get chopped up or get paralyzed because they don’t have the basis of fundamental value to work from. We just need to stay focused on fundamentals and take opportunities as they come. Ignore the noise, which is meaningless over the passage of time. Thank you very much and please let me know if you need anything at all!