Improving Fundamentals Versus Declining Stock Prices

When investing, the fundamental question is what is the value of the business versus the pricing being offered?  If that value is substantially greater than the price offered, one has a strong expectation of attractive profits and a margin of safety, which means that the investor isn’t likely to lose money over the long-term.  Companies are temporarily undervalued for a litany of reasons.  Perhaps the short-term outlook is not very exciting in a cyclical business.  Maybe regulators are delving out onerous penalties and conditions on a particular sector.  Other times companies are misunderstood and it simply takes time for the true value of the enterprise to shine through.  The one fact that is indisputable, is that stock prices change in  value much more rapidly than the actual underlying businesses do.  If you own a farm or a restaurant that based on the fundamentals you believe is worth $1MM, your valuation is not likely to change based on short-term fluctuations in the stock market.  The same can be said for publicly traded companies, but it is the disconnect between price and value that creates long-term investment opportunities.

Currently global markets are in a severe correction, by far the biggest since 2011 and it is not over yet.  Whether that means another 5% or 10% pullback nobody knows, or it could end later today and mark the beginning of a new bull market.  I personally am more interested in the next 50-100% move than the next 5 or 10% move and I’m very confident for our investments, that move will be higher.  In these issues everybody has an opinion, so somebody is bound to be right at some point but the vast majority of people will be wrong.  We don’t put a lot of effort into predicting these timing issues as it really is impossible to know.  What we do know is that the businesses that we own are deeply undervalued.  By far and away for T&T Capital Management (TTCM) clients’, this is our single best opportunity since fall of 2011.  Frankly, it is not even close.  I truly believe that almost every investment we are in has the potential to appreciate 50-100% over the next 3-5 years from current prices.  We aren’t in the overvalued biotech sector, nor are we significantly exposed to companies reliant on strong Chinese growth for the bulk of their profits.  Instead we are in businesses that trade literally at discounts to their “liquidation” value!  These are profitable businesses and are some of the most systemically important enterprises in the United States.  Most of these companies are exposed to the areas of the economy that are strong and are likely to continue to get stronger over the next several years.

Let’s talk about companies such as Citigroup  (C) and Bank of America  (BAC).  Both of these banks have greatly improved their financial condition over the last 6 years.  They have double the capital and double the liquidity in comparison to where they were prior to the Financial Crisis.  Both trade at meaningful discounts to their liquidation values, despite being quite profitable.  Both companies and the banking sector as a whole, have been penalized regularly through litigation and regulation that has costed tens of billions of dollars that came straight from shareholders’.

Fortunately, the vast majority of these lawsuits are now in the past and the underlying profitability of the companies will continue to show.  While continued low interest rates mean continued low net interest margins, it also means strong mortgage origination and buoyant merger and acquisition businesses.  These banks have a multitude of different businesses that enable them to make money in both low interest rate and high interest rate environments.  They have also aggressively cut costs and improved efficiency to bolster margins and these gains have been picking up steam each quarter.

Currently Citigroup trades around $50 with a tangible book value of roughly $59.  The stock has come down from the high $50’s in the general market correction.  This means that the stock is trading for roughly 15% less than its closest proxy to liquidation value although there is no way the company will be liquidated of course.  2% of Citigroup’s revenues come from China and most of that is servicing Chinese subsidiaries of investment grade multinationals.  Through the first half of this year, Citigroup has made $10 billion and has returned about 10% on its tangible equity.  I believe that it is very likely that Citigroup will continue to grow its tangible book value by an absolute minimum of 10% per year adjusted for dividends.

Year Tangible Book Value
Year 0 $59.00
Year 1 $64.90
Year 2 $71.39
Year 3 $78.53
Year 4 $86.38
Year 5 $95.02

The table above shows that if Citigroup can grow tangible book value by just a measly 10% per annum over the next 5 years, tangible book would be roughly $95 per share.  Keep in mind that Citigroup’s peers are returning 13-16% on tangible book and Citigroup has many factors that lead me to believe it will be on the higher end of that spectrum moving forward.  It is also very unnatural for a profitable bank to be trading at a discount to tangible book value, particularly when credit quality is pristine and the major litigation is in the past.  I could do this same exercise with just about every large position in our portfolios.  The fundamentals are great.  I believe you will see relatively strong earnings results as this quarter ends a week from now. That could very well be a nice catalyst.  In an era of ETF trading, many stocks trade in unison but over the long-term it is the value of underlying businesses that matter. Always keep that in mind and this clearly shows that even if the overall market doesn’t do that great, we can still succeed with our long-term perspective by focusing on the businesses that are deeply undervalued and that are likely to succeed in today and tomorrow’s economic environment!