I spent my weekend catching up on some of the recently released annual reports of the big banks. The more I read, the less I could explain current share prices, which are down quite a bit on the year. Despite these companies growing in intrinsic value each year over the last 5 years, some of the big banks are trading at prices lower than they have been since 2011. This is an extreme disconnect and is one reason I’m exceptionally confident about our prospects for strong investment returns moving forward.   The thing about the stock market is that there are times when prices don’t reflect anything close to “fair value.” Short-term concerns can cause prices to veer far off course in either direction. The job of the value investor is to utilize “Mr. Market’s” manic moods to his/her advantage, as opposed to being traumatized based on some short-term market turbulence that is 100% to be expected from time to time. Keep in mind that some of Warren Buffett’s biggest investments are banks, including Bank of America, Wells Fargo and American Express, all of which are down materially in 2016. I highly doubt he is panicking as he knows that times like this when valuations don’t reflect reality offering opportunity and are not something to be feared, although there is no doubt it can be painful in the short-term.

Early in 2016, the narrative was that the United States was likely heading into an economic recession. The economic data has not backed this up as job creation has been stronger than expected, while other areas such as manufacturing and services also show continued slow growth. Another area of concern was low energy prices having an impact on credit for financial institutions. This was a very big story in the first quarter. I cannot stress enough that the big banks’ exposure to energy is very reasonable, with much of it concentrated in the higher quality investment grade names. For most of big players, energy loans comprise only 3-4% of total loans, so non-investment grade loans are less than half of that even. All energy-related bonds are secured, which will help reduce losses on defaulted loans. Also, this isn’t like housing where it can take many years to foreclose on a property, or where there is extensive risk of litigation from securitized products. While the banks have already begun provisioning for energy losses and we should continue to see some incremental increases over the next couple of quarters, barring a major recovery in energy prices, the impact on profits and capital is not likely to be greater than 5-10%. That is a far cry from the 25-30% drop that some of these companies have seen in value. Citigroup for instance has a market value $80 billion less than its shareholder equity. Where are those credit losses going to come from to justify that valuation? We are buying dollars for 50 or 60 cents on these companies.

The last major issue that market participants are dwelling on is pressure on net interest margins due to this historically low interest rate environment. These pressures have been going on for quite a few years now, but banking profits have still been improving. Much of this is due to the fact that while net interest margins might be dropping, increased deposits actually have led to net interest income staying flat or even increasing. Lower interest rates also help various businesses such as mortgage origination. The truth is that there is no reason for the big banks to be so inexpensive. Because these companies have so much capital, they are in a position where they will be dramatically increasing capital returns via enhanced dividends and stock buybacks over the next 3-5 years. This will be a major catalyst and we will get more info on this in June, when the Fed conducts the CCAR process where these returns will be approved. While increased capital and regulations have reduced profitability from the “go go days,” the big banks are safer than they have been in decades. The declines in the stocks have further reduced risk and created an opportunity for very large returns moving forward. The key is understanding that investing is a long-term process. Focusing on short-term swings in stocks can be incredibly misleading and can lead to incredibly poor decision making.

Stocks such as Citigroup, Bank of America and Morgan Stanley can rally 35-50% without being close to overvalued. There also is very little doubt that they will be increasing their book values per share even if growth were pretty much zero in the United States, which is not going to be the case. As always, I’ll be sure to provide comprehensive research reports on all of our major positions after earnings are released over these next few weeks. Below is a link to an excellent article by Dick Bove explaining the massively overestimated problems with energy loans on the big banks. Thank you very much and let me know if you need anything!

Oil impact won’t crush banks