I’ve been writing extensively about the incredible undervaluation of the big banks relative to intrinsic value.
Financials in general are by far and away the cheapest and most attractive area of the stock market.
Remember banks have been around for many centuries, and the reason for that is it’s a pretty good business to be in. The Great Recession was so overwhelmingly bad, and the behavior prior to it was so poor, that it has distorted the perception of bank stocks to where the valuations are simply nonsensical when you do the math. Below is an example of what I’m talking about:
Recently, F.N.B. Corp. announced that it was acquiring Yadkin Financial for $7.5 billion. FNB is paying 2.2 times tangible book value and 14.2 times estimated 2017 earnings for Yadkin. Yadkin has a return on equity of 7.3% last year. While I do believe F.N.B. is overpaying, the valuation itself is not irregular for the sector.
Almost all financials are extremely cheap, but the big banks are truly an aberration and offer some of the best values today.
In the old days, the stocks would have never remained so cheap because they would either acquire each other, or just buy back as much stock as was possible to close the valuation gap, due to the accretive nature of stock buybacks at a discount to book value.
With the new regulatory environment, the big banks can’t acquire one another and capital returns must get Fed approval in a bureaucratic process that occurs once a year.
Over the last 5 years, these banks have improved their balance sheets to levels where they are overly capitalized, so we are seeing rapid growth in dividends and stock buybacks that will continue. Just about each quarter, tangible book value and capital levels are growing. Earnings have also been approving for just about all of the banks despite these low interest rates. The stocks have not performed well over the last year but I believe that situation will change, as it becomes clearer that a recession is not imminent and interest rates are more likely to head higher than lower.
To give you an idea of how ridiculous the valuations are for the big banks, I’ll provide a few examples:
- Citigroup trades at around $44 per share. Tangible book value per share is $63.53. Last year’s return on equity was 7.52% and will go much higher, and the company earned $5.41 per share. The stock would have to rally by 44% to get to tangible book value and the tangible book value will likely grow by 15% this year. At 2.2 times tangible book value, which is not impossible in the future, Citigroup would trade at $140 per share. At 14.2 times last year’s earnings, the stock would trade at $77 per share.
- Bank of America trades at around $14.50 per share. Tangible book value per share is $16.68. BAC would go up by 15% to get to tangible book value and that number should grow by 10-13% this year. BAC also owns Merrill Lynch, which would be spun out at a huge premium to book value. This is certainly a possibility if Glass-Steagall were brought back. Last year the company earned $1.38 per share. 14.2 times last year’s earnings would put the stock at $19.60. BAC can easily earn $1.80-$2.30 per share next year. At 2.2 times tangible book value, BAC would trade at nearly $37 per share.
Contrast these opportunities with the S&P 500 as a whole, which trades at about 25 times earnings and over 3 times book value.
All of our major financial positions trade at similarly attractive valuations.
Because we run a concentrated value portfolio, returns will be lumpy at times, particularly being that most of our options all expire in January of 2017. We make no attempt whatsoever to beat the market each quarter or even each year as that is impossible. Our goal is to beat the market over the long-term. In an overvalued market, we want to be zigging when others are zagging and that is exactly what we are doing right now. As valuations converge towards the mean, we should make incredibly strong returns, while I believe the stock market itself might be flat to negative over the next few years.
Thank you very much and as always if you have any questions whatsoever don’t hesitate to contact me directly at 805-886-8140!