There can be no doubt that we are in the midst of a global bear market. It is never a fun process, especially since it has really been since 2008 and early 2009 since the last one occurred, and that memory stings to all of those that were in the market during that time. While we’ve cautioned that stocks overall weren’t cheap, they also weren’t outrageously expensive going into this downturn. Stocks that we at T&T Capital Management (TTCM) are invested in are far cheaper than the market average. Just about every stock we own trades at a considerable discount to book value and at 5-9 times a conservative earnings estimate for 2016. For our stocks to get to anything close to fair value, a gain of 35-50% would have to occur. I cannot stress to you how rare it has to have our stocks be this cheap, while they are also posting solid profits and ever-improving financial condition. It is a situation that cannot last, barring a recession greater than 2008, which I see absolutely no evidence of whatsoever.
This being earnings season, I’ve been reading through the earnings calls of companies in various industries. While clearly, industrials and commodity-related companies are struggling with slow growth in China and the strong U.S. dollar, most of the economy is doing fine. Not great, but fine, not much different than it has been doing over the last 7 years. Consumer credit is great. Our financial system has never been stronger with banks having excess capital and excess liquidity. Cost cutting in the sector has enabled the big banks’ for instance to be able to post earnings growth even in an extremely low growth environment. Even if we are in a U.S. recession currently, as we generally don’t find out until after we are in one, you still wouldn’t want to be selling stocks as the market is a forward looking machine. While painful to endure, this is by far and away the best investment opportunity since 2009. I don’t know when the selloff will end, but I do know that it will.
Barron’s cover this past week was advocating to buy the big banks. This is an absolute no brainer as is AIG, AGO, etc. While we have a big interest in financials, every sector pretty much is in the midst of a bear market. The only exceptions are things like utilities and telecoms, which trade at much higher multiples than historical averages and face their own technological problems over the next few years. We’ve been aggressively selling covered calls on certain positions to generate income and reduce risk, while still allowing for tremendous upside. We wouldn’t even dream of doing this on many of our positions though because the upside is so great from current levels. The way I see it is that one of two things can happen. Either we will see a massive rally in our stocks, or we are going into a recession that is worse than 2008. I see zero evidence of the latter! Neither do any of the CEOs, big and successful money manager I follow, etc.
Over the short-term, stock prices mean virtually nothing, particularly in a panic like we are in currently. As earnings continue to come out and economic data is released, these fears will abate and our stocks should rise considerably. At current levels, stock buybacks will dramatically increase intrinsic value, and fortunately these companies are in a good position to do just that. Bear markets are nightmares to be in but they present by far and away the best opportunities to make money long-term. Of course if you can predict when they are going to occur, you’d try to avoid them, but it does no good to panic when fundamentals are so different than stock prices. Markets overshoot on the top and they overshoot on the bottom. By focusing exclusively on the fundamentals of the businesses, we will make it through these stormy waters. Financials would have to be taking tens of billions of losses this year to even come close to justifying half their stock declines this year, when in fact they will be profitable. This is why I’m so confident that our positions will recover far greater than the market overall. One year from now, the situation is likely to be very different and this selloff will be a nasty memory, but not extremely significant in the big scheme of things. Below is a useful chart and article produced by Deutsche Bank and also the article on Barron’s this past weekend discussing the great opportunity in U.S. banks. Please feel free to call me if you have any questions whatsoever!
Time to Buy Bank Stocks
Big U.S. banks are in better shape than they have been in years, and yet they trade at levels last seen in 2011. Why Citi, JPMorgan, BofA, and Wells Fargo could jump 20%.
January 30, 2016
Everyone knows that stocks have had a miserable January, one of the worst ever, but what they don’t know is that it could be a good sign. Even after rallying on Friday, the Standard & Poor’s 500 index finished the month down 5.1%. That’s the seventh-worst start since 1950, based on data from the Stock Trader’s Almanac. It’s encouraging, though, that five of the six weaker Januarys were followed by gains in the rest of the year.
This year, with declines in oil and other commodities raising concerns about global economic growth, investors have gravitated toward defensive sectors, like telecom and utilities, which finished higher in January, while dumping financials, technology, and materials stocks.
Bank stocks got off to a particularly weak start, with the widely followed KBW Bank Index of 24 companies, known as the BKX, falling 13%, led by big losses for the largest banks. Citigroup (ticker: C) declined 18%, to $42.50, and Bank of America (BAC) was off 16%, to $14; Morgan Stanley (MS), which is technically a bank but more of an investment bank, fell 19%, to $26.
With the selloff, the banking sector looks like one of the best bargains in the market. “This is an exciting time,” says CLSA banking analyst Mike Mayo. “Bank balance sheets are as strong as they’ve been in decades, and stock prices resemble recession troughs. Earnings are more stable than they have been in decades, and capital ratios are at the highest levels in 80 years.” Credit Suisse analyst Susan Katzke calculates that nine big banks she covers have tangible equity capital ratios averaging 8% now, double the levels in 2007, prior to the recession.
At its nadir last week, the BKX index was at its lowest level since mid-2013, and valuations were back to levels last seen in 2011, when the stock market was rattled by fears about Greece’s financial crisis.
As the table shows, the 10 leading banks and investment banks now trade for eight to 12 times projected 2016 earnings—a steep discount to the market multiple of about 16—and many trade near or below tangible book value. Some sport yields of 3% or more, and all will probably get the regulatory go-ahead to lift dividends later this year.
Tangible book, a conservative measure of shareholder equity, excludes goodwill and other intangible assets, which usually stem from acquisitions. It’s often viewed as a measure of liquidation value and doesn’t give banks credit for franchise value and low-cost deposit bases.
There’s probably at least 20% upside in all of these banks, which would still leave some below where they started the year.
“We’re constructive,” says Jason Goldberg, a banking analyst at Barclays. “The concerns we have are more than reflected in current valuations.” He says eight of the 22 banks in his coverage traded below tangible book value last week. The last three times that happened—in summer 1990, early 2009, and August 2011—turned out to be excellent buying opportunities.
WHAT ARE THE KEY ISSUES now? Wall Street is worried about the industry’s loans to the increasingly distressed U.S. energy sector. But based on information provided on banks’ energy exposure in fourth-quarter earnings releases and presentations on conference calls, that exposure looks manageable. Oil-and-gas companies generally account for no more than 1% to 3% of total loans, and banks already have set aside reserves against potential losses.
On the Wells Fargo (WFC) call, for instance, executives said they believe the bank to be adequately reserved for its $17 billion of disclosed energy exposure. CEO John Stumpf said the situation for banks now is better than it was in the 1980s, when energy prices collapsed. One reason is that much of the debt on the books of energy borrowers is subordinate to bank debt, giving banks more cushion.
JPMorgan Chase (JPM) CEO Jamie Dimon said on the bank’s conference call, “These are asset-backed loans, so a bankruptcy doesn’t necessarily mean the loan is bad.” Disclosure varies among banks about the extent of their energy exposure and the credit quality of borrowers.
For Citigroup and JPMorgan, the bulk of the exposure is to investment-grade borrowers, mitigating risk. Wells Fargo disclosed the $17 billion exposure to nonrated or junk-grade borrowers, but didn’t detail its lending to investment-grade borrowers, viewing it as safe.
Sanford C. Bernstein analyst John McDonald calculated that if cumulative losses on energy loans run at 7% to 14%, in line with the experience in the 1980s, the hit to earnings at major banks in 2016 and 2017 would be modest, at 2% to 5%. Says Mayo: “Banks have enough capital today to charge off every dollar of energy loans and still have more capital than they did at the last downturn.”
The bigger issue is whether U.S. energy problems portend broader credit problems. On that score, bank executives are upbeat, emphasizing the benefit to consumers from lower energy prices and a healthy housing market. Energy lending is a fraction of the size of mortgage lending in 2008. “The U.S. economy has been chugging along at 2% to 2.5% growth for the better part of five years now. In the past two years, it has created five million jobs,” Dimon said. “Corporate credit is quite good. Small-business formation: It’s not back to where it was, but it’s quite good.”
THE POLITICAL BACKDROP doesn’t help the banks. The top two Democratic presidential candidates bash the banks at every turn, calling them irresponsible and even criminal actors who caused the 2008 financial crisis. Sen. Bernie Sanders advocates a breakup of big banks, labeling them as too big and powerful and dangerous. The Republican candidates haven’t been much better with their rhetoric. Mayo argues that a mandated government breakup might help the stocks, since many trade below sum-of-the-parts valuations.
Locked inside Bank of America, for example, is the desirable Merrill Lynch brokerage franchise, and Morgan Stanley isn’t getting much credit for its lucrative brokerage unit. JPMorgan and Goldman Sachs Group (GS) have valuable asset-management businesses that aren’t getting much investor recognition.
There are other negatives besides energy loans. Net interest margins are under pressure, and revenue growth has been sluggish for several years. Earnings growth this year could be subdued, especially if the Fed does not increase interest rates, as expected. “This is the opposite of the situation before the financial crisis. Banks then had strong earnings and weak capital. Now they have strong balance sheets but softer earnings,” Mayo says.
The case can be made for all 10 of the banks. JPMorgan, the subject of a favorable Barron’s cover story last spring, has held up better than its peers in the past year. It’s a favorite of Mayo, who calls it the “Lebron James” of banking because of its strong offensive and defensive qualities. “Under $60, JPMorgan is an outright buy,” he says, ticking off its 3% dividend yield and 5% total return of capital, including stock buybacks. He has a $75 price target. The shares, now $59, trade for 10 times estimated 2016 earnings.
Citigroup is the cheapest of the bunch, trading for under eight times projected 2016 earnings and less than 70% of tangible book. While its emerging market exposure is weighing on the stock, Citi doesn’t get much credit for the great strides it has made since the financial crisis.
IT’S RARE TO FIND both Goldman Sachs and Morgan Stanley trading below tangible book value. Current returns aren’t great, with Goldman Sachs earning an 11% return on equity and Morgan Stanley, 8%. Yet, at nine times projected earnings, both discount much weaker outlooks.
Wells Fargo, Warren Buffett’s favorite bank, is rarely a steal, but it looks appealing now at $50, or 11 times estimated 2016 earnings, and yielding 3%. Its returns are among the highest of its large peers, and it’s less exposed to rocky financial markets than rivals like Citigroup and JPMorgan with big trading operations.
U.S. Bancorp (USB), another holding of Buffett’s Berkshire Hathaway (BRK.A), probably is the best-managed large regional bank in the country, with some of the highest returns. It commands the highest price/tangible book ratio among its peers, thanks to a nearly 20% return on tangible equity.
Half of its revenues come outside of typical lending, including such areas as payments processing. It has one of industry’s best CEOs in Richard Davis. At $40, the stock trades for 12 times projected 2016 earnings. Barron’s Roundtable member Scott Black recommends the stock in the current issue.
Citizens Financial Group (CFG) and Regions Financial (RF) are favored by Matthew Lindenbaum of Basswood Partners, a New York investment firm with a focus on financial stocks. Both traded last week at discounts to tangible book value and have ample capital. Citizens has a tangible equity/asset ratio of 10% and Regions, 9%. At $21, Citizens trades at 12 times projected 2016 earnings, and Regions, at $8, fetches 10 times estimated 2016 net. Regions has higher energy lending exposure than other regionals.
“Their businesses are doing fine,” Lindenbaum says. “They have a lot of capital with decent returns that are going higher. They also are consolidation candidates.”
Given depressed sector valuations, it may be hard to go wrong with almost any major bank or investment banking stock.