Today, the results of the stress tests including capital allocation plans were announced and the results were quite favorable. These tests are honestly rather silly as the Fed uses hypothetical models and the most draconian assumptions possible to forecast the results. Also, there are extremely subjective measurements made by a lot of bureaucrats, so bad relationships etc. can clearly impact results. Despite these issues, all of the major U.S. banks passed the test pretty much with flying colors. Some have to slightly modify their buybacks and dividends, but that is simply due to differences in how the Fed measures things and how the individual banks measure them. The Fed doesn’t share its formulas because they are concerned the banks would game the system, which they are probably right about.
Most importantly; our largest position of the banks is Citigroup, which is now able to buy back nearly $8 billion of stock over the next year, in addition raising the dividend. That is a very big number and will be enormously accretive to both intrinsic value and tangible book value, due to the discount at which Citigroup now trades. Basically Citigroup will be buying its own shares at 70-80 cents on the dollar at the very most conservative estimates of intrinsic value. The reason it is leaning more towards buybacks as opposed to dividends, is because buybacks are so accretive at current prices. This changes everything and I’d expect Citigroup to perform quite well moving forward. Any pullbacks in the stock, will allow the company to buy stock at even cheaper prices, enhancing intrinsic value even further. This is the first year of many, in which we should see fairly consistent and large buybacks and dividend enhancements because almost all of these banks are overly-capitalized.
While returns on equity have been subpar, expenses have been cut and many problems have been resolved such as the majority of the litigation. When interest rates increase, the banks will be huge beneficiaries as will our insurance investments. Net interest margins and investment income will improve, which will bolster returns on equity. Bank of America and Morgan Stanley both are also buying back stock and enhancing their respective dividends. This is good news all around. Don’t worry too much about the next day or two of trading, as it really isn’t that significant. I believe it has now become even more clear that the big banks have turned the corner. Those market participants paying rich prices for slow growing and overvalued companies such as a Procter & Gamble or United Technologies, will be buying Citigroup at $70 per share with a 3.5% dividend at some point in the next few years. The story for the other banks will be similar in my opinion. This is where patience and discipline pay off, while also allowing us to avoid the speculative situations, which exist and will likely lead to considerable losses as valuations normalize. Thank you very much and as always, if you have any questions please don’t hesitate to call me at 805-886-8140. Thank you very much!