… it takes patience, discipline and courage to follow the contrarian route to investment success. To buy when others are despondently selling, to sell when others are avidly buying ...

Sir John Templeton

Since the middle of last year financial shares – banks in particular – have been under acute selling pressure. In the case of the United States (US) market, for instance, the Standard and Poor’s 500 (S&P 500) Bank Index has shed half its value since the middle of 2007, with much of the pressure concentrated in the last three months. Falling house prices, distressed borrowers and weakened consumers have been at the heart of this decline. Further, as noted by Schroders’ chief economist, Keith Wade and his team of strategists, whilst the key lending rate in the US has fallen smartly over the past year, and lending rates in the United Kingdom (UK) and Europe have remained largely static, today we have mortgage rates which are well in excess of house price inflation in these markets. This is an indication that borrowing and the housing market are likely to remain weak in the immediate future. In support of this argument, recent data show that the S&P Case Shiller house price index fell 15 percent year-on-year to May.

In turn, the scenario of high positive real interest rates in the housing market implies that people form expectations about house prices in a backward-looking way – taking the current price movement as the best guess of the future. As Wade notes, such auto regressive behaviour suggests that individuals are not forward looking and have difficulty recognising value when it finally emerges. This behavioural pattern is widespread – best evidenced by long booms and busts in various markets, including the housing market and, more recently, financial shares which have gulped down water whilst commodity shares (and energy shares in particular) have swum away (see the figure below).

reuters source data

Source: Data from Reuters

However, lengthy momentum markets establish vast divides between price and value, thereby creating superb investment opportunities. Indeed, the extreme pessimism surrounding bank shares in the wake of the housing market fallout has created a once-in-a-generation opportunity for investors. Negativity about banks’ prospects is extreme. Consequently, bank shares are dirt cheap. But, exposure to the sector is not for the weak hearted or for those with portfolio horizons that are measured in weeks or months. Yet, as top-rated US bank analyst Thomas K. Brown notes in a recent article, if you understand what drives share prices, and have an investment time horizon of at least one year (which is admittedly short as far as investment horizons go), read on. If you are a patient value investor, get out your highlighter and get ready to buy bank shares.

Investors in financial shares have had a lot to deal with recently. Apart from watching energy and commodity shares surge higher since the middle of 2007 as part of a longer wave(see the figure below), in recent weeks financial shares have been pummeled by bad news. For instance, in the past two weeks these shares have been faced by news that US regulators closed IndyMac Bank (which had USD32bn in assets) in the second week of July, and that last week First National Bank of Nevada and its affiliate, First Heritage Bank of Newport Beach, California, had failed and would be acquired by Mutual of Omaha Bank. However, this news pales into insignificance when read against the backdrop that US government-sponsored mortgage company Fannie Mae requires bailing out and that Freddie Mac, the smaller brother business, is technically insolvent, owing USD5.2 billion more than its assets are worth.

reuters source data

Source: Data from Reuters

And there was even more bad news for investors. In the past two weeks General Motors, the world's largest automaker as measured by global industry sales, suspended its dividend; US retail sales for June came in lower than expected; the US dollar hit a record low against the euro; June’s US producer price inflation came in higher than expected; popular bear, Meredith Whitney of Oppenheimer Securities, lowered her rating on Wachovia, the fourth largest banking chain in the US, citing the company’s bleak prospects; Bloomberg ran a story reporting that private equity investor TPG had seen its spring investment in Washington Mutual cut by two-thirds; and Bill Ackman, a CNBC favourite, spoke about his plan to rescue Fannie Mae and Freddie Mac (despite having recently admitted that he had shorted the shares).

Finally, by end July, earnings per share reported by companies making up the S&P500 had showed an average decrease of 24 percent. However, if financial shares are stripped from the calculation, the earnings change prints as a nine percent increase – a material difference by any standard. Detail aside, in sum, the news flow has done little other than incite the flames of fear already raging through fragile financial shares.

Evidence of the extent of the above-mentioned fragility is readily at hand. In one day in the middle of July, Citigroup*, the largest financial company in the world, lost 15 percent of its market capitalisation, a sum equal to about USD15bn. Wachovia, the subject of Whitney’s above-mentioned downgrade, was off by 20 percent on the same day. The CBOE Volatility Index, or VIX, a popular measure of investor nervousness, reached 30.82, where a reading above 30 is considered a panic signal; and XLF, the US-listed financial sector tracker, showed trade of 469mn shares on 15 July, eclipsing its previous one-day volume record, set the prior Friday, by 150 million shares. In turn, this record fell two days later when 528mn shares traded.

If this is the financial sector backdrop, the question is then begged: ‘How on earth can bank shares be considered attractive?’ A number of reasons can be found for patient, deep value investors to start piling into bank shares.

First, the depressed mood in the market described above has promoted the unrealistic expectation that these conditions will persist indefinitely into the future. Bearish momentum investors continue to pile on their shorts, whilst rational analysis about companies’ long-term prospects has given way to the simplistic notion that banks will write off ever-higher amounts of capital, that profit recovery is a long way off and that long-term earnings potential has been permanently damaged. As Brown notes, to support this theme, bearish analysts have devised new methods to justify current (or lower) share prices for banks and other financial shares. We see this type of analyst error regularly, but the best recent example comes from the late 1990s when analysts of technology shares rolled out new valuation methods to justify sky-high share prices at the peak of the Nasdaq (do you remember ‘eyeballs per screen’?).

In similar fashion, Brown notes that bearish financial services analysts have developed new ‘methods’ to ‘value’ financial shares to avoid recommending them in the current environment. One analyst, for example, estimates a bank’s entire future losses, deducts that number from tangible book value, and then assumes the bank raises additional capital at current (highly dilutive) prices. The method then goes on to assume that the share should trade at or below the pro forma adjusted tangible book value. No wonder throwing money down a hole sounds like a smarter option. Clearly, the motive behind the method is to produce a valuation for the share that is as low as possible, regardless of the sensibility behind the method, to justify the bearish call on the share. Conservative analysis and poor analysis should not be confused.

Second, when the market ridicules common sense, it is worth sitting up and taking notice. Brown reminds us that, during the tech boom, great investors such as Warren Buffett, George Vanderheiden, and Julian Robertson were seen as dinosaurs because they refused to participate in the mania. A decade on, the legendary Bill Miller, Marty Whitman, Wally Weitz, and others are being criticised for their refusal to short the financials, and ridiculed for owning them.

Amongst the ‘new media darlings’ is Bill Ackman, whose record, perhaps, is best described as ‘average’. Yet (or perhaps because of this record), he shorted Fannie Mae and Freddie Mac shares a few days before he called CNBC to tell them he has a plan to save the companies, which (coincidentally) involves a complete wipeout of common shareholders. To go from absurd to ridiculous, he has been taken seriously, without a single person who interviewed him on the day of his announcement questioning his true motivation.

Third, there is widespread fear about dividend cuts and that the capital that has been raised recently is excessive and, for this reason, unnecessarily dilutive. To the contrary, some of the bank results that have printed in the current series of earnings announcements are providing signs that the credit problems will not turn out to be as great as widely feared, that not as much dilutive capital will need to be raised and that fewer companies will have to cut their dividends. For example, one of the US’s largest banks, Bank of America*, recently produced better-than-expected second quarter earnings (72 cents versus a consensus 48 cents). Despite the big bounce that we have seen in the price since then, the share still provides a dividend yield of 7.9 percent, or three times the current two-year US Treasury yield. Elsewhere, some of the commercial banks that have reported second quarter earnings have provided evidence of improving credit quality (including changes in delinquency rates, a slowing inflow of new non-accruing loans and a lack of meaningful increases in questionable assets). Also, as Brown notes, from history we know that high-quality banks are quick to write down non-performing loans and aggressive in building reserves.

This backdrop offers ample evidence that the market is being driven by sentiment, and where this happens, value and price can diverge widely. At current prices, many banks offer superb value. To identify some cases in the global environment:

  1. Over the past decade Bank of America (BAC)* has traded at an average price-book ratio of 1.9 times. Currently the share trades at a discount to book value (0.9 times) and a fifty percent discount to the long-term average. As noted above, the share offers a dividend yield of 7.9 percent and is priced on a trailing price-earnings ratio of 8.3 times (versus the long-term average of 12 times).
  2. Allied Irish Bank (ALB)* currently trades at 65 percent of book value, compared to the long-term average of almost two-times book. The share offers a dividend yield of 7.3 percent and trades on a trailing price-earnings ratio of 3.5 times, which is substantially lower than the ten-year average of almost 14 times.
  3. Australia’s largest bank, ANZ Bank (ANZ)*, recently announced that earnings will fall. As a result the share price has dropped sharply in recent weeks. The result is that ANZ is trading at 1.4 times its book value, which is two-thirds of its long-term average of 2.1 times. Similarly, value is evidenced by a dividend yield of 12 percent, which is more than double the ten-year average of five percent.
  4. Other global examples are readily identified, including Swedbank (SWEDa)*, JP Morgan Chase (JPM)* and Barclays Bank (BARC)*, each of which trades at a discount to book value compared to long-term averages that range between 1.7 times and 2.7 times, implying upside to fair value of 70 percent or more in these three cases.

Domestically, the arguments are similar. The depressed mood about bank shares has produced attractive valuations:

  1. Investec (INL and INP)** trades at a price-book ratio of 0.6 times versus a ten-year average of 2.2 times. The current dividend yield of 7.2 percent and trailing price-earnings ratio of 6.2 times also highlight value if compared to the ten-year averages of 4.2 percent and 13.6 times.
  2. Finally, Firstrand (FSR), which can be accessed at a discount via Rand Merchant Bank Holdings (RMH)**, is trading at a 20 percent discount to its ten-year average price-book ratio, offers a dividend yield of 5.5 percent versus a long-term average of 3.3 percent and is priced on a trialing price-earnings ratio of 6.6 times (compared to a long-term average of 12.1 times) in an environment in which earnings are expected to show modest improvement in the current financial year.

Warren Buffet describes investing as simple, but not easy. Whilst the current environment makes buying and owning bank shares emotionally difficult, the investment case is straightforward. Many bank shares offer exceptional value. Not all the company performance indicators are headed in the right direction yet, but there is some early evidence that the perfect storm of 2007 and 2008 may be abating. Value investors know that waiting for the unfasten seatbelts sign can be expensive. Bank shares could correct downward again, especially given their recent strong advance, but for investors, the time to buy is now.

 

Note (1): Shares annotated * are held in the Cannon Global Equity Fund, and shares annotated ** are held in the Cannon Equity Fund or Cannon Core Companies Fund, which I manage.

Note (2): This article draws on ideas and evidence presented by Thomas K. Brown in his article Is It A Bottom in Financial Stocks? Our Short Answer: Yes.