My friend Chris Mayer makes a strong case for US banks…so much so that I’ve been thinking a little about this for my own equities portfolio.
Chris writes a newsletter aptly named Capital and Crisis, which is focused on value investing. It is, as far as I can tell, exceptionally well-written. Chris’s overall macro view and his take on the investments that will likely outperform are as sound as they come…and no, I don’t get paid to say any of that.
Now, when two of my friends whose investment acumen I respect come to a similar conclusion, coming from two very different backgrounds, I think it’s worth looking at.
Brad Thomas is a trader, not a value investor like Chris, but he definitely pays attention to fundamentals and the macro picture. Brad too thinks that US banks present a good value here. Where Brad excels is in identifying and trading asymmetrical set-ups.
I share with you Brad’s thinking below:
Book Value – Making Some Sense Where There is No Sense At All
Many banks have share prices that discount their book values to just cents on the dollar
For example Bank of America (BAC) has a share price / book value (as at 12.12.12) of just 0.47
- Citigroup (C) isn’t priced much more optimistically at a mere 0.58.
What are such low valuations saying to us? Quite simple – The market does not believe the quality of the stated book values of banks such as BAC and C. The market is saying, “I don’t care what the banks are saying their assets are worth. I believe there are still major write downs to come.”
It might be helpful to remember this is the same market that priced these very same banks and evaluated their book values in mid-2007. Yes the very market that was very certain that for BAC, C and the like there was blue skies ahead and loan books were safe, dependable and impenetrable.
“Knowing this, how much faith do we want to put in the current valuations placed on banks by the market?”
Is it entirely crazy to consider that quality of the book value of these banks in the period between 2004 & 2007 is actually of lower quality than between 2009 – 2012?
Markets tend to overshoot on the up as well as down side. The optimism in pricing the banks during 04-07 clearly came unstuck as the GFC unfolded. What were previously considered reasonable valuations quickly crumbled.
Many forget that whilst they are pricing BAC at 50 cents in the dollar relative to their book value, that since 2008, virtually the only people who were able to obtain new loans had to be of such impeccable credit worthiness it was almost ridiculous. Just as credit standards were too lax in the boom years, so too have the credit standards years since the GFC been excessively high.
With this in mind, it may not be crazy to imagine in the next 3-4 years we see a repricing of banks according to their book values that reflect a book of higher quality. If this is the case, banks priced at a multiple (as opposed to a fraction) of book value could become a reality.
Consider in the bear market of 02-03 BAC and Citi had book values of 2x. If they were to be valued at the same multiple today, the share prices would be BAC: $44 and C: $127… Sound ludicrous??
Stranger things have happened – including valuing banks that lent money to ‘NINJAs’ at 2x book value. In light of this, is it not without consideration that banks:
- That have the strictest lending standards in possibly a generation
- That have recently gone through enormous write downs
- AND have access to virtually unlimited funding via the FED
Be valued at a multiple of book value instead of a fraction.
Well I am betting it is not too crazy! I recently purchased Ultra-Long dated warrants on Citigroup. I bought 4000 warrants with a Jan-19 expiry and a strike of $106 for just $0.375 per warrant.
So for just $1,500 I will be long (without the obligation) $42,500 of Citi should it trade above $106 between now and Jan-19 (10 warrants give me the right to buy 1 Citi share)
Even with absolutely zero loan growth in the next 6 years and simply a repricing of book value this might well be achieved. Consider if Citi is priced at 2x it current book value my warrants would have an intrinsic value of some $8,800 (excluding any time value).
Will I be right? Who knows… but for $1,500 I know my downside. And if I do happen to be so lucky, well $8,800 is a nice little payoff for a risk of $1,500.
Remember – it’s your application that is important. Any half-wit can have a view!
With central bankers getting high on ink fumes, and banks accessing ZIRP (for all intents and purposes) loans through the discount window, one can certainly make the case that balance sheets of the major banks should be far stronger than pre-2007.
ROE for 2012 in the sector was a respectable 9%. The banks ARE growing book value, and I think this is providing a disconnect worthy of exploitation.
Any downside Chris?
Sure. No investment or trade comes without risk. Big institutions of any kind tend to scare me, if only due to the inevitable bureaucracy that tends to envelop them like an intestinal worm.
Then of course knowing and trusting what actually exists on the balance sheet and what SPV’s have been created to house “off balance sheet” items is probably a black box none of us will ever really know about…until it’s too late.
This is therefore a speculation, albeit one I think worth considering.
“A vampire squid wrapped round the face of humanity.” – Matt Taibbi writing for Rolling Stone magazine on describing Goldman Sachs.