Tuesday, October 18, 2011

BPS Growth at Banks versus the S&P 500 Index

OK, I keep saying I won't do something and then go ahead and do it a post or two later.

One thing interesting to notice about these bank earnings announcements is how solid they are despite the horrible environment (or so it seems when you read the newspaper).

For example, the S&P 500 index has declined 14% in the third quarter of this year.  The third quarter was truly a horrible quarter with one of the worst declines in market history and a near melting down over in Europe.

If you owned an equity mutual fund, you have most likely lost money; 14% or more.

Of course if you owned bank shares you would have done much worse.

But let's take a step back and see what the banks actually did on a fundamental basis.

JPM's book value per share (BPS) during the third quarter 2011 went like this:

                                                                2Q2011                3Q2011             
Book value per share:                             $44.77      -->       $45.93
Tangible book value per share:              $32.00      -->        $33.04

So the BPS for JPM went up during the third quarter while the stock market went down in one of the biggest drops in history.  (OK, critics will say that is largely due to the debt valuation adjustment; an extraordinary gain due to the *worsening* of JPM's own credit spread.  Yes, that's a one time thing and not a real profit, but so are some other items that offset that in the quarter.  Putting them together, the DVA is not that big a distortion as it seems at first glance).

Why is this relevant?   This would not be an issue if JPM was trading at 2-4x book value, but now JPM is trading under BPS and even under tangible BPS (current price $32/share).

And as I said in a previous JPM post, Dimon thinks the bank should earn at least 15% on tangible book value.  You get to own a business that can earn at least 15% return at under tangible book value. 

If you own the S&P 500 index, you can expect to make 10%/year over time.  Maybe 6-7%/year to be conservative.  Take out the 1-2% management fee that you will end up paying in a mutual fund and that gets you 4-6% return possible in the S&P 500 index over time.

And here, you have an investment that can probably earn 15%/year over time.  Think about that. To see a real life 'stress-test' of J.P. Morgan, go to the above mentioned post and look at JPM's tangible BPS for the last five or six years.

And then in a horrible market where stocks go down 14%, this 'business' manages to increase BPS and tangible BPS.

The same can be said about Goldman Sachs (GS), Wells Fargo (WFC) and other 'good' banks. 

Let's see GS for a second (I haven't listened to the conference call yet).   People will focus on the fact that GS lost money and say, "Aha!  Told 'ya the investment banking model is dead!".

Despite this horrible market environment and a plunge in investment banking fees (my fingers keep Freudian slipping and I keep typing investment baking), GS has managed to keep BPS and tangible BPS flat.

GS BPS at quarter-end was $131.09/share, and tangible BPS was $120.41 versus a current stock price of $99 (this morning, I saw it trade down to $90).  That's pretty cheap.

When people start declaring the end of the investment banking model, stop and think for a moment.  As long as businesses need to raise funds and access the capital markets and as long as people need to invest and trade, the investment banking will exist, thank you very much.

Again, GS has kept BPS flat in a market that went down 14%.  Why is this?  Of course this is due to fees and commissions and other sources of income (which applies to JPM and other banks too).   This is the banking and investment banking model at work.  They have streams of income other than trading gains, net interest income that will absorb losses in bad markets.

And this is why, over time, I expect good financial companies to grow book value (or book value plus dividends) at a pace far exceeding the S&P 500 index and it is the reason why I get excited when very good, solid financials trade at or below BPS.

Having said all that, this is not one-sided, of course.  It would be foolish to pile into financials with all of your net worth.

I expect good financials to do better when bought at or below BPS, but there are risks.  Financial companies do blow up.  At one time, Citigroup and AIG were seen as solid, blue chip financial companies and they blew up.  There were others.   (I was not a fan of Citigroup under Chuck "Still Dancing" Prince, nor was I comfortable with the big black box of AIG's financial products business that was sort of a long time Wall Street mystery (how do they make money?!).  The warning flags were there for both companies long before the blowups).

An S&P 500 index may not be that exciting (even though it's still one of the best ways to invest) and it may go down 14% in a single quarter, but the S&P 500 index itself will never blow up and go to zero (even though it may go down 90% in a depression). 

So as much as I like the financials (and Occupy Wall Street makes it even *more* attractive to me as a cultural contrary indicator of sorts; kind of like the opposite of the Beardstown Ladies), there is only so much I would put into financials.

And as we have seen, financials are very, very volatile.  Most people wouldn't have the stomach for holding these stocks.

Oh, and in case people may wonder if I have been a fan of financials forever and through the crisis, this is not true.  I can't prove it on a new blog like this, but I have hated the financials all throughout the 1990s and 2000s.  I couldn't understand why these banks were trading at 2-4x BPS and in some cases 5x BPS. 

The revenues/earnings of investment banks tended to look like, to me, the Brooklyn Bridge (very cyclical with big booms and busts) so I could never understand why people could put p/e multiples on these very volatile earnings.  Back in 2006 and 2007 they were capitalizing (putting p/e multiples) on huge trading and investment gains.  This didn't make any sense to me either; people were assuming the boom times would continue for a long time.  I thought it would only continue for a year or two and then a drought would follow.  I found it difficult to figure out what the normalized earnings rate would be.

Also, the financial markets is very, very cyclical.  When the stock market goes up, historical returns look good and mutual funds gather a bunch of money.  They invest more, stock prices go up more which brings in more money and the stock market gets more expensive.  Then financial companies' earnings look really good as the industry is booming so valuations go up.  

This cycle is the same in the credit markets, but is arguable more dangerous.  As the economy booms, default rates go down, credit quality improves and credit spreads shrink.  What used to trade at 800 basis point spread to treasuries can shrink to 150 basis points.  This is very dangerous because this encourages leverage (this doesn't exist so much in the equity markets as equities are invested using cash for the most part).

When a credit desk makes $xx dollars on 800 basis point spread, but has to increase earnings 20% next year, but the credit spread shrinks to 600 basis points, they have to increase leverage and get a bigger balance sheet just to earn the same amount.  So to produce earnings gains, they really have to put on leverage.  Imagine spreads shrinking to 200 basis points.  They would have to increase their balance sheet by four-fold to earn the same amount of money as they did when spreads were 800 basis points.  This goes on and on.   Historical default figures look better and better too as capital is more readily available to roll debt no matter how the underlying credit is actually doing.  So in this business, you have the maximum leverage and balance sheet size at the point of maximum risk.  Financial companies are obviously reporting record profits and incredible ROEs, so the stock prices also tend to be at high valuations.  At this point, a small speed bump can cause a complete collapse.  This is sort of what happened in the 2000s leading up to the collapse (and has happened many times in the past).

Smart CEO's stayed out of the game.  People like Chuck Prince begged regulators to clamp down on this reckless lending but inexplicably kept making the same of their own in order to maintain market share.  Folks like Dimon opted out.  They refused to play the game.   (It's an interesting and reassuring footnote to WFC that when John Paulson was structuring CDO derivatives against subprime loans, he demanded that the structures *exclude* WFC loans; he knew they were of better quality than the rest)
Anyway, that cycical and pro-cyclical factor is another reason why I hated financials for a long time.  Today, I don't think we are at that point at all of major risk, and we are certainly not at a cyclically risky point, not by a long shot.

I also didn't like that bank executives exercised their call options (bonuses).  They take huge risk and if they succeed, they walk away with huge bonuses.  If they fail, shareholders lose money. 

This seemed like a raw deal to me.

So I have never really been a fan of financials at all.

I only get excited about them at attractive prices and that's what's driving me to write this stuff now ( I was also very bullish in early 2009 and made some big bets then).  Do I still feel the way I did about financials back then?  Yes and no.    Now that some of the excellent businesses that I assumed would survive the worst crisis in history and seems to continue to grow their business, I feel good about them at these very reasonable prices.

Do shareholders still get a raw deal?   I still sort of feel that way, but at the end of the day, what's important is return on equity.  If I am paying BPS, I care about ROE (return on equity).  If I get a reasonable return there, I don't care too much what the bonuses are, and as long as I feel that the executives are taking prudent risk.

I think firms like Goldman, J.P. Morgan, and Wells Fargo have proven that they take only prudent risk.  I love how Dimon has managed the business throughout this crisis.  The same goes with GS and WFC.

Anyway, wow, that's a bit longer than I expected.   

This is just my opinion and not necessarily a recommendation.  These stocks are very, very volatile and if we do have a double dip, triple dip or depression, some may go to zero so be careful...   Also, one should never buy a stock just cuz some anonymous guy on the internet thinks it's a good idea; that's a quick way to the poorhouse (but then you can go to Zuccotti Park and get free food so you'll be OK) so do your own work!  (if not, stick to an index fund!)

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