Financials Still Look Good: Part 2

Bank of America (BAC)
BAC announced earnings too, and things there are looking interesting.  Like other banks, there is a problem with NIM pressure.  But the investment bank / brokerage business seems to have done really well.

I won't go into any details here, but I just want to jot down what I was looking at.  First of all, the valuation play for BAC is similar to JPM even though I have very different views on the management of each.  I have a very high regard for JPM management, but only so-so for BAC.  These post-crisis / scandal CEO appointments tend not to work out too well over time and I can't get over the fact that this may be true in the case of BAC too.

I know Buffett has endorsed current BAC management, but I think he really sees the value of the franchise; his ownership of BAC was a bet on the cheap valuation of BAC and their competitive position and not necessarily the current management (even though he has explicitly said that the current CEO is doing the right things).

This is the part that is interesting.  In post-crisis / scandal situations, the right thing is usually pretty straight forward.  It's not easy, necessarily, but the job is to clean up the mess made by the previous management.  It doesn't take a lot of creativity, vision, or leadership skills or anything like that.  In a turnaround situation, survival is the priority so you don't need a visionary, charismatic leader.

Chuck Prince and Martin Sullivan looked good too, initially for a few years, when they were just cleaning up.  But they proved to be horrible CEOs beyond that.  I have no proof that Moynihan is any better or worse than Prince or Sullivan at this point.

Anyway, the valuation play here is simply that BAC is worth book value, or 1.5x tangible book value.  I think Moynihan has stated that BAC can earn at least 15% return on tangible book in normal times (when the current high cost of dealing with the mortgage mess settles down).

At 2012 year-end, the BPS for BAC were:

BPS:                $20.24
tangible BPS:  $13.36

It just so happens that BPS is 1.5x tangible BPS, so we get the same valuation target using 1x BPS or 1.5x tangible BPS.  With the stock price at around $11.50,  there is still pretty substantial upside.

I've looked at this from the point of view the sum of the parts, so let's take a look at the old Merrill.  It turns out that the old Merrill is doing very well.  Here are the returns on average equity (ROAE) and returns on average economic capital (ROAEC, basically return on average tangible equity) of the three business segments that is the old Merrill (even though global banking now includes more than just the former investment banking business).

Global Wealth and Investment Management
                         2011        2012
ROAE                9.9%     12.53%
ROAEC           30.52%   25.46%

Global Banking
                          2011        2012
ROAE               12.76%    12.47%
ROAEC             26.59%    27.21%

Global Markets
                           2011        2012
ROAE                4.99%      19.19%
ROAEC              6.34%      26.14%

The returns for Global Markets exclude DVA and UK tax adjustments.  So the old Merrill is looking pretty good.  Combined, I think the total ROAE comes to 14.3% which is very good.

I think it is safe to say that the these three segments, or what we call the old Merrill is worth book value.

So let's see how this breaks out.  Using average balance sheet figures for 4Q12, the allocation of equity and tangible equity to the old Merrill (combined above three segments) were as follows:

Total equity:                   $82.1 billion
Total economic capital:  $42.2 billion

There are 10.8 billion shares outstanding so BPS of the old Merrill is $7.60/BAC share.  Tangible book is $3.91/BAC share.

BAC is now trading at around $11.50, so the old BAC (pre-Merrill) is trading at $3.90/share (keep in mind, though, that some of the old BAC is now in the old Merrill; Global Banking, for example).   What do you get for $3.90/share?

For BAC as a whole, the common equity and tangible equity were:

Common equity:  $218 billion
Tangible equity:   $144 billion

Stripping out the old Merrill from above, you get:

Old BAC:
Common equity:  $136 billion
Tangible equity:   $102 billion

On a per share basis, that comes to $12.59/share in BPS and $9.44/share in tangible BPS for the old BAC (or the post-Merrill-spinoff-BAC).

So you are getting $12.59/share in book and $9.44/share in tangible book for $3.90/share!   That's a 60% discount to tangible book and 70% discount to BPS.

Pretty stunning when you look at it that way.

If the post-spin BAC is worth tangible book value and the Merrill is worth BPS, then the fair value of BAC is:

Merrill value (@BPS):                             $7.60/share
BAC ex-Merrill value at tangible book:  $9.44/share
Total value:                                             $17.04/share

That's 50% higher than the current price of around $11.50/share.  This is less than the $20/share book value for the current BAC as we don't give credit to the goodwill in the non-Merrill portion of BAC (which is goodwill from the Countrywide deal and maybe some others).   So it can be seen as conservative.

Goldman Sachs (GS)
Goldman also reported and had a double digit ROE.   It reported 16.5% annualized ROE for the 4Q2012 and 10.7% for the full year.   

BPS of GS at year-end was $144.67/share and tangible BPS was $134.06/share.  

So GS is now trading right around at book value per share ($144.50).  There has been concern that investment banks are dead, that new regulations will make it impossible for GS to make high returns again etc.

But I disagree with that.  I do feel that GS will be able to generate good returns over time. Just as a review, here is a long term look at the growth of BPS at GS:

              BPS
1999      20.94
2000      32.18
2001      36.33
2002      38.69
2003      43.6
2004      50.77
2005      57.02
2006      72.62
2007      90.43
2008      98.68
2009    117.48
2010    128.72
2011    130.31
2012    144.67

GS has increased BPS 16%/year since 1999, and importantly, BPS has increased every single year during the past decade and beyond despite the internet bubble and collapse, 9/11,  Iraq/Afghanistan, financial crisis etc.  Even since the peak of the bubble in 2007, BPS has increased at 10%/year.

Recent low ROE has been due to, according to management,  conservatism on management's part because of the uncertainties with respect to the macro environment (Europe), regulatory/capital issues (which remain unclear) and lower client activity.

If they thought there was a permanent change in the environment, they would gladly buy back large amounts of stock and return capital to shareholders.  They feel that this environment is temporary and want to hold capital so that they can deploy it when things normalize.  Viniar has said that they would love to buy back more stock but don't want to be put in a position that when things start to move, they don't have enough capital to deploy.

It's no good to take management's comments at face value, of course. But on the other hand, if you don't trust the management, then you shouldn't be in the stock (unless there are other good reasons to own the stock; asset values or potential to replace the management etc...).

I do believe that GS is being conservative.  This is very different from a company that can't earn high ROE even if it wants to and even in good environments.  There is a difference.

GS is still an attractive stock to own, though it's not a no-brainer like it was when it was under $100. 


Morgan Stanley (MS)
MS is an interesting situation.  I was never really that interested in MS except for valuation reasons.  It was just way too cheap, and it still may be.

I know that there are varying opinions on MS, but I am of the view that Purcell did destroy what MS was; when Mack came back, he rushed to get MS back into shape and got his traders to take huge risk to catch up to GS and others and he did it at precisely the wrong time and blew up spectacularly.  What was left was not so inspiring.  Even now, I don't see anything that exciting about MS.

But as I listened to the earnings call and flipped through some recent investor presentations (available at the MS website), one slide really stood out to me and I think was one of the factors that really made MS's stock price pop up a lot.

I was always wondering what was wrong with MS; why couldn't they earn better ROE?  Merrill was doing fine.  JPM was doing fine. 

And then the below chart just hit me over the head.  Maybe this was available before and I only noticed it recently.  But this chart shows the roadmap for MS to get their ROE over 10%.

What struck me is that with the current plans in place, MS is on it's way to earn an ROE of 9-10%. 

They can get to 9% with current plans and with no changes in the market environment.  By returning excess capital, they can get it up to around 10%.  If the operating environment improves, this can get ROE to over 10%.

It also helps that Dan Loeb is now long a bunch of MS.  It's always nice when someone is there for the shareholder to make sure management follows through on plans and achieve their goals.

If the turnaround continues, MS can get back to at least BPS, which is up close to $30/share.

But...
So I do like the financials.  I have liked them since late 2011 when I started posting about it on this blog.  Financials have done well since then, but I do think most of them are still pretty cheap.

I think there is still a lot of fear.  The press keeps talking about derivatives and leverage; people always worry about the last blowup and expect it to happen again really soon.  But my bet is that that rarely happens; you don't get two similar blowups so close to each other.  Yes, there is a financial crisis every few years.   When the stock market crashed in 1987, people worried about another stock market crash for years thereafter (and it has yet to happen).

But I really doubt that there will be anything with the major banks in the next few years.  Once people stop worrying about the last crash, money will start coming back to financials and valuations will normalize.  And again, when I say 'normalize', I don't mean get back up to bubble levels.

On the other hand, I understand that financials are getting mighty popular these days.  Someone who hated BAC at $5 is now saying it's a great buy at $12.  I don't understand that, but that's how the street works.  

Oh, and yes, there are a lot of other great banks and financial institutions.  WFC, for example.  It's a great bank.  But I do think it's sort of fully valued, even though it's not at all a bad investment.  It's not one that I would own now as I do like to buy things that are cheap that I think should be valued higher.  WFC valuation looks OK now; not cheap.  But the stock can do well when housing recovers more and they continue to increase earnings.  But it's a different type of holding than I want in my portfolio at this point.

Anyway, let's see how it goes.

Financials Still Look Good: Part 1

JP Morgan Earnings
So JPM announced earnings and things look pretty good to me.  Sure, there is still steady NIM pressure and this will be an issue this year too.  I think they said it will be a $400 million or so headwind in 2013.  But otherwise, things look pretty good.

I know people say that earnings actually aren't so great as they benefited from a refinancing boom and reserve releases, but I really don't find that a problem at this point.  Reserve releases just means that they over-reserved in the past so to the extent that it benefits earnings now, it just means that earnings were less bad in the past.  As for the refinancing boom, this is a function of lower interest rates so this offsets the NIM decline.  There's nothing wrong with that. 

Of course, at some point if conditions don't improve, reserve releases go away and mortgage refinancings peter out, it will put pressure on earnings for sure.  This is definitely a concern.

But the way I see it, things are still in a pretty depressed state.  Housing, for example, is recovering but is doing nothing compared to what it can do.  I'm not talking about going back to the boom times of the mid-2000s, but a more solid, firmer recovery is very possible if not likely.  In that case, all sorts of areas that are depressed now will start to come back slowly.

The investment bank too seems to be doing very well and it is hardly boom times in that area too.

I still think "normal" is much higher than here for the banks so any reduction in mortgage refinancings, reserve releases and stuff like that is something I fully expect will be offset by "normalization" in other areas.

Also, for many of the banks, legal and other costs are very elevated now and that will also start to come down over the next few years as these problems are settled.

In any case, I don't intend to get into the details, so I'll just look at one thing I do like to look at.  First, let's remember what Dimon said in the 2011 annual report letter to shareholders:

Our tangible book value per share is a good, very conservative measure of shareholder value.  If your assets and liabilities are properly valued, if your accounting is appropriately conservative, if you have real earnings without taking excessive risk and if you have strong franchises with defensible margins, tangible book value book value should be a very conservative measure of value.

So how did JPM do in 2012 based on tangible book value?  Here's an update of the tangible book value per share from 2006 through 2012:

             Tangible BPS      Return on Tangible Equity
2006      $18.88                          22%
2007      $21.96                          21%
2008      $22.52                            6%
2009      $27.09                          11%
2010      $30.18                          15%
2011      $33.69                          15%
2012      $38.75                          15%

So in a not so exciting year for the economy or the banking industry (remember the fiscal cliff?), JPM earned a return on tangible equity of 15%.  And this is in the year of the whopping whale loss.  Not bad at all, and we see how tangible book value can be a very conservative valuation for JPM.

Apple
OK, so let's take a detour for a second.  The other day on CNBC, a prominent analyst explained his Apple stock price target of $750/share.

His rationale is that he sees AAPL earning EPS of $50 in 2013 and $60 next year. At the end of next year, he estimates they will have $200 billion in cash. Since a lot is overseas, take 75% of that cash and it comes to $150/share.

So 10x $60 estimate is $600/share plus $150/share in cash is $750.

Apple is stuck at around $500/share now so if Apple gets there in two years, that's a return of 22%/year.  It should actually get there a little sooner than that as stock prices discount earnings before it is realized. 

But let's just hold that thought for a moment.   (I have more to say about Apple, but perhaps in a future post. I realize that Apple is now down 10%, but analyst price targets are apparently coming down now too, so I'll just leave the above alone).

Back to JPM
So tangible book value per share is a conservative estimate of the fair value of JPM. What is it worth?  Given it's return on tangible equity record of the recent past and Dimon's statement that they should earn at least 15% ROTE over time, I think 1.5x tangible equity is not unreasonable at all.

Assuming JPM can grow tangible book value per share at 12%/year like it has in the recent past, that gets us to a tangible BPS of $48.61/share by the end of 2014.  Put a 1.5x multiple on it and yet get a stock price of $72.92/share.

With the stock selling now at $46.50, that's 25%/year return from here (before dividends), better than Apple! 

OK, I am just comparing JPM to AAPL for fun so don't bother with the hate mail.  I know the rest of the world far prefers Apple to an opaque, highly levered, scary bank.  But I thought it was sort of interesting.  This is not to suggest that JPM is a better investment than AAPL.    JPM has a lot of risk and so does AAPL.

But What About NIM?!
NIM to me is still the primary risk in investing in banks.  I don't worry about another whale loss at all.  But we have to remember that banks are dynamic institutions, not static, unmanaged entities.  If NIM continues to go down, then I am confident that unlike Japanese banks, it will be managed accordingly.  If NIM becomes too thin, uneconomic loans won't be made.  If certain business lines don't earn a hurdle return rate on capital, then the business won't be done.  This is not how business is done in Japan (maybe more on that in a later post).   If there is excess capital because of that, excess capital will be returned to shareholders.

As long as the bank(s) is well managed, I think things should be OK.

Whale Loss Report / Atlantic Magazine Article
I read the JP Morgan task force report on the CIO incident (see here) and it was a great read.  Or, I should say, an unpleasant read for a shareholder.  Does it scare me that this happened?  Not really.  It is actually quite shocking that they tried to manage such a large, complex position with billions in notional amount outstanding on a spreadsheet with a junior employee cutting and pasting data from one spreadsheet to another.   There are other scary things in there.

But the reason why I am not so worried about this is that from the beginning I knew that this blowup occured because the CIO was treated differently than the rest of the company.  It was sort of like a teacher's pet project; Dimon had such faith and confidence in Ina Drew that he gave her a lot of rope and didn't have the firm risk management on top of CIO like it had on other business lines.  As far as Dimon was concerned, if Drew was OK, he didn't need to have anyone else check it out.   I think that was the critical error on the part of Dimon and JPM.

So in that sense, it is highly unlikely that anyone else can be doing something similar elsewhere in the firm.  Of course it's possible.  Nobody can say it can't ever happen.  But I feel like I understand the personal / political dynamic that was going on at JPM at the time.

I also quickly skimmed the recent Atlantic Magazine article on how a whale-like blow-up can happen again and I thought the article was ridiculous.  This is not to say that it can't happen.  But the article really doesn't raise anything new and uses large numbers that do tend to scare people, like the notional amount of derivatives sitting on bank balance sheets.

The article mentions that Bill Ackman thought "for once I thought you could trust the carrying values on bank books" after the crisis and bought $1 billion of Citigroup stock in 2010 and then sold out last year at a loss of $400 million.  Ackman is quoted as saying, “For the first seven years of Pershing Square, I believed that an investor couldn’t invest in a giant bank. Then I felt I could invest in a bank, and I did—and I lost a lot of money doing it.”

But does this have anything to do with bank disclosure or bad trading on the part of Ackman?   I don't think there was a disclosure/opacity issue responsible for his loss.

Notional Amount is Not Indicative of Risk
Also, as is usual in these articles, they raise the issue of the astoundingly large notional amounts of derivatives outstanding.  Wells Fargo has $2.8 trillion on it's books, but that's nothing compared to $72 trillion on JPM's books.  These are huge numbers.   These figures are usually compared to GDPs.

This figure is really not all that relevant in measuring risk.  I don't know if accounting and ISDA standards have changed since I've been in the business, but if it hasn't changed much, this notional amount is of very little value in measuring risk.

If I was a bank and you are a customer, you may want to fix your floating rate obligation.  So we can do an interest rate swap where you pay me a fixed rate and I pay you a floating rate.  Let's say we do this on a notional amount of $1 million.  Then let's say short term interest rates go down and you think it will keep going down so you want to go back to paying a floating rate.  We can do another swap on the $1 million.  Then we have two swaps outstanding for a total notional amount of $2 million.

So the notional amount outstanding on my book went up from $1 million to $2 million, but my risk actually went down as my exposure to you has been eliminated by an offsetting swap.  Under ISDA rules, whatever obligation we have to each other can be netted out.   Go back and forth again two more times and my notional outstanding can go up to $4 million, but my risk including credit exposure to you, has not increased at all; in fact it can be absolutely zero.  You would not know that from the $4 million outstanding notional amount figure.

People always talk about Buffett's costly unwinding of Gen Re's derivatives positions. The marks were good until they reached for it; once they started to trade out of it, the marks didn't reflect reality and it cost them a lot to get out of.   And yet, Buffett personally owns a million shares of JPM stock with $72 trillion notional of weapons of mass destruction on the books. 

How can this be?  I think it's important to remember that the sort of derivatives on JPM's books and on someone like Gen Re's (or AIG's) can be very different in nature.  Why?  JPM's credit rating and role as lead bank for many large global blue chip corporations means that it is the primary counterparty for simple, plain vanilla derivatives used to hedge foreign currency and interest rate exposure.  When Proctor and Gamble wants to hedge global FX risk, they do swaps with the likes of JPM or other major city bank.  They typically will not go to AIG or Gen Re who are not their bankers.

A major corporation like IBM may sell bonds to the public; some institutions may have a need for floating rate instruments while IBM wants to offer fixed rate, straight debt.  Someone like JPM can do the offering and do a swap with the investor (do a fix-float swap), or have IBM offer a floating rate bond and do a swap with IBM.  This can happen across currencies (IBM may offer yen bonds, swap it into fixed dollar payments etc...).

This is why the major city banks have such large notional derivatives outstanding.

Why are other institutions' derivatives more toxic and tricky?  It's because Gen Re, AIG and others can't compete and make money in plain vanilla derivatives.  They can go to Johnson and Johnson and say, hey, we want to help you manage your interest rate risk.  But they won't be able to compete with JNJ's bankers.  It could be a credit rating issue or just a banking relationship issue (main banks may be willing to do hedging transactions for very low margin as part of maintaining a relationship.  Pricing may also be more competitive as big money center banks have many similar counterparties to offset differing hedging needs etc...  There is a network effect here too).

Most likely, it will be that JNJ will already have derivatives outstanding with a few of the large banks already and to do a deal with an existing counterparty is just more efficient from a documentation, collateral management, netting and other issues.

It's hard to break into that side of the business.  This is why other institutions often have to compete in more exotic derivatives that are harder to price (and have wider spreads).

Also, most of the notional outstanding are FX or interest rate swaps.  Very little of the notional outstanding is based on equities, commodities or other volatile instruments.  Why is this important?   Think about a fix-float swap.  One counterparty agrees to pay fix and receive float from someone.  If the counterparty goes under and if the swap is effectively terminated, future payments just stop.  If the bust counterparty can't pay their fixed rate payment, then you don't pay your floating rate payment.  There is no loss of principle or anything like that.  What would usually happen is that there might be a hedging loss; whatever hedge you put on you will have to unwind and you may take a loss on it.  Typically, such losses would be covered by collateral held so no loss would be incurred unless there was a large market move after the termination of the swap.

During the financial crisis, notional derivatives outstanding was not an indication of how much risk a bank had.  In fact, people always thought that JPM would be the first domino to fall due to their derivatives book.  (Critics will say if the financial system fell, JPM would have fallen too. Dimon denies that and I side with Dimon on that one (or at least he said they would have been fine even if things got far worse; I don't know about a total collapse).  But either way, if the financial system failed and everyone went under, then it would be moot anyway; banks with less derivatives outstanding would have failed too).

The first banks to fall were the subprime lenders, then some of the regional banks like IndyMac and Wamu (not known for large derivatives outstanding).  Bear Stearns and Lehman both failed due to pretty plain vanilla positions (mortgages in the case of BSC and commercial real estate loans in the case of Lehman (the then CFO did say that commercial real estate loans was what killed Lehman; they were plain vanilla, straight loans).   AIG failed due to derivatives, yes.  But it wasn't the size that did them in but the one-sided, unhedged bets that killed them (and they were neither a bank nor an investment bank).  Citigroup's large losses occured in SIVs, a security that didn't even appear on the balance sheet; it had nothing to do with the notional derivatives outstanding.

This is not to say that there isn't some funky stuff in JPM or WFC's derivatives books.  There usually are some funky/exotic things in any book.  But they tend to be a very small part of the trillions in notional outstanding.

Other Losses
The article also mentioned a proprietary trading loss of $14 million and an economic hedging loss of $1 million (at Wells Fargo) and noted that these figures are small, but how do we know how big it could have gotten?  They talk about these small losses and tell us that it could have been far, far worse, but we wouldn't know because Wells Fargo doesn't tell us how much risk they are taking.  I found this to be reaching a bit too much.    This seems a bit silly to me.

This is not to say that there aren't any risks.   Banks / investment banks are risky businesses.

OK, I was going to talk about Bank of America, Goldman Sachs and Morgan Stanley (just brief comments, nothing deep) but this post is already really long so I'll send this out first and finish my thought in the next post.  Plus I haven't posted in a while so it'd be nice to get something out there now.

Wells Fargo-Goldman Sachs Merger

(Warning: The above title is a title of a blog post, not a news headline!)

OK, so I asked in my last post if GS would be better off as part of a bigger bank and I couldn't put that thought away.  In the past there were rumored merger partners like Wachovia (that was just during the crisis, though), AIG and HSBC (and some others; WFC might have been mentioned during the crisis). 

But WFC kept coming to mind.  Both WFC and GS are owned by Buffett and he loves both of them.

First of all, this is just for fun.  I know this is a long shot and in this political/regulatory/public sentiment environment, this is probably not going to happen (if GS is an octopus, what would you call WFC-GS?!).  But this is a blog so I can write whatever I want, so that's what I'm going to do.

Also, it's a little silly to react too much to short term trends.  I did say the independent investment banks are doing horribly compared to ones that are part of bigger banks.    Morgan Stanley just announced their 2Q and it just confirms this.

So let's add MS to the table from my other post about Merrill:


Independent investment banks
                       2Q ROE                6 month ROE
GS:                 5.4%                      8.8%
MS:                3.5%                      1.4%

IB's as part of bigger banks:
                       2Q ROE                  6 month ROE
JPM (IB):       19%                        18%
JPM (AM):     22%                        22%
BAC/MER:     12%                       13%

The difference is quite clear.  MS's result is horrible.  The market environment is bad, but is it really *that* bad?  I don't know.   The results are horrible, though.

What's stunning about MS is that it's horrible across the board.

From their earnings supplement, here are the returns on average equity for the the various MS segments:

                                                   6 months periods
                                                   2012              2011
Institutional securities                0%                0%
Global wealth management       5%                2%
Asset management                     3%                *
Total                                           1%                1%

I haven't been following MS too closely but I am a bit surprised that shareholders have been so patient there.  Again, look at JPM's returns and that includes the big whale loss!  How can MS not make money?

Investment Banks Better off Inside of Other Banks
OK, so MS may be horribly mismanaged but the fact that the usually very well-managed GS is not doing too well either may imply that investment banks may actually be better off inside other banks.  This is just something that comes to mind just by looking at the facts (even though admittedly, the facts are very short term and may not be indicative of long term 'facts').

Wells Fargo-Goldman Sachs?
So this idea leads me to the Wells Fargo-Goldman Sachs merger idea.  First thing that you are going to think of is what it's going to be called (OK, maybe not the first thing or second thing...).

Wells Goldman
Wells Sachs
Fargo Goldman
Fargo Sachs
Goldman Wells
Goldman Fargo

OK, so none of these really click so let's move on.

As JPM, BAC and WFC grow domestically as the largest banks, increasingly competing in major metropolitan centers like NYC, it's interesting to note that both JPM and BAC have large investment banks.  C, which I haven't included here also has a large investment bank.

WFC stands out as not having a large investment bank even though they do have a wealth management/brokerage segment.

So in that sense, WFC-GS might make sense.  Of course, just because everyone else has something is no reason to get one for yourself.  But still, let's keep looking at this.

First let's take a look at the other large integrated banks:
                    ($bn)
                    Total assets             Equity                     Equity of IB
JPM             $2,266                     $176                             $47
BAC            $2,296                     $212                             $66
WFC           $1,314                      $140                             (n.a.?)
GS                  $923                       $69                            $69
WFC-GS     $2,237                     $209                            $69

So look at that!  GS fits like a glove into WFC and puts it into the ballpark of JPM and BAC in terms of asset size, equity and equity invested in the investment banking business (The JPM IB equity includes $40 billion for the IB and $7 billion in their asset management business).  

It fits so well it seems almost inevitable!

(WFC does have wealth management and brokerage, so the equity in that business is not zero but it's not disclosed separately (I don't think), and it's not that big)

From this point of view, it looks completely normal and reasonable.

The Merger
OK, so this is a big deal.  I briefly thought about BRK just buying GS outright, but realized that there would be some regulatory issues (don't ask me what; I don't know exactly, but it would probably be complicated).  Plus, a market cap of $47.6 billion of GS is a bit much for even Buffett to swallow now (but you never know!).  He is looking for a $20 billion whale, and maybe even a $30 billion one if cash keeps accumulating.

Buffett has said that every bone in his body tells him to hold on to his GS warrants, so we know he really likes the business and the management.

Anyway, back to the WFC-GS merger.  Since this is a whopper of a deal, the best way this can be done now would be a stock-for-stock merger.  Why?

Because WFC is trading at 1.3x book and GS is trading under book, it would be deliciously accretive to WFC!  Why not?

Of course, I doubt GS would sell itself at under book value, and certainly not 30% below book value.

But let's take a look at this anyway.  This is a blog, not a deal book (so I can do what I want!).

As of the end of 2Q2012, here are the relevant figures:

                                      WFC                       GS
BPS:                              $26.06                    $137.00
SOS:                               5.3 billion               500 million
Common equity:           $138 billion             $68 billion
Stock Price:                   $34.00                     $96.00
Market Cap:                   $180 billion            $48 billion
P/B ratio:                        1.3x                         0.7x


So at current prices, WFC would need to issue 1.4 billion shares to take out GS.  What would happen if the deal gets done right now at these levels?

After the deal, WFC would look like this:

Common equity:         $206 billion
Shares outstanding:      6.7 billion
BPS:                            $30.74/share

So this deal would be accretive by $4.70/share, or 18%.  That's a nice bump in BPS.  How many years would it take for MS to do that on it's own?   Or even GS?

Of course, with market sentiment the way it is, the market may not increase the valuation of WFC on this merger and in fact may reduce it (the market is already telling us that it doesn't like the investment banking business, as the one bank that doesn't have a major IB attached to it is trading at a higher P/B than the other two (JPM and BAC) and independent investment banks are trading below book).

But a lot of that might be offset if GS can generate higher ROE within WFC than on it's own.   The most important reason why investment banks are trading below book is their single digit ROE.

Benefits of a Merger
There are a bunch of reasons why this merger would be good and of course many that would be bad.  First of all, I would think that the regulatory and political environment would be very bad for this deal.  I'm not sure WFC wants the headache of having to worry about the Volcker rule and other regulatory issues.

On the other hand, the benefits that immediately come to mind are:

• Cross selling of products throughout merged bank
• Capital efficiency of having a more diversified business model

I'm sure there are plenty of other pros and cons, but I am just jotting down things that come to mind off the top of my head.

I think both MER and JPM are doing better than GS and MS partly because of the cross-selling advantage.  Dimon has mentioned that in the past.

Also, capital efficiency is another big plus, even though I understand most people would disagree with me and say that hiding a risky investment bank behind an FDIC/taxpayer supported bank is a horrible idea.  I've never subscribed to that view, but of course I understand this deal would be a nightmare for folks who do take that view.

Conclusion
I don't necessarily advocate this merger even though the more I think about it the better it sounds.  As an investor, we can't just react to short term results and events and seek instant gratification.

I still think it's a good idea to look at investments and evaluate them on what you think they can earn in a more normalized environment five years out or so.  So this above analysis clearly is short-term oriented; I am reacting to the poor results at independent investment banks over the past 12-18 months. 

I don't know about MS, but I still like GS and think they will do very well over time.  I do believe that this conservatism is short-term based on the uncertainties and heightened risk of a total financial blowup in Europe (and GS doesn't want to get caught with it's pants down; there would be no political will for any sort of rescue next time around).

But it is something that came to mind as I go over these results, so I just jotted it down (for fun!).

And I know, this post goes against everything everybody seems to be saying. 

Merrill Doing Good, What's Wrong with GS?

Bank of America announced their earnings and it looks OK.   Of course, there is still an issue with low interest rates and loan growth like at other banks.

This is not intended to be a full recap of BAC's second quarter.   I don't want to comment on every quarterly announcement of companies I talk about here unless there is something I want to say about it.

And since I recently posted about the value of Merrill Lynch, as a sort of follow-up to that, I decided to take a look at the old Merrill and see if they're still doing good and it turns out they are still doing pretty well; better than Goldman, in fact.  So what's wrong with Goldman?  That's another question for later.

Anyway, here are the results of the three segments that are sort of the old Merrill Lynch even though Global Banking includes the investment bank (underwriting, advisory etc.) and what used to be the Global Commercial Bank.

So I just grabbed these figures from the supplement so I can add it all up to see what the aggregate result of the old Merrill is (EC = economic capital, which is basically tangible equity. GWIM = Global Wealth and Investment Management, units = $mn):

So in the second quarter, the old Merrill earned an ROE of 11.9%, not bad at all.  In case some people object to the mixing of the commercial bank with the investment bank, I also put a row at the bottom which only includes Global Markets and Global Wealth and Investment Management.  The ROE figure is close, so I think it's OK to look at the whole "combined" figure; the commercial bank doesn't distort that too much.

In the first six months of 2012, the old Merrill earned an ROE of 13.17%.   This is a pretty solid result, and the results seem solid across the segments.


So how does this compare to Goldman Sachs (GS) and JPM's investment banking operation?
Here are the ROE figures for GS and JPM (investment banking operation and asset management operation):

                        2Q ROE                  6 month ROE
GS:                      5.4%                      8.8%
JPM (IB):          19%                        18%
JPM (AM):        22%                        22%

So Merrill compares very favorably against GS, but not so great against JPM.

Of course, since these equity figures are internally allocated equity figures, it's hard to say if they are 'realistic'.  I think management tries to allocate enough equity so that on a stand-alone basis they would be able to conduct business at the same level. But that's still quite a bit different than actually being stand-alone like GS.

So what's wrong with GS?
It seems like GS is being very conservative and cautious; they do have excess capital and liquidity and their VAR is, I think they said, the lowest it's been since 2006.  They are clearly being very cautious.  On the conference call they do sound confident that opportunities will arise but they just don't know when. They do talk about having a lot of capital ready to deploy, and that they have a lot of operating leverage so that when things stabilize and pick up, they can really make some good money.

But still, why is GS earning single digit ROE's while JPM is earning 20% ROE and even the old Merrill is earning double digit ROE's?

Yes, one point is management; GS is being very conservative for whatever reason.    Does this have to do with GS being independent?  Do they have to be more conservative than JPM and MER because they are not part of a bigger bank and therefore there is nowhere to turn if conditions worsen (in terms of reallocating capital/liquidity to it)?

I still like GS, and I do believe that GS knows what it is doing and is waiting for the right opportunities to deploy capital profitably and I don't think this single digit ROE is going to continue forever (I know many will disagree with that; many will say, ha, told ya so.  Investment banking is dead!).

Diversified Business Model actually GOOD?
So I was wondering if the superiority of JPM and MER versus GS is the diversified nature of JPM and BAC.  One of the benefits of Berkshire Hathaway is that cash all goes to Omaha and then it gets redeployed by Buffett according to where the best opportunities are.  So if you are a furniture store not doing so well but generating cash, you don't have to reinvest the cash in the business; you send cash to Omaha and Buffett will deploy it where he sees good returns.

This is one of the benefits of the diversified financial institutions too which was popular back in the 1990s and 2000s; this idea is not so popular these days, though, obviously.  But these things seem to move in cycles.  Sometimes a diversified model is good, at other times it's bad. 

I actually think there is a benefit to the diversified model.  Of course, any good idea can be taken to extremes.  When a diversified model reduces risk (or perceived risk), that encourages more risk-taking until you take it too far and blow up.  But that doesn't mean a diversified model is necessarily a bad idea.  (If you lever up thinking you have a diversified portfolio, you might lever up too much and blow up like LTCM.  But that doesn't mean running a diversified book is a bad idea).

So in the case of JPM, they can deploy capital where it sees opportunity.  What's interesting is that JPM's allocated equity to the investment bank is constant at $40 billion, which means that all returns generated are paid up to 'corporate' or wherever it goes.  It doesn't build up equity and then create the need to invest more.  

Dimon will up the allocated equity on an as-needed basis.

On the other hand, GS has a very focused business model so when capital builds up, it just stays there at corporate (or wherever) with nowhere to deploy the capital.  Of course they can pay it out as dividends or repurchase stocks, but then that would be a permanent return of capital to shareholders and if opportunities suddenly arise, they won't be able to get that capital back.

At JPM, if something happens and opportunities arise, they can shuffle capital back and forth between business lines.

So that does increase capital efficiency.  I understand that there is an argument that this sort of thing may actually encourage too much risk-taking and an eventual blowup.   But as I said above, you can take any good thing and take it too far.

(Also, I will leave out the benefits of cross-selling that JPM and MER might be enjoying at this point).

I know this argues against the BAC-MER spinoff, but it is something that came to mind when going through the second quarter numbers for these institutions.

The Opposite Question
All of this ironically raises a question that goes the other way (that actually used to be asked all the time); should GS be a part of a larger financial institution?!  That would be the corollary to all of the above observations.
I have no strong views on that at this point, but it is an interesting, contrarian thought (contrary to people calling for MER to get spun off, for big banks to split up etc).

Wall Street Firms Only for Employees?

So I keep hearing people say that Wall Street firms exist only for their employees.  One guy on Bloomberg TV said that GS only exists for it's employees; why not get that compensation down and return some of it to shareholders? 

As proof that GS exists only for the employees, he states that compensation is 40-50% of net revenues.

OK, so let's think about this for a second.  Is it really true that GS only exists for employees?  If someone started a business only for the benefit of the employees, can it really exist for a long time?  I tend to doubt that.  We have heard so much how awful GS is despite the "muppet" story and Fabulous Fab etc.  Are people really that stupid and irrational to keep doing business with these awful people?  Or does GS actually provide a service that people want to pay for?

Compensation Ratio
Anyway, first of all let's think about this 40-50% compensation expense ratio.  Banking is a service business and it makes sense that much of the expense in a service business is labor cost.  Unfortunately, there isn't much detail in financial disclosures to calculate labor costs in various industries.

One industry where labor cost is disclosed is the restaurant business, which is a service business.  McDonald's has a breakdown of costs for their owned restaurants.    From that we see that owned restaurant labor costs as a percentage of restaurant sales is 25%.  But wait a minute; banks and investment banks report revenues as "net" revenues, net of interest expense which is basically their cost of goods sold.

So let's look at labor costs at McDonalds as a percentage of "net" revenues (revenues less cost of food and paper).  That comes to 38%.

So 38% of McDonalds restaurant sales (net of cost of goods sold) go to payroll and benefits.  McDonalds, too, then exist only for their employees?  By this definition, yes.  McDonalds restaurants only exist for the employees.

How about another restaurant?  Darden Restaurants is a large chain restaurant.  I am not cherry-picking any names here; that's the first one that came to mind that seems like a 'typical' chain restaurant (that runs "owned" restaurants versus franchises them which have different economics).

Labor costs at Darden is 32% of sales.  If you exclude cost of goods sold, then labor costs is 45% of "net" sales.  So I suppose Darden restaurants too only exist for their employees according to this person that is complaining that GS only exists for their employees.

How about another one?  I remember Dimon mentioning newspapers when he commented on this issue. 

Again, I am not picking names that make my point.  The first pure play newspaper that comes to mind is the New York Times.  Wages and benefits at NYT in 2011 were 37% of total revenues.  That's 37%.  Yup.  New York Times too exist only for their employees.

How does this 37% compare to the evil banks?

Compensation and benefits expense as a percentage of net revenues for the three financial firms I mention often here are:

GS:        42%
JPM:      30%
WFC:    34%

These are all figures for the full year 2011.

OK, so maybe I am reaching here a little bit.  Fine.  

Let's look at this another way then.

People keep saying that GS (and other investment banks and banks) exist only for their employees but let's look at shareholders.

I already mentioned how great JPM has done for shareholders throughout the crisis.  You can see growth in tangible book and book value per share over time, plus JPM pays a nice dividend even now.

Here's the post on the JPM 2Q.

It looks to me like JPM is doing fine for shareholders. 


GS No Good For Shareholders?
OK, fine you say.  JPM has a lower compensation ratio than even the New York Times.  And they have done well for shareholders over time (management can't control stock price so you have to look at ROE, growth in BPS etc...).

Let's see how the poor GS shareholder has done (I'm just cutting and pasting here from an old post):

• The average ROE from 2001-2011 is 17.2%, and for the last five years it's been 15.1%.

That looks good to me.  How many companies have achieved that?  I'm sure New York Times shareholders would love performance like that!

BPS for some key years were:
                   
                   2006       2007      2011
BPS           $72.62     $90.43   $130.31
TBPS         $61.47     $78.88   $119.72

• Since the peak in 2007, GS grew BPS by +9.6%/year and tangible BPS by +11%/year.
• For five years, the respective growth rates were +12.4%/year and +14.3%/year.
• For the past decade, 2001-2011, BPS grew +13.6%/year.

That looks pretty impressive to me.  How many companies have achieved something like this, especially after all that has happened in the past decade?

Anyway, it doesn't really matter what people say but when people keep saying something over and over without looking at the facts, it gets a little annoying and I can't NOT point it out.  It's a little disappointing that so many reporters and commentators have been in the business for many, many years and still don't seem to check the simple facts before commenting.   There are a lot of people saying a lot of things all the time and a lot of it has no basis in fact!    Beware of these people.

Financials Still Cheap

The financials have really exploded this year as unemployment and other economic figures continue to show some decent recovery.  Europe doesn't seem like it's going to blow up tommorow.   China seems to be going into a hard landing but China might be a laggard to what has happened in the U.S. and Europe in the recent past.  Ironically, China may recover if the U.S. continues it's recovery.

Anyway, I have liked the financials recently and they have done well, but some of these stocks are still pretty cheap.

Some of the well managed insurance companies like White Mountain (WTM), Markel (MKL) and Alleghany (Y) continue to trade not too far from book value and Berkshire Hathaway (BRK) too seems to be trading at around 1.1x book value.  Buffett indicated pretty strongly that he thinks BRK is worth far more than book value and actually took the time to tell us that each segment is worth far more than book value in his Letter to Shareholders.

Here's a quick look at two of my favorites.  (I also bought some Bank of America (BAC) LEAPs recently before the pop after the stress tests; I may post about that later but I thought this was a Greenblatt (Stock Market Genius book)-like trade)

Goldman Sachs (GS)
GS has come back strongly since last fall and is up to $126/share or so despite the very public and 'humiliating' resignation of a junior employee (I think it was more embarassing to the resigning employee than to GS; I immediately saw that as a sour grapes story).

But even after rallying so much, GS stock still trades at slighty above tangible book value.  Again, I tend to think that's incredibly cheap, barring of course another financial crisis.

GS didn't do quite so well in 2011 as they decreased their risk to wait for opportunities.  Some say that they have shrunk their book due to regulatory uncertainty, but during conference calls they always said that it was solely a function of opportunity.  They don't take a lot of risk when they don't see the opportunity.  

Anyway, let's see how they did over the past decade or so in terms of return on average equity (ROAE) and return on average tangible equity (ROATE).

I don't know why this table is upside down; I typically input numbers going down, but oh well...   It's not worth fixing.  I just pulled these quickly from their annual reports; they used to report only ROAE, and then both and now they only put ROAE.  I think that's because book value has grown to make goodwill a much smaller portion of book value so over time ROAE and ROATE will converge.

The average ROE from 2001-2011 is 17.2%, and for the last five years it's been 15.1%.

From this you can see that GS has done incredibly well since 2000 in terms of returns.  It is pretty amazing, actually. 

Think about what happened since 2000.   We had the internet bubble collapse and the stock market went down 50% (NASDAQ went down 80%) and they earned double-digit returns throughout.  This period also included 9/11 and the Iraq and Afghan wars.

Right up until 2007, they earned very high returns and then the crisis came.  This was the worst financial crisis in history that took many banks and brokers down and GS came through it without losing money in any single year.

With this 'horrible' decade where the stock market went nowhere (which is misleading as it actually had TWO bear markets where the market went down 50%), GS had only two years where ROE was below 10% and didn't lose any money.

Since 2001, GS has only had two single digit ROE years and never lost money despite two big bear markets.

BPS for some key years were:

                    2006     2007       2011
BPS           $72.62    $90.43   $130.31
TBPS         $61.47    $78.88   $119.72


Since the peak in 2007, GS grew BPS by +9.6%/year and tangible BPS by +11%/year.
For five years, the respective growth rates were +12.4%/year and +14.3%/year.
For the past decade, 2001-2011, BPS grew +13.6%/year.

That's pretty amazing.

I know, I know.  Investment banking is dead and they will never make good returns ever again.  The Volcker rule and many others will limit what they can do.  

But we've seen all of this before.  Dimon has said that this talk that banking is dead is ridiculous and that the industry is *always* changing; he's seen it before many, many times before over the decades.  Every time, people think it's all over.  But banks adapt and find new ways to make money.  This time is no different.

I also remember reading about Mayday and the Big Bang when stock brokerage commissions were deregulated.  That too was supposed to be the end of the investment bank as their 'fixed' commissions made them so much money in the past.   Oops.

GS will be much more adaptable than many other financial institutions since they don't have the bank branch infrastructure, long dated assets like insurance companies; they can move capital to where they can earn an acceptable return.   If there is no return, they will return capital to shareholders etc...


JP Morgan  (JPM)
So JPM has also rallied a bit to around $45/share.  Is it still cheap?  Dimon has said they can earn $24 billion in a more normal environment, so with 3.77 billion shares outstanding, that's an EPS of $6.36/share or so.  At $45/share, JPM is still trading at 7x 'normalized' earnings.   That's pretty cheap for a bank of JPM's quality.  At 10x p/e, JPM would be trading at $64/share or so and at 12x, $76/share.

As I started to type this up, I had forgotten that I already made a JPM post about their investor day (look here).

But anyway, it's just a simple update so I'll keep going...

Like GS, JPM has done really well throughout the crisis even though JPM was supposed to be the first domino to fall (due to derivatives, leverage, investment bank attached etc...).

But again, here is JPM's return on equity (ROE) and return on tangible common equity (ROTCE) for the years 2005 through 2011:

            ROE       ROTCE
2005       8%       14%
2006     12%       22%
2007     13%       21%
2008       4%         6%
2009       7%        11%
2010      10%       15%
2011      11%       15%

Return on equity by segment:

                                                   2010        2011
Investment bank                         17%          17%
Retail Financial Services              7%            7%
Card Services and Auto              16%          28%
Commercial Banking                  26%          30%
Treasury and Security Services   17%          17%
Asset Management                      26%          25%

The return on equity by segment shows that most segments are doing pretty well except Retail Financial Services, which should recover as the economy recovers and if housing stablizes and employment continues to go up.

So despite all the naysaying about financials, I continue to believe they are cheap and will do well over the next few years.

Cheap and Cheaper

I know, this is a broken record blog.  We all know financials are cheap and we all know there are plenty of reasons why they are cheap and why they might be right to be priced cheap.

However, I tend to still like the well-managed financials.

This is laughable and I don't mean to suggest financials should trade at over 3x tangible book value, but here's a valuation of historic deals in the investment banking sector I pulled out from the Merrill Lynch merger proxy (merger proxies are great sources of information; investment banks do a lot of valuation work to validate deal values and you get all that stuff for free in the filings):

OK, that came out pretty small but historic investment bank acquisitions have happened at an average of around 3x tangible book value with a median valuation of 3.4x.

Of course, this is pre-crisis so the world is quite a bit different now.

But I do think investment banks are certainly worth more than tangible book, if not a multiple of it.  Right now, people are worried about a complete European implosion and financial blowup that may be worse than what we saw in 2008/2009 in the U.S. 

Anyway, here's a list of price-to-tangible book values that was in the "Heard on the Street" page of the Wall Street Journal this morning:

                                   PTBV ratio
J.P. Morgan                95%
Goldman Sachs          76%
Jefferies Group            76%
Citigroup                    52%
Morgan Stanley          51%
Bank of America        44%

As I mentioned before, I really do like J.P. Morgan (JPM) and Goldman Sachs (GS).  I do think they are both very well managed.  JPM is a huge bank so will be subject to macro forces, but management has proven they can handle once in a hundred year events.

GS, too, has managed the crisis pretty well but they may be more flexible and agile than JPM since they are not a major bank.  Investment banks tend to be pretty nimble.  GS doesn't have a large physical presence (bank branches) or a large retail sales force (retail brokers) so don't have a large fixed cost base burden.  If things don't recover, you can be sure they will cut costs quickly and will move capital to where they can earn an adequate return.

At this point, according to the recent earnings conference call, GS is waiting for things to clear up a bit since things are in a sort of 'crisis' situation.  They do think that when things stabilize they will be able to deploy capital profitably.  If they thought this downturn is permanent, they would then use their excess capital to repurchase shares (and will probably cut more costs).

An interesting play here too is Jefferies Group (JEF).  I don't own JEF, but tend to really like it especially so cheap.  They are a small investment bank which has good sides and bad.  Right now, they are seeing the bad side of it.  JEF shares have tumbled alot after the MF Global blowup; people are now concerned about smaller firms that are too small to survive (versus too big to fail firms).

Some of my favorite value managers at Leucadia (LUK) bought into JEF stock on this decline as they are confident in the management of Richard Handler.  I think JEF will be able to pull through this as they do have a great reputation and Handler is known to be a conservative CEO (unlike the more risk-taking, reckless Corzine).

But in finance, you never know.  Good firms will go down in crisis situations, sometimes (although I don't think that happened in the 2008/2009 crisis; I think the firms that went down in that crisis weren't really good, well managed, conservative firms.  They were reckless, aggressive, overleveraged, horribly managed firms (BSC, LEH etc...)).

The good side of a smaller investment bank like JEF is that they may have more opportunities if they have a good niche (many smaller investment banks like Cowen haven't made money in years) and are well-managed.  The good thing is that they don't depend on mega-deals.  Bigger investment banks have to do bigger and bigger deals to increase revenues, just like larger and growing private equity funds have to do bigger and bigger deals to deploy bigger and bigger amounts of capital.

Anyway, all of these are financial companies and as I keep saying, one should be very careful how much exposure they have in any single sector (otherwise, I would be buying JEF too, but I have enough financial exposure now).

If Europe does really implode, financials can certainly go down more.  By their very nature, they are risky and another financial crisis of bigger than 2008 proportions is not a zero probability.

I do talk a lot about financials here now just because I do tend to think they are cheap, and because of my experience in the industry I tend to be more comfortable with some of them than most other investors and the general public (that seem to resent/hate financials!).

But that doesn't mean investors should pile into these things too much!

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!)

Goldman Sachs is Cheap!

I talked about how great it is that people can buy BRK and LUK at book value, and that JPM is selling at or below it's tangible book value per share even though JPM is capable of earning much more than 15% on that tangible equity.

The markets are falling apart now and financials are getting even cheaper.  Again, there are tons of financials that are getting cheap.  Some really cheap ones are Citigroup and Bank of America, for example.  Although these banks may rally sharply over the next few years and I assume investors will make out well, they do have a history of problems and they are large institutions tied to the GDP of this country.

However, if you look at a firm like Goldman Sachs (GS), they are much more nimble than those large banks as they can typically more easily move capital to where the opportunities exist.  They are not burdened by large consumer loan portfolios and large bank branch networks, for example.

Also, GS earns half of their net revenues in the non-U.S. market.

I just wanted to post this quickly as it seems like such a tremendous opportunity so I won't go into the details of this company.

But let's just say that GS is one of the best financial companies out there.  They did very well through the Great Recession with very little in losses (like the other of my favorites, JPM, BRK and LUK) and have managed to grow book value in the past few years despite the worst environment in 100 years (or whatever).

Anyway, the bottom line is that the book value per share of GS at the end of June 2010 was $131.44/share and the tangible book value per share was $121.60/share. 

And the stock is now trading at $93/share!    That's a 30% discount to book value and a 24% discount to tangible book value per share.

Not too long ago, you had to work hard and make partner to be able to buy into GS at book value, and here it is for anyone to buy at way below book value.

If that's not an opportunity, I don't know what is.