Solid Results at Oaktree, But...

Oaktree Capital Group (OAK) announced pretty good earnings for the full year of 2012.  The funds, across the board, returned around 15%.

For those who don't know, OAK is co-founded and run by Howard Marks, a legendary Buffett-like figure in the fixed income world.  It would be well worth your time to google Howard Marks and read his "memos" and watch youtube and any other video interviews you can find on the net.  He also wrote a fantastic book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor.

Anyway, I'm not going to repeat all the stuff that you can get from the earnings release.  If you're interested, you can just go to the OAK website and read about revenues, adjusted net income, distributable earnings, economic net income and all of that.  I'm just going to look at some things that made me raise my eyebrows and then maybe take a quick look at valuing this thing at the end.

I did happen to pick up some OAK last year as it tanked after the IPO so I am sitting on some nice profits on this position but it doesn't feel as much like a no-brainer that it did last year.  Anyway, I am getting ahead of myself.

No Longer Counter-cyclical?
The first thing that made me raise my eyebrows is that on the conference call, Howard Marks said that in 2012, they raised $12 billion in capital for funds which was their sixth year that they raised $10.8 billion or more. 

I thought, great!  That's really fantastic.  They are on fire!

But then I thought, wait a second.  I thought these guys were counter-cyclical.  I remembered a graph they had in their S-1 (prospectus) last year that really impressed me.  Here it is:

So in 2006, while private equity investors fell over each other investing, Oaktree Distressed Debt funds were laid back and not doing much.  The same happened in 2007.  But then when the wheels fell off, Oaktree pounced and made a lot of investments while private equity scaled back dramatically.  See how investments ballooned from $1.5 - $2.5 billion in 2006-2007 to $9.9 billion in the 4Q08-3Q09 period.

OAK can raise a lot of funds to maximize management fees, but this is not who they are.  They won't raise funds just to earn fees. 

But then we see that OAK has raised more than $9.8 billion for the sixth straight year in 2012.  To be clear, the above table is only for the Oaktree Distressed Debt funds and not for all of OAK.  In recent years, they have been adding different strategies (real estate, Europe etc...) so it's not apples to apples (plus the above table is for capital invested, not capital raised).

But still, with default rates and high yield spreads at historical lows, it's hard to imagine where all of this capital will be invested.  I don't mean to second guess Howard Marks or the smart folks at OAK.  They are the pros.  I'm an equity guy so have no clue about fixed income markets.

It seems to me, though, the combination of low nominal interest rates and low credit spreads around the world is at a historical level.  It's hard to imagine how they can earn good returns going forward in this market.

Marks did say on the conference call that he thinks they can still earn 10% returns over time. This was in response to a question of whether OAK would consider lowering the 8% hurdle rate of return (before earning incentive fees) because interest rates are so low.  Marks said that it is a fair intellectual argument to say that that should be lower, but he doesn't want to go to the investor and say they are lowering the hurdle rate due to lower interest rates when he still thinks they can earn 10% going forward.

Marks did say that their funds have done very well when launched in turbulent times but has also done OK when launched in good times.  I suppose we can point to 2006-2007 launched funds.

But even then, interest rates weren't this low even though credit spreads might have been this low. 

In any case, this is just my own reservation.  OAK believes that there are opportunities and that's why they are raising capital.  They are more concerned with deal flow.  It the deal flow is not there, they can't invest, but they feel there is plenty on the way.

I have to say that investing in a fixed income asset manager during the peaking of the biggest bond bubble of all time, and one that particularly specializes in credit analysis when credit spreads are at ridiculously low levels is a little frightening. 

Of course, OAK is just about the best in the business, but even great equity managers suffer during stock market bear markets.   In a real blowup, OAK would definitely benefit as their pool of potential investments would expand.  But their current funds would take big marks against them, so that's sort of a conundrum with owning OAK today.  It can get bad before it gets really great.


Interesting Nugget From Call
By the way, there was an interesting comment from Marks on the call.  Someone asked him about OAK's underperformance (versus benchmarks) in 2012, as they have underperformed by 50 bps or so.

Marks said that nine or ten years ago, some consultant asked OAK to add up their performance in each quarter the markets (benchmark) went up and do the same for each quarter the market went down.  Marks cautioned that this is out of memory, but he said that OAK's funds underperformed by 55 bps in up markets but outperformed by 600 bps in down markets (annualized).

That's a fascinating piece of information.  This should probably go into every OAK presentation.  (I think Och-Ziff puts a similar thing in their filings; how their funds do well in down markets).

Anyway, let's take a quick look at what this thing is worth.

What's it Worth?
At the end of the day, we can't really predict where the bond market and credit markets will go.  People have been calling the bond market a bubble for a long time.  So the most important thing (as Marks would say), I guess, is to figure out what this thing is worth.  The uncommon sense thing for the thoughtful investor to do would be if the stock is trading substantially below what it's worth, buy it (or hold on to it).  If not, sell or don't buy.  Of course, since OAK is a great organization, it makes sense for long term investors to hold on even if it is fairly valued.

We can look at OAK valuation as the sum of four (or five if you include DoubleLine as a separate piece) parts:  Fee-related earnings stream,  incentive fee stream, balance sheet value (cash, treasuries and investments in funds) and off-balance sheet accrued incentive fees.

Fee-related Earnings
In 2012, Fee-related earnings (which is management fee minus compensation expense and SGA) was $307 million.   It was $315 million in 2011.   Management fee-generating AUM has been stable at $67 billion in 2011 and 2012, so I think this $307 million is an OK number to use to value this stream.

At 10x this, that's $3.1 billion value for this stable stream of income.  With 150 million total units outstanding, that's worth $20.70/share.

Incentive Fee Income
This part gets a little funky because it's very lumpy, so we have to make some assumptions.  I think the funds that OAK offers are designed to earn 10% or more over time.

The incentive fee is 20% of what they earn (once the hurdle as passed), and much of that is paid out as performance bonus to the fund managers (and other employees, hopefully).   Looking at the accrued incentive fees at the end of both 2011 and 2012, it looks like employees get 40% and OAK gets 60% (this varies by fund/strategy so may change over time).

So instead of using actual incentive fees earned over time, I'll assume the funds earn 10% (they earned 15% in 2012 so 2012 earnings are obviously better than they would usually be), they get 20% of that and pay out 40% of that for the bonus pool.

Let's assume incentive fee creating AUM of $34 billion.  It was $34 billion in 2012 and $36 billion in 2011.

So the incentive fee earned in a typical year on $34 billion would be $3.4 billion x 20% = $680 million x 60% (40% to employees) = $408 million.

10x that stream would be $4.1 billion.  With 150 million units outstanding, that's  $27.20/share.

Balance Sheet Value
OAK has cash, investments and funds on it's balance sheet and some debt.  This equity value is largely liquid, financial instruments so should be counted at book (funds are carried at market value).

Total assets at OAK was $2.36 billion and total liabilities were $966 million.  Book value comes to $1.4 billion.   If we use $1.4 billion and add it to the above parts, there will be some double counting involved as some of the assets on the balance sheet is being used to generate the above management fee and incentive fee (think office supplies/equipment etc.). 

So let's deduct the $146 million in "other assets".  I don't know what's in there, but we can be sure that PC's, servers and other office equipment isn't in any of the other balance sheet categories.

That would get book value down to $1.25 billion.  That comes to $8.33/share. 

Off Balance Sheet Accrued Incentive Fee Value
Due to the way OAK accounts for incentive fees (not booked until realized and paid), there is a lot of value that hasn't gone through the income statement and doesn't show up on the balance sheet (incentive fees only hit the income statement and balance sheet when it is paid out (or when it becomes payable)).

This amount of accrued incentive fees held at the fund level is $1.3 billion at the end of 2012.  This comes to $8.52/share.   (If the funds were liquidated today, this is the amount that would be payable to OAK as incentive fees (this is net of what gets paid out as performance bonus too))

Add it Up
So if you add it all up, you get:

                                                   Value of per unit
Fee-related earnings:                      $20.70
Incentive fee:                                  $27.20
Book value:                                       $8.33
Accrued incentive fee:                      $8.52
Total:                                              $64.75

DoubleLine
OK, so then there is another piece to this puzzle, and that's OAK's 20% stake in DoubleLine which is on the balance sheet at $29 million. That comes to less than $0.20/share, but it's grossly undervalued there.  

As I said in a previous post, I figured DoubleLine is worth somewhere between 1% and 2% of AUM.  DoubleLine now has more than $50 billion in AUM (versus I think $28 billion at the time of OAK's S-1 filing).   So the value of DoubleLine would be $500 million - $1 billion.  20% of that would be $100 million - $200 million.  That's far higher than the $29 million balance sheet value.

It's already on the books at $29 million, so the incremental value per unit would be $71 million - $171 million.  On a per unit basis that comes to $0.47 - $1.14/unit.

Now, that's not a whole lot given the $50-51 stock price and $64.75/unit fair value.

But Wait!
In the earnings release, DoubleLine's results is included in investment income.  I assume that is a cash dividend distribution to OAK from DoubleLine (I think someone confirmed that on the conference call).   That amount was $22.7 million for 2012.

But on the conference call, OAK said that the DoubleLine stake created distributable earnings of $34 million and that they feel although this goes through the investment income line, it is actually more like fee-related income.  If that is the case, let's put a 10x multiple on that and it comes to $340 million.

That comes to $2.27/unit.  That's far higher than the valuation we would get from a 1%-2% AUM valuation.  Excluding the $29 million already on the balance sheet, that's an additional $2.00/unit in value you can add to the above $64.75/unit  sum of the parts value for OAK.

So the total, total would come to $66.75/unit.

With the stock trading at $50.74/unit right now, that's a 24% discount to what it's worth.

Conclusion
So OAK still looks cheap despite a nice runup.  I don't know the details of the DoubleLine earnings, so I don't know what can be 'normalized' and what's due to a good market last year.  But it seems like using 2012 figures leads to a far higher valuation for DoubleLine than a 1-2% AUM valuation.  I'm still on the fence on that one, but it's certainly possible that DoubleLine can be worth more than 1-2% AUM if they offer more funds with higher fees.   But again, I just don't know the details.

OAK is a solid shop run by solid people and it is definitely one that you can own and be comfortable with over the long term.  I would not worry about management, corporate governance, risk management and things like that.

But what I do worry about is the current state of the fixed income markets and the sub-6% high yield rates.  It just sounds insane to me that junk yields less than 6%.  I don't know how anyone can generate high returns going forward in this kind of market without going further out on the risk curve (and that often doesn't end too well).

I thought initially that OAK would be a great holding in front of a European collapse or something like that; they would raise funds and go over there and pick up the pieces.  But it sort of looks like that might not happen (due to intervention by the ECB etc.).

But seeing how they are doing so well and making so much money in this almost maniacal bull market in credit, I fear what would happen on a hiccup.

I don't worry about OAK over the long term, of course.  But I can't help but imagine that returns on capital raised today will be far lower than any of their funds in the past, and this may not bode well over the short-medium term.

I know, I'm a long term investor and I shouldn't think of things like that; I should just think about the long term.

But there is a part of me that feels like I'm looking at a private equity manager in 2006-2007 when looking at a fixed income manager today.   

Anyway, that's just a quick look and thoughts on OAK today.  I may have more to say or corrections after seeing the 10-k (or more immediate corrections which would be pointed out in comments below).

I still own OAK, but would look to lighten up on further gains.  I wouldn't mind owning a smaller stake as a 'permanent' holding, but wouldn't overweight it too much in my active account.

It's a conundrum for me;  I love the company, management etc., but I don't love the sector at all right now; too much love there... 

Create Your Own Apple Stub

Einhorn is unhappy with Apple's $137 billion cash hoard on the balance sheet and wants Apple to issue perpetual preferred shares to enhance shareholder value.  He said in an open letter that every $50 billion of preferred shares it distributes (at 4% rate) will increase value to Apple shareholders by $32/AAPL share.

First of all, I noticed that there were some mistakes in talking about this and one press report stated that Einhorn made this claim "without elaborating".   I think he made it very clear how the value would be realized.

So let's just look at this for a second before I go on.

Here are just some basic figures I pulled off the internet:

AAPL shares outstanding:               940 million
Analyst EPS estimates:
      Year-ending September 2013:  $45/share
      Year-ending September 2014:  $50/share

Einhorn assumptions:
          AAPL valuation:             10x P/E
          Yield on preferred:            4%

Before Preferred Distribution: 
          EPS:                                  $45/share
          Cash per share:                  $145/share
          Value per AAPL share:     $595/share (10x p/e + cash per share).

After $50 billion Preferred Distribution:
          EPS:                                  $43/share  (EPS - ($50 bn x 4% pref dvd/ 940 mn SOS)
          Value per AAPL share:
               Cash per share:             $145/share
               AAPL shares:               $575/share (EPS of $43 x 10 + cash per share)
               Value of preferreds
                      (per AAPL share):  $53/AAPL share ($50 bn / 940 mn SOS)
               Total Value:                 $628/AAPL share

$628 - $595 = $33/share (difference due to rounding).

Voila!

[ Note after the fact: In response to comments below, I revised the above table to include cash per share in the total valuation of AAPL. The result is the same as before as cash per share doesn't change pre and post preferred distribution.  But by not including it, it looked like it would be even more value accretive if AAPL distributed cash instead of preferreds.  Anyway see comments below. ]

This is pretty much the stub stock scenario in Greenblatt's Genius book.  Speaking of which, this is another perfect case of where we can go out and create our own stub, like Greenblatt said we could (and should).

Create Your Own Stub
So the problem with AAPL is basically that it is ridiculously underleveraged.  They have so much cash on their balance sheet that it's a drag on the performance of the whole company.  They have $137 billion cash on the balance sheet that comes to $145/share.  That's just nuts.

But Greenblatt reminded us that even if companies don't do leveraged recapitalizations too much anymore (except private equity owned entities), we can do our own recap and create our own stub.

So here I'll just take a quick look at creating an AAPL stub, which I thought I'd never do.  Who the heck buys LEAPs on volatile tech stocks?  Who needs leverage to own a stock that went from $100 to $700 almost overnight?

Anyway, let's just say we want to lever up 2-1.  I'll just look at the $250 strike January 17, 2015 calls.  You can go up or down the strikes according to your taste.
Apple is now trading at $458.60/share and the 250 strike calls is offered at $211.

So buying the $250 strikes at $211 means you are paying a $2.4/share premium (($250 + $211) - $458.60).  Plus you don't get dividends by owning LEAPs, so you lose out on that.  Dividends now is an annualized $10.40/share.  The $2.40/share premium above is for two years (let's round this to two years), so that's a premium of $1.20/share per year.  Add that to the $10.40 in dividends you don't get and that's an annualized carry cost of $11.60/share.

Since you are 'borrowing' $250 over two years, your annualized financing cost is 4.6%/year.  But this assumes dividends don't go up this year and next.  This may be unlikely given all the talk of too much cash on AAPL's balance sheet.   If dividends go up 20%, then the carry cost will go up to 5.5% (assuming a one time bump up in dividends of 20% for the two years).

But this ignores the put option value of owning a 250 strike call instead of actually borrowing cash to buy shares.  If you bought AAPL on margin and the stock really tanked, you would get margin called.  With a call option, you can't possibly lose anything below $250 as you are only long a call option that becomes worthless (if AAPL goes below $250 and stays there).

A $250 strike January 2015 put option is offered at $8 or so, so to be really accurate, you should deduct $4/year off of the financing cost above.  That gets the carry cost (cost of loan) down to 3% (or 4% if dividends are 20% higher). 

That's not bad at all.  I know interest rates are zero, but for a small investor to be able to borrow money at 3-4% is not bad at all.  I realize there are discount brokers that offer lower margin rates, but still.

All Options Expire Worthless!
I don't want to push this stuff too much (as I don't really know who is reading this), but just to show how low risk something like this can be, let's think about this for a second.

Many people rightly believe that all options expire worthless.  Never mind that that's not really possible, but it's not a bad way to think so as to stay out of trouble and not buy calls and puts out of an urge to hedge or get some 'free' upside on a momo stock.

But a well thought out LEAPs strategy can be very good. 

Let's take a look at this trade, for example.

If you buy a 250 strike AAPL LEAP for $211, you can't lose your entire investment unless AAPL goes down to $250/share in two years.  From what I read, I think that's a low probability (well, more on what I think of AAPL later). 

One thing that kills option investors is the time value decay.  You buy at-the-money or out-of-the-money calls to try to capture upside in a big momo stock that you are afraid to own outright.  Or you buy at-the-money or out-of-the-money SPY puts because you are terrified at what the fiscal cliff will do to your IRA.

When you buy at-the-money options over the near term, you are not really borrowing money.  You are paying more for the volatility; you are paying a premium for the opportunity to buy or walk away depending on what happens to the stock.   This optionality is what you are paying for.  You can test this easily by calculating the financing cost of a position and compare it to the option premium.  For short-dated options, the financing component is tiny compared to the total option premium.

I have no proof, but I think if someone did a study on options and how people lose money in them, I bet that most of the money is lost due to the amount people pay over the instrinsic value of an option (intrinsic value is simply the in-the-money amount of an option).  In other words, it's the time value that kills them.

Not!
So using this unproven rule of thumb that I just pulled out of thin air, let's look at this AAPL LEAP trade again.

The stock is at $458.60/share.  The strike price plus option premium on the 250 strike LEAP is $461/share.  So you are paying $2.40/share over the stock price.  Add the $21/share of dividends you won't get and you are paying $23.40 over the stock price.   So if the stock price does nothing for the next two years, this is what you lose.  You lose $23.40/share (or more if dividends go up).  That's just 5% of the notional amount of the trade, or 2.5%/year.  That doesn't sound too traumatic.

If the stock price goes up or down, you make the same amount as if you were holding the stock, pretty much on a dollar for dollar basis (at expiration, of course.  Until then, your option will go up and down according to the delta of the option).   And then under $250, you don't lose any more.

My point is that on a time value basis, you are paying very little premium so you don't lose a lot of money here if the stock goes nowhere.  Compare that, for example, to owning an at-the-money call option which, by the way, is offered at $69 now for the same maturity (2 years).  That means you lose 20% of the notional amount of the trade with the stock flat over two years (including dividends you don't get).

So I would tend to look at these in-the-money LEAP trades (and even shorter maturity options) differently than 'typical' option trades; they act more like financing trades.  Of course it's still risky as you are levering up.

What I Still Think of Apple
Not that I have much to add to the Apple debate going on all over the place, I still view Apple the same way as when I made my previous posts about it last year.  (Why I Left Apple and Apple is No Polaroid)

I still think Apple was a Steve Jobs story and not an Apple Inc. story.  I still think the market breathed a huge sigh of relief after Jobs passed away as Apple continued to perform in the following year.  That's what took the stock up to $700.   I keep reading about how "Apple did this.  Apple did that.  Dell couldn't do that.  Microsoft didn't do that".  And I always think, no,  Steve Jobs did this.  Steve Jobs did that.

I still think that the cell phone market will get more and more competitive and mobile companies will get more and more resentful about the huge subsidies they pay for subscribers to get iPhones.  When price competition heats up in mobile markets around the world, more and more operators will opt not to pay $500-600 subsidies.   I understand that early on it was the other way around.  Mobile operators needed the iPhone to attract subscribers.

Over time, I think the "amazingness" of Apple products will become increasingly commoditized. Sure, Apple may still be able to maintain a premium brand status just as they held on to that over time with the Mac, but that may not be enough to maintain or increase the value of Apple as a company.

I do think that Apple is only cheap if one assumes that Apple will come out with something just as mind-blowing as the iPod was, then the iPhone and then the iPad.  If all we have going forward are upgrades to iPhones and iPads and competitors continue to close the gap, then I tend to believe that Apple is probably not a cheap stock.

Anyway, I know many people disagree with this view (and many agree), and the hard thing about this discussion is that there really is nothing I can point to to prove it one way or the other.  There are plenty of people who know way more about Apple than I do so don't mind my opinion too much.

Advantage for the Little Guys
But having said all of that, this Apple LEAP trade does look interesting.  This is one of the advantages of being small investors.  Someone like Einhorn probably couldn't put this trade on.  He has no choice but to activist management into action. 

But little guys like us can just say, hey, if you don't want to lever up, I'll just do it myself, thank you very much.

Mr. Market versus Mr. Buffett

Not to beat a dead horse, but this Wells Fargo situation kept lingering in my mind so I thought I'd make this followup post.  It is well understood by value investors but since I have a pretty wide readership in terms of stock market experience, I thought I'd post this because there is something to be learned from thinking about WFC, Buffett and how the market works.


What Mr. Market Sees

WFC Stock Price Since 2001

• Mr. Market sees a volatile stock.  WFC went from $40/share to below $10/share during the crisis; way too volatile.  A 75% decline is just unacceptable to own for a conservative portfolio.  Of course, Mr. Market is the cause of this volatility.  The volatility just illustrates the manic-depressive nature of the stock market.
• Not only is the stock very volatile, but it has gone nowhere for a long time.  
• Mr. Market views banks as too risky not only because of the stock price volatility and gone nowhere-ness, but because it's too complex, opaque and leveraged. Mr. Market prefers the 'safety' of bonds, the 'safety' and non-correlatedness of private equity funds, hedge funds and other alternative investments as the stock market has done nothing in the past decade and is just way too risky.
• Mr. Market sees no future for the banking industry; higher capital requirements and heavier, more extensive regulation makes the future of the industry bleak.  Also, the size of some of the bigger banks (like WFC) makes it unlikely it can grow more in the future.  Skeptics point to the lame top line growth at many financials in recent years.
• Mr. Market reads newspaper and magazine articles that predict a repeat of the most recent crisis; people tend to spend a lot of time fighting the last war.  There is a weird obsession in the media with large, 'evil' banks who have gotten away with murder unpunished.

What Mr. Buffett Sees

• Mr. Buffett does not care about stock price movements.  He only cares about the health of the underlying business.  He believes that stock prices will generally reflect the value of the business over time, but not every single day, month or even year.  Stock prices can be misvalued for long periods of time.  This does not bother Mr. Buffett in the least.  If a stock goes down 80%, he doesn't care as long as the intrinsic value of the business hasn't gone down 80%.   He worries about permanent loss of capital, but never worries about temporary loss of capital due to stock market volatility (if you want to avoid this temporary loss of capital, as in anything else, there will be a cost!).
• Mr. Buffett is in no rush to get rich (or richer, I should say).  Much of the folly in financial markets comes from the need for people to get rich quickly.  In fact, I've had people tell me that they speculate in foreign currencies at 100-1 leverage because they said they are not rich enough to be able to buy stocks and wait for them to go up over the long term like Mr. Buffett, nor are they smart enough to be able to pick stocks like Mr. Buffett.  Another favorite is that they simply don't have the time to be reading annual reports.  Of course, it never occurs to them that if they are not smart enough to pick stocks, who says they are as smart as Soros to be able to make money trading FX?  Needless to say, I've never heard of a good outcome from people who have said this to me.
• Going back to bullet point one, Mr. Buffett only cares about the underlying fundamentals of the business.  While Mr. Market focuses on the stock price movements in the above chart, Mr. Buffett focuses on the following table which shows how WFC has grown BPS over time (including dividends):

                                                WFC BPS growth (including dividends)
                    2002                     +19.1%
                    2003                     +21.4%
                    2004                     +19.2%
                    2005                     +17.5%
                    2006                     +21.0%
                    2007                     +15.1%
                    2008                     +20.8%
                    2009                     +27.1%
                    2010                     +13.2%
                    2011                     +11.7%
                    2012                     +15.8%

• The above table is just astonishing.  Show this to someone without telling them what it is.  Ask them, would they invest in a fund like this?   If this wasn't a major bank, people would be all over this thing.  How many funds or hedge funds have this kind of track record?  This is what Mr. Buffett looks at; not stock price history (except when buying shares, price is important so as not to overpay).
• Having looked at this, it solves another puzzle.  For years, Berkshire Hathaway (BRK) fans have been calling for share repurchases and dividends and things like that.  People seem to be very upset that Mr. Buffett hasn't bought back more shares.  Now we can see why he hasn't been buying back more shares; he sees something better.  Here is the above table with BRK's own BPS growth right next to it (be sure to be seated when viewing this table, or hold onto something):

 
                                        WFC                  BRK
                        2002        +19.1%              +10.0%
                        2003        +21.4%              +21.0%
                        2004        +19.2%              +10.5%
                        2005        +17.5%              +6.4%
                        2006        +21.0%              +18.4%
                        2007        +15.1%              +11.0%
                        2008        +20.8%                 -9.6%
                        2009        +27.1%              +19.8%
                        2010        +13.2%              +13.0%
                        2011        +11.7%                +4.6%
                        2012        +15.8%                   ?         

              5 year avg:        +17.6%                 +7.3%
            10 year avg:        +18.2%               +10.2%

OK, so I cheated as we don't have BRK's 2012 BPS yet.  BRK five and ten year periods are through 2011.  But I don't think it makes a difference in the story it tells.  WFC's performance is just amazing compared to BRK.  It has beaten BRK in every single year, and in most years by a pretty wide margin.  This is unbelievable.  And this is the decade that included the financial crisis?!   You'da thunk BRK woulda done better than a major bank with tons of mortgages.

Go through the table again, starting at the top and slowly look at both figures, year by year, and imagine the headlines in those years.  You would never have guessed the outcome of these two entities in any of these years.

There is a tremendous bias against banks these days, but if there wasn't, Mr. Buffett's thinking should be as clear as anything.  You would be insane to call for him to be buying back BRK stock when he can be buying WFC at an attractice price.

In fact, if Mr. Buffett starts to buy back large amounts of stock when WFC is trading at these levels, this is what I think should happen:

Imagine Mr. Buffett's Face in this Picture

I am not tech savvy enough to cut and paste Mr. Buffett's face over Sewell Avery's.  But yes, if he chooses to buy back BRK stock (right column) over WFC shares (the left column in above table), that would mean he has finally lost his marbles.  Call in the troops.  Take him away!

Back to Bullet Points

• While Mr. Market seeks comfort in the safety of bonds and alternative investments that promise to make money year in and year out no matter the environment, Mr. Buffett understands that this is nonsense.  Bonds are bubbled up right now and have a lot of risk, and again, the history of folly in the investment world is often caused by not only the need to get rich quick, but to get low-risk returns.  The promise of consistent profitability, low volatitily and non-correlation manufactured by financial engineering often delivers on the promise for a time until it blows up.  The cure is often worse than the disease.  Mr. Buffett understands this very well.
• While Mr. Market sees the end of banking as a profitable business, Mr. Buffett disagrees.  He concedes that the days of 20x leverage and 30% ROE are over, but it's still a very good, profitable business.  We don't need another bubble for banking to be a good business (again, look at the above table!).
• Mr. Buffett doesn't worry about top-line growth as he sees that it will come when the economy recovers.  He sees a housing recovery as the key to lower unemployment and a stronger economy and he sees that coming, eventually.  He has tried to time the recovery before and got it wrong, but he still has no doubt it will come.
• Even if the top line doesn't grow too much, Mr. Buffett understands that if you have a profitable business model and excess capital, it can be returned via stock repurchases.  He doesn't need a company to grow; intrinsic value per share of a business can grow a lot without a lot of top line growth.  If you earn 15% ROE and see no top-line growth and just repurchase shares with the profits and you do so at book value, you can grow your BPS 15% (well, even if you don't repurchase shares BPS will grow 15%, but then ROE will go down next year if you can't deploy that 15% at 15% ROE).  If you pay 2x book, you still grow BPS at 7.5% (yes, it would be dilutive to BPS, but can still grow it.  If my other other post is right, then you can still grow intrinsic value per share even if you buy stock above BPS).  If management is competent, businesses can be managed to enhance per share intrinsic value.  There are a lot of value creating levers.
• Mr. Buffett is not worried about the riskiness of banks.  He has been investing in banks for decades and knows banking better than most bankers.  A few obsessed journalists writing scary stories about how opaque the banks are (who probably have never even read a 10-k all the way through) is not a concern.  Some of these writers have only lived through one cycle.  Buffett (and to a lesser extent, Dimon) have seen many cycles and understands that it's the same thing over and over.  
• He agrees with Dimon who pointed out when people were skeptical of the Fed stress tests that they have actually just lived through a real-life stress test and passed with flying colors.  WFC too has passed this real-life stress test amazingly well.  People will argue that that is thanks to TARP, but even the Geithner hating, big bank busting Sheila Bair has said that WFC and JPM are well managed and weren't in trouble and didn't need TARP.  It's amazing that these banks did so well in a 100-year crisis; particularly when WFC was one of the biggest mortgage lenders and the bust centered on residential real estate.
• Mr. Buffett finds it ironic that people say banks were bailed out by the government (so won't invest in them) but are fine with investing in hedge funds, private equity funds etc.   When they bailed out the big banks, they bailed out the financial system.  If the financial system failed, many hedge funds and other investors would have lost a ton of money; look what happened to prime brokerage clients at Lehman, clients at MF Global etc. 
• Mr. Buffett finds it ironic that banks are accused of being opaque when they consistently file hundreds of pages of material with the SEC every year, and yet people invest in hedge funds with nowhere near the disclosure.  Dimon said the other day something like, "We file a 400 page 10-K every year, what do you want to know?"  Perhaps if Madoff had to file with the SEC (in similar detail), people wouldn't have lost money.  Mr. Buffett has been reading annual reports for more than half a century.  I doubt most journalists have even read one all the way through.  (I don't blame them; much of the low quality in journalism is due to deadlines and quotas; I don't think any journalist is any dumber than anyone else.  It's just that if you are an investor thinking about spending billions of dollars to buy into a stock, you are going to do a little bit more work on it than someone who needs to get an article to his editor by 2:00 pm Thursday.  This is why TV journalism can be even flakier; their deadlines may be shorter and they need to fill airtime with stuff.  And you just can't put out a lot of high quality stuff all day.  I am always shocked at how little financial journalists seem to know and understand even when many have more years in the business than me.  Are they that stupid?  I realized it's not that at all.  They don't have a deep understanding because they never dig that deep as they don't have the time.  They only have to dig deep enough to get the story out.  Then it's on to the next story.  That's why my sister understands more about business than some of these so-called veteran journalists; it's not the journalist's job to understand.  It's their job to sell newspapers, magazines, and fill air time)  Oftentimes, you're better off going with the guy with decades of experience and someone who probably has read every single filing for hundreds of companies going back decades over some guy rushing out an article for a deadline where the 'story' is already predetermined (and probably the headline too).

Anyway, this can go on and on so I'll stop here.  I thought it would be an interesting post for some (but same old, same old for us value people).





                   

Wells Fargo is Cheap!

OK, so in my last post I commented that WFC is a great bank but is fully valued.  This thought stuck to my mind over the weekend.  Sometimes when I write something (whether blog or email), what I write bounces around in my head and I have second thoughts about it long after I hit the "send" or "publish" button.

I was wondering, is it really fully valued?  If it is fully valued, then why does Buffett keep buying WFC stock?  He has been buying even before the crisis when the storm clouds were very visible, and even now after financial stocks have rallied a lot.

Why I Said It's Fully Valued
First, let's just look at why I think (or thought) WFC is fully valued.  This valuation approach is the same as how people look at other banks like JPM, BAC and others.

But anyway, here it goes.  Below is the ROA and ROE of WFC since 1997.

               ROA       ROE
1997      1.37%      12.81%
1998      1.04%        9.86%
1999      1.85%      17.66%
2000      1.81%      18.53%
2001      1.40%      14.94%
2002      1.77%      19.60%
2003      1.64%      19.36%
2004      1.71%      19.56%
2005      1.72%      19.57%
2006      1.73%      19.52%
2007      1.55%      17.12%
2008      0.44%        4.79%
2009      0.97%        9.88%
2010      1.01%      10.33%
2011      1.25%      11.93%
2012      1.41%      12.95%

Here are the averages for the various time periods:

                              ROA             ROE
Since 1997             1.4%              15.0%
Last 10 years          1.3%              14.5%
Last 5 years            1.0%              10.0%

WFC has a decent, consistent record.  One way to look at it is that WFC in normal times can earn 1.5% ROA and a 15% ROE or something like that.  With a 15% ROE, WFC can easily be worth 1.5x book value.

As of the end of 2012, BPS of WFC was $27.64/share.  1.5x that is $41.46/share.   At $35/share, WFC seems to be trading at a 15% or so discount to what it's worth; not so exciting.  Of course, it is still a good, solid holding.  If it's worth 1.5x book and the book keeps growing, WFC can obviously still be a great stock to own.

So one way to look at it is that although it may not be trading at a discount to what we think it's worth, it's still a good investment due to future growth.

Just for fun, let's just take a look at what BPS has done over time at WFC.  If we are going to pay close to 1.5x book and our returns will come from growth in BPS instead of a valuation adjustment, we have to see what BPS has done and think about what it might be able to do in the future.

             BPS        DPS
2001       $8.00    $0.50
2002       $8.98    $0.55
2003     $10.15    $0.75
2004     $11.17    $0.93
2005     $12.12    $1.00
2006     $13.58    $1.08
2007     $14.45    $1.18
2008     $16.15    $1.30
2009     $20.03    $0.49
2010     $22.49    $0.20
2011     $24.64    $0.48
2012     $27.64    $0.88

So looking at it this way, it's pretty incredible.  Look at how much BPS has grown over time, and through the crisis too.

Here are the growth rates of BPS over five and ten year periods:

                       BPS growth per year
Five years          +13.9%
Ten years           +11.9%

But BPS growth excludes dividends, so let's add that back and see what BPS growth + dividends would have been:

                       BPS growth w/dividends
Five years       +18.2%
Ten years        +17.6%

That's pretty stunning.  This kind of record shows that BPS/share for WFC is a no-brainer long.  This BPS growth did get a one time bump up from the Wachovia merger, but it's still pretty impressive.

1.5x book value implies a 12%-ish sort of return.  Of course, with 1.5x book as a terminal value, then the return can be 18% over time if they do just as well in the future as they have done in the recent past.  You can say that the last five - ten years was an outlier bad period for financials (but others would argue that the 2005-2007 was outlier good years so it balances out).

In any case, either way, 15% ROE seems achievable and the same would apply here.  You can say 15% ROE = 10% return at 1.5x book, or if you see 1.5x as fair value going forward with no change in terminal value for the foreseeable future, you can expect a 15% return over time even at 1.5x book.

I tend to see things the first way; 15% ROE at 1.5x book = 10% expected return.  This may or may not make sense according to what you think.  But that's just the way I look at things and I think it's the conservative way to look at it.

Back to Buffett
So let's get back to Buffett.  He has been buying WFC even at non-distressed prices.  Why?  I remember when someone asked Buffett about banks and book value and Buffett said that book value is not important.  He does advocate ROE as an important measure of a business, but oddly enough, when discussing WFC during the crisis, he said it's not important.  At the time, he said the cost of capital was the most important thing; the one with the lowest cost will win.

(I think he does look at BPS and it is important to him, but maybe other factors are more important depending on the situation).

The other piece of the puzzle is Buffett's goal of earning a pretax 10% return.  This is what Buffett has been quoted as saying.  At last year's annual meeting I think he mentioned that he likes to pay 9-10x pretax earnings for a good business.

I think a while ago, Munger also mentioned using WFC as a benchmark to evaluate potential investments; if it's not better than WFC, why bother buying something else?   I may be wrong, but I do think that within the context of that discussion he mentioned that WFC can earn 10% pretax return on the then current price.

So that also confirms that this is the valuation benchmark at Berkshire.

Now you see where this is going.  For financials, the Street often uses 10% as the discount rate; if a financial company can only earn 5% ROE, then it's only worth 50% of book.  If it can earn 20% ROE (consistently), then it's worth 2x book etc...

Using Buffett's valuation measure, you will get a different result.

So let's go back to WFC with this new valuation tool (well, it's not new but...).

WFC at 10x Pretax Earnings
In the year just ended, WFC had pretax earnings of $27.1 billion (I added the $9.1 billion in income tax expense to the $18 billion net to common; the pretax income on the income statement includes minority interest and dividends payable to preferreds so $27.1 billion gives us pretax income to common shareholders).

Using Buffett's measure, WFC is worth $271 billion.  With 5.266 billion shares outstanding,  that comes to $51.46/share.

WFC is trading at $35/share now so that's a 70 cent dollar right there.  That's 50% upside, not in two years, but NOW! 

And keep in mind, this is not intrinsic value or fair value or anything like that; it's a price that Buffett would happily pay for the shares.  He says he wants to pay 10x pretax earnings, right?  He needs to earn a 10% pretax return, right?  Well, $51.46/share gives you that.

But, but, but...
This price would come to close to 2x book.  What kind of nonsense is that?  How can a financial stock trade at 2x book in this post-crisis, new, new normal world?  I know.  It sounds ridiculous.  If I said this out loud in a bar downtown near the New York Stock Exchange, I would get laughed right out of the room.

But I'm just putting things together.  There is nothing new here.  I am not making big projections, assuming anything incredible or anything.  I just took some facts that are out there and just slapped them together and that's what you get.

Also, I know most people still fear banks and think another crisis is around the corner.  Well, if you are a WFC shareholder and see what it did during the last crisis, then you should be praying for another crisis!

Rich Get Richer During Bad Times (or Big Get Bigger)
I will put another piece of the puzzle here.  At one of the recent annual meetings, Munger talked about how Rockefeller, Carnegie and others got rich.  They got rich during the bad times.  When bad times hit, these guys grew by buying up the distressed competitors.  This is how it's always been, so it's silly to worry about bad times.  Munger said that if you don't get it, you are an idiot (maybe he had a more elegant way of saying it, but I do remember he said it strongly).

I think this was in a context of answering a question about some fear about the future (of the macro outlook, stock market etc...).

And if you look at the above BPS growth of WFC, you can see how exactly right Munger is.  WFC shareholders should wish for a financial crisis every year!  (WFC grew BPS including dividends at +18%/year in the last five years; it grew BPS + dividends 27% in 2009.  How many hedge funds (who are supposed to make money in volatile markets) made a 27% or better return in 2009? And of those that did, how many have not given it back?).

Buying distressed asset funds / private equity funds / hedge funds to take advantage of volatility and bad times may not be a bad idea, but here is a company that is is doing it, right in front of our eyes.  They do very well in good times and even better in bad times.  Why do people bother looking for someone to hedge their 'deltas', give them non-correlated, leveraged alphas and things like that?  Sometimes (or most of the time), the medicine kills the patient; this need to reduce or eliminate perceived risk ends up killing them.   And sometimes the answers are just so simple.

Anyway, others will point to the one time-ness of the accelerated BPS gains by WFC because of the crisis, but you can't have it both ways.  You can't argue that WFC is no good because another crisis is around the corner, and then worry that the BPS gains in the recent past is one-off so not indicative.

Conclusion
So there you have it.  The greatest investor of all time will be buying WFC all the way up to $50/share (and this will keep going up over time).  And for those worried about another financial crisis around the corner, you want to own a company that will benefit from it.  If you buy WFC and study it's history, you will just start praying for another crisis instead of worrying about it.

What's not to like?

I get it.

(No, I do not own WFC at this time.  I have owned it in the past and may in the future.  By using the above measure, maybe JPM / BAC / GS are even cheaper than I think they are.)

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.