Charting Banking Series Intro
“We worry top-down, but we invest bottom-up” – Seth Klarman
Despite its name, this is not a series on Technical Analysis. I think it is time to share some nice graphical data, result from a lot of time spent recently analyzing banks, that tell some underappreciated, misrepresented, or difficult important facts on the strength of the industry. Most of these graphs are from companies that I do not have and even some of them will be from companies that could be good shorts. So just the facts.
The streetcapitalist has a great interview with a bank analyst that raises some very good points on the suitability of this industry for value investing. The black box nature, leverage, and thin margins can look more suitable for speculative plays:
In Margin of Safety, Seth Klarman says that value investors don’t invest in banks often because their asset books are too opaque. How, when you’re analyzing a bank, do you make sure the assets have a credible margin of safety?
It depends on a lot of factors. 1. The types of loans and geography 2. How loans are performing. 3. Management’s track record in originating loans and honesty. 4. How the macro is performing and 5. How aggressive/conservative management is in working through problem loans.
So dealing with the transparency, that’s a good question. Investing in financials is more of a gamble than any other category. You will simply not have the transparency you have at other simpler businesses. In other sectors management on conference calls can give you line item guidance that you can just plug in your models to come out with next quarter EPS within a small range of error. How many financial management teams got it wrong or thought they wouldn’t be the last one’s holding the bag during the crisis? I remember hearing Ken Lewis (CEO of Bank of America) talking about how the recession will end in 2Q08. And this guy basically gets a real time update on the economy on a daily basis.
So you want a wider margin of safety. If you would buy a company at 6x P/E, you might want to aim for 4x P/E.
Financials are truly a different animal in my opinion. There is no advantage in investing in financials (meaning you are not getting superior moats or higher ROE businesses compared to other sectors) If you thought the market was dead cheap in march for example, there were plenty of businesses in plain vanilla sectors (retail) that had rises greater than or similar to financials and were much easier to understand. Assuming these stocks were undervalued and haven’t gone up for speculative purposes, you can see that car rental company Avis Budget Group (NYSE: CAR) is up 11 fold since its low compared to Bank of America which is up 6x. I would say Avis is a lot easier to understand than BoA.
So why did value investors get it wrong?
As a value investor, investing in a financial requires really getting comfortable with the macro-economic situation. So unless you’re doing some kind of arbitrage (market-neutral) play, you will have to look at the macro. If you want to ignore the macro because Warren Buffett says it is useless then you want to stay away, especially if you’re not benchmarked or don’t have a mandate to invest in financials.
The thing is that now banking microeconomics has become the developed world main risk. With banks and shadow banks being the main channel of credit, and with a government every day more limited in its options, it is clear we need a healthy banking system… and I worry.
And since the sector interconnectedness and fragility is the main driver of the credit cycle, this is a critical issue to follow in a top down risk analysis. I would argue that to understand the risks and the probabilities of a revisit of the March 2009 lows, a rapid recovery, or a range bound market it is important to understand the health of this industry and have a view on it. And if these analysis bring some collateral bottom up opportunities even better.