Be greedy when others are fearful, Francis Chou edition
From his latest letter, Francis Chou seems keen on financials, retail and pharma equities, and for financials he discloses his thesis for stock warrants of large banks.
Medium banks were easier to understand and bound, so that is where I focused first, but TARP warrants was how I expected to buy large banks when things became more clear. And things are becoming clearer by the day.
Large banks are an opportunity that I have been procrastinating for quite a while, in particular Bank of America that looks very cheap at 0.5 BV and 3x PTPP earnings. Large banks are sound with strong balance sheets but it is difficult to pull the trigger when probably there are more surprises coming. Francis Chou conveniently lists some of these potential negative events.
This is not an original idea, everyone that has read You Can Be a Stock Market Genius will remember Joel Greenblatt’s discussion on the use of LEAPs (long dated call options) for situations with binomial outcomes like the Wells Fargo turnaround in the 1990s. Greenblatt liked very much Bruce Berkowitz’s WFC thesis but had similar concerns to Chou’s today on the transparency of the balance sheets. Greenblatt decided to buy LEAPs, because in case of a collapse both common stock and LEAPs were worth zero, but you can commit less capital with LEAP derivatives for a similar upside to the common stock so the payoff proposition was much better.
Chou’s decided instead to buy warrants and it might be an even safer bet. The expirations are much longer and they include some very interesting anti-dilution clauses negotiated by the federal government that the general investor can now enjoy. We should still remember though that the attractiveness of these instruments also depends on the price and upside expected for each specific bank.
This is the excerpt from Francis Chou’s letter:
REVISITING THE BANKS:
In the 2006 annual report, we noted our alarm at the cavalier approach of financial institutions with regard to their lending standards, particularly to subprime borrowers. We also expressed concern with the widespread use of derivatives by financial institutions (…) Well, starting in 2007, financial institutions went through a cataclysm. Directly or indirectly, almost all of them had to be bailed out by the U.S. government. Looking back at the crisis, this is what we have observed:
- The U.S. government will not let major financial institutions fail.
- The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
- Interest rates will be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made are quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
- Financial institutions in general are hoarding capital. This will provide them with ample cushion to absorb losses if a double dip recession were to occur.
- The books of financial institutions were carefully examined by all kinds of government agencies, including regulators, before the government allowed them to repay the U.S. Treasury under the Troubled Asset Relief Program (TARP).
- Most of the big banks are selling below 10 times their potential earning power in the future.
An Interesting Way to Invest in Banks
Please note: the investment described below is the view of the writer and should not be seen as a recommendation.
One of the more interesting ways to invest in the better capitalized banks is through the stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank’s stock at a specific price. When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public.
So, what is so unique about these stock warrants?
- They are long dated, with most expiring in 2018 or 2019. This time frame of eight- plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
- The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, you don’t see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class ‘A’ warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
- Many of the banks have excess capital on their balance sheet. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
- The concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish we need sound financial institutions that can generate reasonable profits.
- Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company’s future prospects, its position in the industry and how well it will do in a future economy. Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk averse. Too bad we had to go through so much turmoil to get there.
Below, August 13, 2010 prices of some banks stock warrants.
Even so, everything is not hunky dory for the banks. Banks face many issues and challenges. I have listed a few here:
- We still do not fully understand or trust the numbers
- Financial regulatory reform may reduce earning power
- New Basel rules may require more capital and reduce profits
- There may be a double dip recession
- The unemployment rate may go higher and create more defaults
- Commercial real estate prices may fall dramatically
- Banks are still not marking loans in their books properly
- Residential real estate prices may fall further
- States and municipalities are in bad shape
Our investing horizon is long-term – eight years or more for these bank warrants. Over that period, we believe the odds are it will work out to be decent investment – more so for the better capitalized banks. We view it as the glass being more than half full rather than being more than half empty.