“Is it Time to Tiptoe Back into Financial Stocks?,” Jason Zweig asks in Saturday’s Wall Street Journal. He argues that Ben Graham’s answer to the question, were Graham still around to consider the matter, would be “no.” “When bankers themselves have no clue what their assets are worth,” Zweig writes, “there is no way most outsiders can determine which stocks are undervalued and which cannot be valued.”
Inasmuch as Zweig literally wrote the book on Ben Graham, you’d think his take would be definitive. But I don’t buy it—both as a matter of analysis and a matter of history.
Zweig’s premise seems to be that no one inside or outside a financial services company can ever reasonably value the institution’s assets--particularly if the assets are secured by real estate at a time when real estate values are declining on average. The stock’s valuation? Irrelevant. Investor sentiment? Beside the point. Rather, Zweig sees the companies as no more than black boxes. By his logic, Graham-style investors (as opposed to speculators) would never own these companies. But we know as a matter of fact that that is not true.
Interestingly, Zweig’s argument is the same one used by some analysts at the bottom of the last bear market for banks. Just days before Wells Fargo bottomed in 1991, George Salem, the chronic bear of the moment, told the Wall Street Journal that (if I recall the phrase accurately) even Mark Spitz can’t swim against the tide in a hurricane. At the time, the U.S. commercial real estate markets were in the midst of a nasty downturn: most geographic markets were overbuilt, absorption rates were low, and prices were falling. Of the top 50 banks, Wells Fargo had the largest ratio of commercial real estate loans to total loans.
If Zweig were writing back then, he’d have agreed with Salem and would have warned readers to stay away. There was no way, he’d have argued, to predict the level of losses Wells Fargo would suffer.
Literally, of course, Zweig would have been right. No one, inside or outside the company, could accurately predict what Wells’s ultimate losses would be. But what they could do—and what financial services investors can do now, regarding the banks in general--is make reasonable estimates of ranges of losses, and estimate companies’ future earnings power, then compare that to their market values.
How ironic is it that one such investor that did that back in 1991 was Warren Buffett himself, who, despite the uncertainty and worry about hurricane-force winds, began purchasing Wells Fargo’s stock in December, 1991. Those purchases, in hindsight, turned out to be close to the absolute bottom for the stock.
I’ve known Jason Zweig for almost two decades; I like him and have a high regard for his work. I spent 45 minutes on the phone with him as he prepared this article in particular. But for him to claim Ben Graham would not buy financials today contradicts Graham’s analytical discipline--and is inconsistent with the past behavior of the best Ben Graham student of all time!
Anyway, now let’s go to specifics of what Zweig had to say:
Zweig: “To see why I think Graham would sit on his hands, you need to understand his crucial distinction between investment and speculation. ‘An investment operation,’ he wrote in his first book, Security Analysis, ‘is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.’"
TKB: Many financial services companies now provide highly detailed disclosure of their asset positions. Investors willing to do the analysis can come up with range of loss estimates in order to get comfortable with the promise of “safety of principal” of the potential investment. They can also forecast the return the companies can earn on their estimated equity once the problems pass, in order to make a reasonable estimate of potential returns.
This is not the first downcycle in credit. Each prior one has provided a raft of investment opportunities. While this cycle has its differences from past ones, it has many more similarities.
Zweig: “You cannot even pretend to be protected against loss while real estate prices--the wobbly foundation for most financial stocks--are still crumbling.”
TKB: Of course lenders are going to suffer more losses--but that’s not the debate. Investors can make their own forecast as to the magnitude of future declines in real estate values and then extrapolate their effect on the specific exposures of financial services companies.
Last cycle, commercial real estate loan values kept falling, and nonperforming assets and losses kept rising long after the stocks began to recover. Losses and nonperformers will be lagging indicators this cycle, as well.
Zweig: “Each quarter, the banks set aside in reserve against losses on their loan portfolios and say they believe those reserves should be adequate. The next quarter, they find out they were wrong.”
TKB: Whoa! This is terribly misleading; I’m surprised Jason Zweig wrote it. I’ll spare you the details of the minutiae of reserve accounting. Suffice it to say, though, that managements have very little discretion. Rather, reserves are built, held constant, and reduced largely via formula, based on what happened during the quarter. Auditors do not permit (and investors would not want) managements to have broad discretion over the size of reserves. There is nothing significantly different about how reserves are being managed this cycle compared to that last one. And the result will be the same: when the credit problems finally start to shrink, it will be clear reserves were overbuilt, and earnings unnecessarily depressed.
Zweig: “I’m not saying there is no money to be made on financials in the next couple of years. But the potential for further losses is at least as great as the odds of big gains.”
TKB: Here Zweig unfortunately falls into the sell-sider’s standard waffle. Usually it goes, “I see big gains ahead for financials but worry about the near term downside.”
True value investors, by contrast, tend not to worry what might happen in the interim. Instead, they come up with their best estimate of a financial company’s intrinsic value by estimating the magnitude of likely losses along with its “normalized” earnings level two or three years out. They then compare that estimate of intrinsic value with the stock’s price today. Zweig says such estimates are impossible. I disagree. Having spent the bulk of my waking hours lately going through this very process, I believe many financial services stocks are significantly undervalued.
Zweig: “If you are still tempted to bottom-fish for financial flounder, at least diversify. . . Whatever you do, use only the money you were saving away for that trip to Las Vegas.”
TKB: Was Warren Buffett using his Vegas money to buy Wells Fargo’s stock back in late 1991? I don’t think so! To say these companies are too risky because they can’t be analyzed is just a way of saying, “I don’t want to do the analysis” or “I am incapable of doing the analysis.”
Perhaps the most significant quote from Ben Graham’s investment bible, The Intelligent Investor, appears in Chapter 8 where he says,
. . . the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his huge advantage into a basic disadvantage. [Emph added.]
I believe the incredible bear market in financial stocks has ended or is close enough to ending. Ben Graham-type investors should be doing their analysis and buying pieces of companies selling at tremendous discounts to intrinsic value. Ben Graham would be saying “do the work and buy” not “stay away because they are unanalyzable.”
What you you think? Let me know!