Thoughts & Comments
WSJ: Financial Companies Can't Be Analyzed. Wrong!
This is what people were saying at the last bottom, too.

Thomas Brown  ( about me )
Posted 07/28/2008

“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!

  Add your comment



sunraj Posted On 7/28/2008 6:33:52 PM

Still don't see a great reason to bottom fish in a black hole of potentially unlimited off-balance sheet liabilities and business models that are opaque. Who knows what kind of prop trading these places do and what else they're on the hook for. (see MF Global, Calyon, Soc Gen, etc...) The stocks that are down ~80% or more are unlikely to recover for years, if ever. Lots of good opportunities to deploy capital in businesses that can be understood, like selling iPhones. Zweig is right, only reason to buy financials is a quick trade for another relief rally.

DavidK101 Posted On 7/28/2008 10:20:22 PM

Tom - comparing this bear market to the last one in the early 90s is missing the point precisely. Of course buying in a bear market is when a value investor makes their money. But consider what Bruce Berkowitz said in a recent Morningstar interview about why he only owns one financial today (AmeriCredit) whereas in the early 90s, he filled his portfolio full of financials: "15 years ago during the last crisis, early `90s, late `80s, I would be buying you know Freddy Mac and MBIA, Wells Fargo, but today you just can’t understand and you haven’t been able to understand what these companies own or who they owe." Many of the large financials today have many more pages of disclosure than they used to, but less clarity. That's the point.

jasonnorbeck Posted On 7/29/2008 1:28:49 AM

I agree w/ Tom. I am very happily long Freddie, because I have studied the company for years and I understand that its undervalued. Just because everyone has an opinion, doesn't mean they know what they are talking about.

JorgeJose Posted On 7/29/2008 6:58:23 AM

I agree with the comments. If you are a "short-term" person, then you are a speculator in the financial sector. If you are a long-term investor, then your objectives are for at least 5-10 years--and financials will not disappear regardless of what is currently happening in the US financials (banks, mortgage lenders, etc,.). There are some good Banks which have been taken down with everything else---shortsightedness---we should look at the one's who have solid management, made conservative mortgage lending and then pik the stock! How about USB?

jamesa40 Posted On 7/29/2008 1:35:54 PM

Hmmm....wasn't it Warren Buffet that said "Only buy what you understand?" Didn't he buy WFC and still continues to hold it? I believe he's taken positions in other financials as well. Sure the Merrill's of the world have gotten into stuff that they surely regret today, but there are a lot of financials out there that make money the old fashion way. You just have to take some time to look into them, rather than toss out the whole lot.

DavidL Posted On 7/30/2008 8:58:58 AM

Financial stocks are inexpensive, we know that. Financial stocks are, by definition leveraged, we know that. The current financial hurricane is a Category 5 storm, we know that. Fraud was frequent and perverse incentives rampant for a number of years, we know that also. In the fog of war, making decisions is based on an enormous amount of uncertainty. The biggest single uncertainty as I see it is macro. Can policymakers help get "the consumer" through what Robert Shiller would call irrational pessimism. Bias rules in envirionments like todays. As a sceptical optimist I would agree that the weighting goes toward investing in the high quality tranche of bank stocks.

dhiren1 Posted On 8/5/2008 1:21:08 PM

Tom: Simple question: You are conveniently using Buffett's Wells Fargo investment to prove your point. What about Buffett's lack of action in this current mess? He has not stepped up to invest in any of the financial distress. Are you claiming that you have an understanding or ability to analyze the stuff that these companies own? Citi has bunch of stuff marked at 52 cents on a dollar; Merrill created a market at 22 cents. This difference could mean life and death for these companies which is next to impossible to handicap. You may get it right by sheer luck though. Most of these investors who are owning FRE or FNM or anything of this sort are using a discount to "reported' book value to make an investment thesis. This is too simplistic as the reported book value has no meaning in these companies. Institutional money manager may take a long term view on these companies and in the long run, some of these may survive. But in the meanwhile, the money manager may no longer stay around to manage money because of withdrawals that he / she will see in the fund.
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