I had to crack a smile this morning when I read that line from Jason Zweigh’s column, The Intelligent Investor, titled “Is It Time to Tiptoe Into Financial Stocks?” In the article Zweigh discusses a question lingering on the minds of many value investors at this moment of what Benjamin Graham would do with banks today and specifically: Are they a buy?
Zweigh makes the accurate observation that no one would know for sure, due to Graham’s passing in 1976, but I agree with his suggestion that the answer to the question of if Graham would buy financial stocks today can be found in his teachings as a definitive and resounding no.
When you look at the price charts of many financial stocks over the past year you might begin to feel excitement at the possibility of buying into a stock trading in excess of 60-80% below its 52-week high, offering attractive yields, trading slightly above book value and some possessing networks of investment, retail or mortgage operations both domestically and globally. That can be a tempting indicator of relative value, but the financial institutions of the past aren’t likely to mirror the ones of tomorrow. Results from the banks in the future are likely to reflect lower expectations for ROE and growth largely due to the change in appetite for risk, more stringent lending practices and a conservative availability of credit.
Here is where the significance of the title of this post is revealed. Bankers are smart people – I know a few of them. Even when investors, shareholders and the government begin to question, mitigate or shake their battle armour in an attempt to recoup their losses the brain trusts of the banks are already stewing new and innovative product offerings that hold the potential to increase profits in the future. They’ll find better ways to spread risk, to complicate financial products further and sell them at higher commissions with promises of increased returns.
There’s no doubt in my mind that many of the banks, currently experiencing problems or not, haven’t fully disclosed the extent of their exposure to bad loans, risky credit obligations or derivatives. There’s been a perplexing tune sung by the management of these banks in the absent protection of their brands that leads me, as an investor and student of strategic management, to suggest that an assumption be made about current risks. Full transparency comes at a cost and if Warren Buffett places such high regard on the importance of brands then why are so many of the CEO’s of these companies silent and invisible? There’s been almost no chaos management in this situation on their part.
I’ll suggest that this behaviour indicates that even the banks don’t know yet the extent of their exposure and they’re counting their pennies because every dollar counts. Banks are holding onto assets (both liquid and illiquid) that might be worth $0.20 today, $0 tomorrow or $2.00 a year from now. Some of these assets/obligations will make money on the future gains of losses taken today, but these banks are only writing off as much as their quarterly cashflow will allow. If they write off more, they risk needing to sell attractive assets at fire sale prices, weakening their capital ratios or creating fear that results in a run on the bank. Why an investor shouldn’t invest in some of these companies is fairly simple in my mind:
- There’s a significant lack of transparency and doesn’t appear to be improving anytime soon
- Companies continue to raise capital and issue preferred shares/bonds in an attempt to strengthen their balance sheets
- The public relations, investor relations and marketing departments of these companies haven’t been given the green light to start spending on brand protection and brand development programs yet
- Current losses could expand into catastrophic losses as seen with the failures of IndyMac & Bear Stearns for some of the more exposed financials
- While gains reported on aggressive write offs in the future is likely, the proportion of current losses to future gains ($0.20 today, $0 tomorrow or $2.00 next year) is completely guess work at this time.
Buying a basket might be a strategic investment when you count that a minority groups of banks will fail while the majority survives, but the preservation of your capital or “safety of principal” as Graham often cited isn’t known and that to me spells risk.
