Thursday, March 31, 2011

Inherent Challenges in Investing in Financial Stocks

I admit to a general reluctance to invest in financial stocks.
I do not have confidence in the financial statements, particularly the balance sheet.  I think that book value (assets minus liabilities) per share is a key valuation measure for most financial firms.  But it is extremely difficult, if not impossible, to ascertain what a financial firm's book value is—specifically the asset component, whether it’s the investments of insurance companies or the loans and other investments made by banks.  

This was true even two decades ago, when most banks were simply banks.  Back then, they derived the bulk of their profits from the spread between what they paid out in interest on deposits and what they received in interest on loans to commercial and consumer borrowers.  Loan quality was crucial, and it helped to have a sense of the conservatism and ethical standards of management in how risky the lending practices were and how much was set aside in anticipation of loans going bad. 

But as the largest banks effectively became hedge funds in the last decade through trading operations and assets held off the balance sheet, ascertaining asset values has become extremely difficult.  And since banks and other financial firms often operate with significant leverage, it is crucial that what is assumed to be an asset is actually worth what the financial statement says it’s worth.  Otherwise, reductions in asset values have a magnified impact on the book value.

Unfortunately, the bursting of the housing bubble and the resulting financial crisis led regulators to loosen the stringency of reporting standards for financial firms.  For many of the assets on the books, firms are allowed to effectively set their own asset values based on financial models estimates, instead of relying on the actual market prices for similar assets.

So for investors in financial firms, there is the risk of a sudden decrease in the value of assets on the balance sheet as a result of writedowns.  Since book value is so important in the valuation of financial firms, I think it is important for investors to conservatively allow for a margin of error in valuing such companies.

The largest financial firms are now considered “too big to fail” because their collapse would jeopardize the entire financial system.  These firms have reported asset values (and book values) that I frankly have no confidence in.  The mindset of the authorities seems to be the same as that in Japan after their bubble burst in the early 1990’s.  That is, look the other way in (not) regulating them and hope that the companies can muddle through over a number of years by  gradually working off the impaired assets.

Smaller financial firms don’t have that luxury.  This week Hudson City Bancorp, the largest U.S. bank to forgo a government bailout, announced a $644 million loss from paying off debt that was underwater, under pressure from regulators.  The bank bought back $12.5 billion of securities that cost it higher rates of interest than the bank was earning on its assets (investments).  The bank still has more than $16 billion remaining of the money-losing securities.

The Hudson City's book value fell by more than 10% and would seem to be vulnerable to a further drop of 12-15%.  The share price dropped more than 20% since March 2, when the bank disclosed that regulators were pressing the bank to reduce risk.  It seems that the pressure on the bank's management of maintaining an exceptional growth rate of ten consecutive years of record profits led to excessive risk taking (as we saw during the housing bubble with many other firms).

I suppose one could simply invest in the biggest financial institutions on the assumption that no matter how much risk they take, the government will prop them up.  But with unknowable asset values, questionable earnings levels (and associated p/e multiples), and generally minimal dividend yields, I tend to favor other sectors for investment.

If, however, a financial firm’s management is skilled, shareholder-oriented, and ethical; and if the tangible book value (removing “goodwill” from the asset list) results in the stock selling at or below that figure; and if there is a solid record of earnings and dividend payments, particularly in a consolidating sector, there may be attractive opportunities.

Steve Lehman

S & P 500:  1325
Russell 2000:  839

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