Thursday, December 8, 2011

Avoid U.S. Financial Stocks--With Few Exceptions

I long have had a bias against investing in bank stocks.  The main reason is that I don't have confidence in the reliability of their financial statements.  It was difficult enough when banks primarily took in deposits and made loans.  Even then, it was difficult to ascertain the soundness of the loan books.  One could get a sense of the conservatism of management's accounting practices by comparing loss reserves to non-performing loans, and noting the rate of loan charge offs.  

But as major banks became effective hedge funds with leverage of about 20:1 (common equity ratios of about 5%), it has become nearly impossible.  Banks not only hold loans and investments in various securities (some quite arcane with no reliable market values), but they have extensive derivatives holdings as well.

As U.S. banks struggle to emerge from the U.S. financial collapse in 2008, they still have substantial risk exposure to the European financial crisis.  According to the Institute of International Finance, American financial institutions have $767 billion of exposure through bonds, credit derivatives, and other guarantees to private and public-sector borrowers in the Eurozone's weakest economies.

Owning shares in the major U.S. banks at this point is highly speculative, as a positive outcome in Europe will likely send share prices sharply higher, while an unfavorable outcome will cause the opposite.  I don't have a strong view on either outcome and am generally avoiding Euro-related investments now.  

Instead, I'd favor major Canadian banks, which are rated as the most financially sound in the world.  They have dividend yields of 4-5% and reasonable long-term growth prospects.  I would favor buying these on a pullback, as they have rebounded with markets recently.

Steve Lehman

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