Tough times in the banking sector started early in 2007 with the first signs of trouble in the sub-prime sector. Newly minted loans were going bad, even before their first anniversary, and hedge funds were unable to sell their holdings when redemption requests came in from investors. A “market route” in July of 2007 left bank stocks -15%, and those brave investors who stepped in to buy the stocks selling at 85-cents on the dollar were quickly rewarded. By September, the bank stocks had rallied about 10% in a relief rally.
We know of no investors who bought in July and sold in September, however. Too bad. By November banks had fallen, again, this time to 80-cents on the dollar. December saw headlines of various foreign nationals and big mutual fund companies committing new money to the sector. By defining bank stocks as cheap because they were selling at a hefty discount to their previous highs and because they had very high dividend yields, many very large and sophisticated investors made some very regrettable investments.
As 2008 began, banks began cutting dividends and raising equity at distress prices, diluting the earnings power and decimating the dividend yields available to the old shareholders. Boards started firing CEO’s and investment banks destroyed their own credibility by raising additional capital to cover losses that management had previously said they wouldn’t report. Massive write-offs, insufficient cash flow, an uncertain dividend outlook and shrinking accounting (book) values for the banks makes it unclear whether a bank purchased for 80-cents on the dollar is selling at a discount or a premium.
To our way of thinking, it hard to imagine that ground zero in the sub-prime debacle would bottom out at only down -20%. Especially given banks’ high operating leverage and a black box of loans that, frankly, nobody outside the now discredited loan committee can actually value, a banking problem is more likely to lead to the sector losing 50% of its previous value, which it has now done.
Analysts are now using “distress sale valuation ratios” developed during the Savings & Loan crisis 15 years ago. Based on these ratios, finally some of the banks are starting to look cheap.
It might finally be time to bottom-fish. Unfortunately, we have no better insight on this matter than did the big institutional investors who were buying Citibank and MBIA last December. By our definition, these stocks are not yet timely. Timely stocks are able to attract new money into the sector. Stock prices are going up, not setting new lows every day. In “What Works on Wall Street,” James O’Shaugnessy showed that one of the worst buying strategies is buying stocks off the “new low” list, which is where the bank stocks now reside. Calling bottoms is tough. Moreover, bottoms are often preceded by a crescendo of selling into a climactic sell-off, so those who are early may spend the next two years just getting back to even.
Instead, we choose to miss the bottom. So far we’ve missed “the bottom” at least four times in the past year. We missed it last year in July, again in November and January and March. Soon, perhaps this time, we will really miss it in earnest. The money we’ve saved by not being too early, however, is too great to overlook. There are values being created in the banking sector, and we should be able to profit when the industry rebounds.
We choose not to guess at when banks will bottom. The industry is almost certainly undervalued given the massive industry-wide sell-off in the sector. We will wait until they are clearly more timely before committing our money to the sector. As this year clearly demonstrates, sometimes it’s more important what you don’t own when building a portfolio, and “being early” is often just an aphorism for “being wrong.”
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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