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By James Anderson, Barron's | 9 October 2008
Advice from folks who've actually made money on financials.
Like some thinly traded bourse in a remote part of the world, the S&P 500 bank index rose or dropped by at least 3% on more than 70 trading days through late September. The Nasdaq bank index, once a quiet congregation of community-savings institutions, experienced similar gyrations more than 30 times. And it got even more volatile in the last week of the month, with these indexes showing one-day shifts of 15% or more.
Top performers: Jeff Miller of American Independence, David Ellison of FBR Mutual Funds and Anton Schutz of Mendon Capital Advisors. "I'm not sure I could count up that many sudden turns for either index in the 20 years before," says Raymond Stewart of Rasara Strategies, a White Plains, N.Y., institutional investment firm. "It's starting to look like what you'd see in the commodity-driven economy of a developing country," says Stewart, who has tracked banks for 29 years.
Of course, it's not just banks. Insurers were off 32% through the third quarter of this year; savings and loans, 28%; asset managers, 26%. Financial-service companies generally have surrendered 44%, according to SNL Financial, a Charlottesville, Va., research firm. And each sector has been subject to violent swings. The credit crisis has chopped an average of 26.4% off financial-stock mutual funds.
"My charter says I can carry up to 20% of assets in cash and go above that under certain market circumstances," says David Ellison, who runs the FBR Small Cap Financial and FBR Large Cap Financial funds (tickers: FBRSX and FBRFX). "Right now I'm well above that," he says. That's one reason Ellison has easily topped his peers' performance this year: His small-cap fund is up 0.25% for the year while the large-cap version is down a relatively modest 14.79%. Similarly Jeff Miller of American Independence Financial Services (ANEIX), an institutional fund that's off 5.83% in 2008, says he's had as much as 25% in cash.
By some accounts, Wells Fargo's (WFC) purchase of Wachovia (WB)— which occurred without government assistance— could be just the catalyst the devastated sector needs[!?!]
Whatever the case, there are a few finance names that fund veterans— including Anton Schutz, head of Mendon Capital Advisors, as well as Ellison, Miller, Stewart, long-time bank analyst and hedge-fund manager Fred Cummings, and Warren Marcus, a former Salomon Brothers bank analyst who heads a money-management firm— believe are good values that will emerge as long-term winners. Don't misunderstand. No one predicts an easy 12-month period for financials, regardless of Congress' passage of the bailout plan. But a handful of community banks, mid-sized regional and larger lenders with the capital to snap up the weak merit consideration, along with some insurers, investment-banking advisers and asset managers.
Community banks represent an under-researched sector that has lured many investors in the past quarter as they scrambled to get out of the big banks making headlines. Many smaller lenders— though not all— didn't gorge themselves on securitized goodies, and now seem the better for it. "The business model there is un-scathed— in fact, that subsector is a major beneficiary of the turmoil in the markets this year," says Schutz, who as head of Mendon runs the Burnham Financial Industries A portfolio (BURFX), which has a loss of 3.68% year-to-date, and the Burnham Financial Services portfolio (BURKX), off a relatively small 9.83%.
"One key trick to investing in the group is geography," says Schutz. "You don't want to venture into the high-growth, overbuilt and overvalued markets such as Florida, Arizona, Nevada and much of California, yet." Like most investors in volatile markets, these experts make clear that smaller-cap bank stocks— although down 8.9% year-to-date— rose 18.3% in the third quarter. Thus, price has become an issue in what is already a restrictive sector.
"A lot of bank names are ahead of themselves right now, trading at overvalued levels compared to their historic valuations and earnings," says Cummings, who spent 19 years as an analyst for the likes of McDonald Investments. [[July 15 was the most recent by end September, 2008: normxxx]] bottom for the sector [[not hardly! : normxxx]], as the Securities and Exchange Commission's ban on short-selling financial-institution shares [[since lapsed; lasted for 3 weeks in September, 2008: normxxx]] forced short sellers to cover their positions. Measured in terms of price to earnings, the banking universe, with market capitalizations of $100 million to $8 billion, is trading at 21 times 2009 profit projections, due to rising prices and analysts' downward earnings revisions. That's well above historic highs of 15. And many smaller banks are paying out CD rates that far exceed short-term funding rates from Treasuries.
Even with these caveats in mind, the metrics for some smaller institutions are compelling. "In most cases, they've maintained a solid funding base and have lent to people they know; their securities portfolios are plain-vanilla Fannie Mae and Freddie Mac holdings in the case of mortgage-backed securities, C&I (commercial and industrial) loans, residential mortgages and home-equity loans," says Cummings. "The Mom 'n Pop banks didn't get into the esoteric stuff. They've stuck to taking in deposits and writing loans [[a-a-ah; but many of these loans were for ARM mortgages— with various "sweeteners": normxxx]], a perfect formula for a period like this," adds Stewart.
And their price-to-tangible book value ratios are reasonable. The group is trading at the low side of its 150% to 300% historical range. The average Tier 1 capital ratio for community banks is 11.6%, versus 8.2% for larger banks. (Tier 1 capital is a core measure of financial strength; it is based on shareholders' equity and may also include irredeemable preferred stock. The Tier 1 capital ratio is the ratio of a bank's core equity in relation to its total risk-weighted assets.) Regulators typically use 6% as the threshold for sound capitalization.
Credit quality, a yardstick that will only become more important in a slowdown, has held up, too. The group's non-performing assets now average 1.32% [[that was in the third quarter, remember: normxxx]], a level Cummings expects to deteriorate in the coming months, though he still thinks it is "manageable." Even with construction-loan loss reserves up 144% and earnings for the group down from 2007, Cummings says the subsector is profitable, unlike big banks.
There's another plus, says Schutz: In pinched credit markets, managements with good capital reserves can make out as lenders under the right circumstances. Schutz is so bullish on Cleveland's TFS Financial (TFSL), with about $10 billion in assets, that he's parked almost 9% of his portfolio in it. "They actually have too much capital— and with big guys [in trouble] and a distressed market in Ohio, they can expand their balance sheet and make loans," he says.
Management is putting its stockpile to use in another great way, too: Buying back shares. "That makes this a no-brainer," says Schutz. TFS's gargantuan price-to-earnings ratio of 79 is misleading, he says. The lender is a mutual-holding company that has the option to buy its shares back below book value. Were it totally public and deploying all its capital, its book value would be $16.50 a share, just above its [[early October: normxxx]] price of $12.63.
Stewart likes Minnesota's TCF Financial (TCB), with $16.5 billion in total assets, whose ratio of non-performing assets is under 1%. He favors the shares because TCF's Tier 1 capital is a sturdy 8.3% and its price to tangible book of 240% is in the middle of the stock's typical range. "These guys have traded at a premium because of a solid home market and the fact they might fit a larger bank's desire to acquire a stake in the Midwest," says Stewart.
Cummings is a fan of Center Financial (CLFC), a big lender in Los Angeles' Korean community. Center, with $2.1 billion in assets, has solid capital levels, including a Tier 1 figure of 9.5%. Better yet, its non-performing loan ratio is a miniscule 0.33%, compared to the current group average of 2.27%. Even after a run-up, the shares trade for a little more than 11 times earnings and 136% of its tangible book.
Care to Venture In? Cheap Prices have lured many savvy investors into financials. (See current (February, 2009) 2-year financial index.) So far these bets have been losers.
Among slightly larger banks, Cummings favors Huntington Bancshares (HBAN), where credit issues— a loan to a subprime lender in particular— have been enough to scare investors, even though they don't seem life-threatening. The stock trades at nine times 2009 earnings projections and yields 5%. The good news, too, is that the Columbus, Ohio, bank's Tier 1 capital ratio is a healthy 9%. Its assets total more than $50 billion.Cummings thinks a stabilized environment may fan merger activity toward the second quarter of 2009. He views Provident Bankshares (PBKS) as a likely candidate to be acquired. It sits atop a tempting market in Maryland and other parts of the region, has solid Tier 1 capital levels at 10.7% and trades below 150% of tangible book. Possible buyers would include M&T Bank (MTB), PNC Financial Services (PNC) or BB&T (BBT).
Move a bit higher up the financial food chain, and you find a group of stocks Marcus says he'd take to a bomb shelter. It includes SunTrust Banks (STI), US Bancorp (USB) and Marshall & Ilsley (MI), a trio that has credit problems but nothing approaching those of the banks making headlines. "If you asked the general bank-analyst universe what its favorite large regional would have been a year ago, SunTrust would have been most widely picked," Marcus says. The Atlanta bank offers a dividend yield of more than 5% and, after taking Coca-Cola public in 1919, retains a sizable stake. Management has said it would tap that stockpile "in a pinch."
US Bancorp, in which Warren Buffett holds a stake, has shown solid financial strength, and has Tier 1 capital of 8.3%. Marshall & Ilsley operates from a Milwaukee home base that is geographically removed from the real-estate debacle's Sun Belt epicenters. Moreover, management had the foresight to spin off the company's big processing subsidiary, Metavante, late last year, a move that bolstered M&I's capital cushion in advance of the banking sector's troubles this year.
Insurance seems to be the stock market's new whipping boy, as exemplified by spurious Washington-fed rumors about a big insurer's imminent demise. The upshot: Prudential (PRU) and MetLife (MET), two of Schutz's holdings, have drifted down to very cheap levels. While the group has typically traded at a price to book value between 1.25 and 1.5, MetLife's book value of about $42 a share means it is now priced below its book value [[MacAllaster (from Barron's tound-Table, 2009): MetLife is $36 a share; the 52-week range is $65 to $16. It yields 2.6%. The company raises the dividend every year. Any time you can buy MetLife under book value, you should.: normxxx]] [[eg, a : normxxx]] (For more on MetLife, see "Snoopy Braves the Turbulent Skies.")
The same holds true for Prudential, which [[also trades below: normxxx]] book, and was also the subject recently of a favorable story in Barron's ("A Gibraltar of Tough Times," Sept. 1, 2008). Pru has earned a premium to its peers due to a return on equity in the mid-teens, well above its competitors, says Schutz. Concerns about the insurers' holdings on a mark-to-market basis don't make sense, he says, noting "the business operates on long-term assets and long-term liabilities. These guys therefore don't have to sell asset-backed paper today because it's still performing."
What's more, Met and Pru both stand to gain on sales of AIG's assets, or by reeling in talent from their fallen peer. Another insurer, Aflac (AFL), gains the money manger's seal of approval because of its strong portfolio and earnings potential. [[But see "Aflac shares drop sharply following downgrades": normxxx]] Keeping to the theme of sound and simple business models, asset managers also offer a good opportunity, after pullbacks this year. Historically, the group has traded between 15 and 17 times forward earnings.
Schutz and American Independence's Miller are both bullish on investment bank Lazard (LAZ). Lazard, which doesn't put its capital into deals, stands to benefit as an adviser to investment and other companies that have to restructure or wind down their operations. As a testament to its health, Lazard is bringing home a 15% return on invested capital, says Miller, who expects it to boost cash flow 20% in 2009.
Miller also like Franklin Resources (BEN) and Federated Investors (FII). Franklin's return on invested capital is 25%, while money-market behemoth Federated should benefit from a flight to quality amid recent money-fund problems. Federated also generated huge returns on invested capital— 70%— and is growing earnings by more than 10% a year.
The Bottom Line
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Tread carefully, but there are a handful of names within the broad financial group that look attractive to successful investors in the sector. Lest you think these portfolio managers have donned rose-tinted glasses, there are many names they don't like, and their cash levels remain high. Schutz points to AmeriCredit (ACF), a used-car lender that could suffer as consumer charge-offs mount in the months ahead, and Wilmington Trust (WL), which had the misfortune of owning now-worthless Fannie Mae and Freddie Mac preferred shares. Wilmington is also taking a hit in the distressed mid-Atlantic construction-lending market.
A third institution, Umpqua Holdings (UMPQ), also is a victim of the poor construction-lending environment. One of its real-estate borrowers in Bend, Ore., has gone belly-up while still owing the small bank $3.4 million. Cummings points to Anchor Bancorp Wisconsin (ABCW), a $4.9-in-assets outfit caught in a capital pinch, especially under the pressure of a nonperforming-assets ratio of 3.44%.
The lender has a loan-loss reserve of just 33%, compared to a 144% industry average. Management is trying to raise $50 million in capital, which will be dilutive to stockholders, particularly in light of its $166 million capitalization. It wouldn't be a frontier market without some major casualties.
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Here's Another Reason To Expect A New Wave Of Bank Failures Soon...
A recent issue of American Banker said eight out of 12 Federal Home Loan Banks (FHLBs) would have less than the minimum regulatory capital if losses from mortgage-backed securities were deducted. The Pittsburgh FHLB said permanent losses could exceed the bank's retained earnings— which has never happened in the FHLBs' 76-year history. This is a big deal because, as with Fannie and Freddie, FHLB securities are owned by all FHLB member banks.
(See Seattle Bank’s Risk-Based Capital Requirement A member of the Seattle FHLB who spoke on the condition of anonymity said, "They simply ran out of cash...")
There are currently more than 8,000 members, all of whom own shares in their regional FHLB. When the FHLB fails— which may be inevitable— thousands of banks holding FHLB securities will take writedowns. That'll bring many banks already weakened by losses in Fannie and Freddie preferred stock that much closer to insolvency. Understanding government's role in the financial crisis is a test. If you don't understand that the crisis happened in spite of government "insurance" schemes and regulation; that it was compounded by government insurance which assured the banks that they could privately reap the rewards for their successful risks, but could always depend on a government bailout in case of failure, you fail the test.
M O R E. . .
Normxxx
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