This commentary originally appeared on Real Money Pro on Oct. 18 at 8:22 a.m. EDT.
"We've been known from time to time to suffer from premature accumulation."
-- Bruce Berkowitz, Fairholme Fund
With last week's JPMorgan Chase (JPM) third-quarter earnings release, yesterday's Wells Fargo (WFC) profit miss and this morning's earnings reports for Bank of America (BAC) and Goldman Sachs (GS), it is now an appropriate time to review a financial stock sector strategy.
Similar to Fairholme's Bruce Berkowitz, I suffered from "premature accumulation" in buying bank stocks and the Financial Select Sector SPDR (XLF), when I grew more bullish on financial stocks several months ago.
My current strategy for financial stocks, in summary:
- avoid bank stocks;
- short asset manager shares; and
- long life insurance companies.
Banks Are Trading Sardines, Not Eating Sardines
I must admit, as Cumberland Advisor's David Kotok relates below, most of the headwinds facing bank stocks are now well known (and this would normally create a buying opportunity):
[T]he financial stocks, which have been devastated for four years, are currently positioned for a buying opportunity. In Cumberland's case, we have scaled into financials several times and taken up the weights in the regional banks. So far, that is proving the correct course of action. We have taken the overall financials exposure above market weight. We continue to be a scaled buyer in financials.
Ten days ago, the entire banking system of the United States was for sale below its stated book value. One could argue it was for sale below its tangible book value, which means you could buy all the banks in the United States at stock exchange prices trading for less than their liquidation value. Clearly, that is an absurd pricing level.
Are banks now sound? Answer: some are, some are not. Are there still problems ahead in the financials and in the banking sector? Obviously, yes. Is regulatory change an issue? Again, yes. Are earnings derived from net interest margin an issue? Once again, yes. Does that mean that banks are dead forever? Our answer is a resounding no.
The time to enter a sector and start to take up the weights is when it has been devastated in a bear market for several years and priced to an extreme. When you price the entire banking sector below its liquidation value, below its tangible book value, you are seeing a pricing level in a climate where all the bad news is known or identified. Only then are you are defining an entry point. Further, the financial sector has lost ten percentage points of the value share of the stock market since its peak. Think about this sector where it once was 24% of the market weight and derived 40% of the market's earnings. Now it is 14% of the market weight. Its earnings are substantially down from the peak earnings that were extant five years ago when everyone wanted to own financials.
Nevertheless, while there will be intermittent trading (sardine) opportunities in the sector, I see these factors as valuation/profit headwinds for years to come:
- The big money center banks are suffering under the burden of cumbersome and expensive regulatory initiatives; they are the piñatas of populism.
- Higher ROE businesses (e.g., prop trading) are being reduced in size under the pressure of No. 1.
- The specter of low interest rates continues to pressure net interest margins -- and this won't change for many quarters according to Fed. Bank industry profit models benefit from higher interest rates, as banks have an imbalance of rate sensitive assets over rate sensitive liabilities.
- The capital markets outlook remains lackluster.
- Legacy issues continue to be costly (e.g., mortgages), as measured by both legal expenses and losses.
- Subpar worldwide economic growth and limited improvement in the employment rate suggest that the credit quality recovery of the past two years is maturing.
- Earnings power models for the bank sector have been revised lower almost every quarter and probably still remain too high. There is little low-hanging business fruit left in the way of pricing banking products (e.g., the imposition of a $5-a-month charge for checking won't dent the secular pressures).
Asset Managers Are Vulnerable to Disintermediation
I would remain short asset managers, especially those such as Franklin Resources (BEN) that have had disproportionate growth in non-U.S. fixed income and are now exposed to the threat of disintermediation (bond fund outflows), retail investors' disinterest in equities and depreciation in bond funds' asset values due to continued euro instability and the inevitability of higher interest rates.
Life Insurance Is Stupid Cheap
While life insurance stocks act nearly as poorly as bank shares and are similarly subject to valuation/earnings risk from an extended period of low interest rates, many of the other headwinds facing bank stocks are not apparent to the insurance sector. The recent share price weakness can be seen as an opportunity, as the industry's fundamentals remain on sound footing. As contrasted to the banks, earnings and ROEs are going to continue to expand, as the demand for structured, guaranteed financial products (as retail investors remain risk-averse and avoid the equity markets) continues the strong growth experience of second quarter 2011 in the quarters ahead.
At a 30% discount to book value and at under 7x projected 2012 profits, the life insurance sector is stupid cheap.
Doug Kass writes daily for Real Money Pro, a premium service from TheStreet. For a free trial to Real Money Pro and exclusive access to Mr. Kass's daily trades and market commentary, please click here.