As I knew they would, the questions were plentiful after yesterday's article. How can we approach the markets by saying "I don't know"? Aren't you predicting the future with your trade of the decade in small banks? You seem awfully convinced that they will see a continuing wave of takeovers as banks struggle to deal with compliance issues and a weak economy. I do indeed have a high degree of conviction about what is going on in community banks, but as much as I like the story, it doesn't drive my investing decisions. The numbers do.
When I look at the small banks, I see that the regulatory costs are rising. They are a drag on earnings right now. At the same time, the credit crisis is in the past and credit quality has improved dramatically. Their balance sheets have been rebuilt, and many of them are flush with capital. Activist investors are involved in the industry and pushing banks to engage in activities like dividend increases, buybacks and outright sales, to move stock prices higher.
All these things make a good story, but the reason I am such an enthusiastic buyer is not the story. It's the numbers. I can still find many banks trading at a discount to book value, which also have high-quality loan portfolios and strong balnces sheets. If all the banks were trading at a premium to book value, I would have no interest.
My thesis could be wrong. Congress could act to provide substantial regulatory relief for small banks, and the merger wave would slow down as a result. Of course, all the money saved goes right to the bottom line so that's not awful from a shareholders perspective. We could have another real estate decline that hurts banks, but as long as I restrict myself to only owning those with strong loan portfolios and lots of capital, I will be able to weather that storm.
I don't know what could happen in the future to change the story, but as long as the numbers do not change materially, it should still end up being profitable for me.
Contrast that to infrastructure stocks. I am as certain about infrastructure spending as I am about small bank consolidation. Our highways, roads and bridges are in need of repair. The electric grid needs massive upgrades, as do many water systems around the United States. I don't know when the Federal, state and local governments will start spending the money, but I am pretty sure they will have to before too much more time goes by.
It is a fantastic story and I am highly confident that it will play out exactly as expected. I own no infrastructure stocks right now. They just are not cheap at current prices. None of them show on my screens. They did back in 2009, and we loaded up on stocks like Granite Construction (GVA), Pike (PIKE) and Mueller Water (MWA) and sold then when the traded back up to large premiums to my estimate of their corporate value.
I would love to own them, but they are not cheap enough to offset the delays and risks I do not know about. Many things could happen to delay spending in the current economic environment. Anything that slows the spending would weigh on earnings and push the stock prices lower, and I have no valuation discount to prevent a possible permanent loss of capital.
I am pretty certain that cyber security is the next big thing. As we move all our data onto the cloud and business is increasingly data-driven, keeping that information safe is going to be an ongoing struggle. However, it is a pretty young industry and I have no way of knowing which companies will be the winners and which will be the loser over time. The market leaders like Fortinet (FTNT) and Palo Alto (PANW) trade with triple-digit earnings multiples and there is no margin of safety to offset all the unknown developments that these companies will face in the future.
The story is fantastic but the numbers are horrible. There is no way to know what will happen in the future, especially in the fast-moving world of technology, but if the cyber security story doesn't play out exactly as anticipated, investors owning these stocks could suffer unrecoverable losses from current levels.
The future will contain surprises and unanticipated events. We have no way of knowing what they will be, or when they will occur. If the numbers do not support the story and expose you to the chance of a substantial loss, it is probably best to admit you don't what the future holds and you are not willing to pay up for a good story with an unknowable ending.