To some, the recent poor price action in financials represents a threat: the decrepitude represents an opportunity to me.
On Friday I read Jim "El Capitan" Cramer's "No Wonder Bank Stocks Have Been Hit So Hard". Despite what Jim describes as generally adequate 1Q2020 EPS results, it is his view there is a message in the recent weakness of banks shares:
"You better start asking that because from the looks of the stocks of the banks, many of which reported excellent quarters, this group is in real trouble...And, most of all we want to own stocks of companies that get paid for their services and don't get stiffed and get away with it for the next three months. That's the banks. No wonder they've been hit so hard."
- Jim "El Capitan" Cramer
It now seems that we have entered, at least to Jim, a world in which somehow lenders are sacrificed and borrowers are in the driver's seat. Jim looks at the next few months and with the consumers supposedly walking away from the financial obligations (I guess despite the Fed's aggressive backstop/s), he surmises that a gruesome message is accompanying bank stock weakness.
I have to respectfully disagree - as the contractual obligations between a lender and debtor have not been repealed permanently. Jim, I believe, is responding to a moment in time and not to a permanent transformation in contract law.
Rather than the above quote from his Friday column, I call on a past wise quote from Jim that I vastly prefer!:
"Every once in a while, the market does something so stupid it takes your breath away."
With many now tag teaming me on bank stocks (on this site and on Twitter) I want to respond to Jim (and others) and repeat my view and tell a story about investing in financial stocks in the early 1980s which provides an analog to today.
I see the weakness in bank stocks as an extraordinary and possibly historic opportunity which I outlined clearly in "Large Money Center Banks Represent One of the Most Attractive Areas of the Market Today".
As I mentioned earlier, the current instability in bank stocks represents an opportunity to me.
I do not believe critics of bank stocks adequately respect the value of the industry's deposit base, excess capital and loan loss reserves (to absorb credit losses), profitability and earnings power.
In a focused analysis of the banking industry delivered on Friday, an old friend, Wells Fargo's bank analyst Mike Mayo, did an excellent job in telling a complex story about how the banking industry is well positioned today compared to the beginning of The Great Decession (GFC) in 2007-09.
If you can get Mike's report read it. Here are some of his key conclusions and factors that Mike thinks investors are not appreciating:
* First, bank results reflect the greatest front-loading of provisions for a recession in modern history; our est. y/e 2020 reserves now equal 50% of the Fed's stress test losses (severe scenario) and 64% of the bank stressed scenario.
* Second, reserve builds are non-cash charges, but quant models might not account enough for that factor, leading to unjustified valuation discounts, per our firm's strategist Chris Harvey.
* Third, go outside of equities for extra insight. As it relates to credit quality, the bond markets have rallied while bank equities sold off, partly on fears of credit. Who is right? The bond market got the GFC more right, and we think that history will repeat. While bank stocks trade at almost historic discounts vs. the average stock, bank bonds trade inline to a touch better vs. the average corporate bond. (Our favorite stocks include C, GS, USB, and PNC).
Here is the math:
For banks, this is an income statement recession and not a balance sheet one - i.e., no equity raises and dividends cuts at the largest banks, in our view. For this report's analysis, we use 5 of the largest banks (C, JPM, BAC, USB, PNC), assume a three-year time frame, 10% balance sheet growth (based on RWA), and a decline in earnings (PPNR) by 30% in year 1 and still down 15% by year 3 (i.e., incorporates ZIRP). The result: these banks have $350bn of loss absorbing capital, or enough for 13% loan losses vs. 8% cumulative during the GFC. On the one hand, earnings purgatory should continue in 2Q20. Yet, our forecast is that banks can still cover dividends twice over, have enough reserves this year for a "U" shaped recovery, keep an option to benefit from a "V" shaped recovery, and potentially get re-rated higher after this period by showing resiliency that remains underappreciated.
I am going to highlight the bottom line of Mike Mayo's charts (referred to above) which emphasize the banking industry's sizable war chest. However, I would note that I found a potential flaw in this analysis which actually understates how much better the banks are today (from an absorption basis) compared with 12-13 years ago. Mike takes after tax profits in calculating banking industry war chests - he should be taking pretax profits (which would substantially increase the industry's ability to absorb credit losses):
1. An estimated $350 billion of capital for loss absorption over the next three years.
2. Enough capital to cover over 1/2 more losses than experienced in the GFC.
3. Reserve builds in 1Q20 were $30 Billion ($17 Billion with non-cash charges).
4. Reserves in 1Q2020 already equal 42% of the Fed Stress Test Losses.
5. In 2020 models, banks are already reserved for 50% of the Fed's stress test losses .
6. When using company determined stress test, banks in 1Q2020 are 54% reserved for bank stressed scenario.
7. When using company determined stress test, 2020 models have banks reserved by almost 2/3rds of the bank stressed scenario.
Let's take a deeper dive with JP Morgan:
JP Morgan has loss absorbing capital of $118.5 billion for 2020-22 - but even that may be understated. JPM currently has (+)$18.6 billion of excess capital (calculated by excess CET1 over minimum CET1% capital requirement), (+)$25.4 billion of current reserves ( allowance for credit losses as of 1Q20), 2020-22 projected after tax earnings of (+)$93.1 billion (new earnings over 3 years uses 2019 PPnR as a base, then assumes a 30% haircut in year 1, then up 10% in years 2 and 3 (but still down 15%) and (deduct)( -)$15.6 billion of used capital for forward growth (the minimum additional capital required in order to fulfill capital requirements, given RWA increased over 3 years). (Note: Mike uses $93 billion in after tax profits (over three years) in the calculus of $118.5 billion in loss- absorbing capital. I contend Mike should be using pre tax profits, which would dramatically lift JPMorgan's loss absorbing capital of $118.5 billion to almost $190 billion and improve the cushion in all the margins and percentages listed below).
JP Morgan's loss absorbing capital as a % of 1Q2020 end loans stands at a high 15.5%. This compares to peak GFC net charge offs (3 years) of only 8.6% (reflects the three highest cumulative years of net charge-offs at JPM). So JPM is better positioned by 6.9% vs the GFC experience.
JP Morgan had $18.6 billion of reserves at year end 2019 and built up $6.8 billion in first quarter reserves, bringing total reserves up to $25.4 billion. This represents 42% of the most severely stressed adverse government loan tests. Using a full year mode, takes the 42% to over 50% of the government's most extreme stress . However, if we use the bank's most severe test it takes the current number of reserves to over 65% and, with estimated reserves made over the balance of the year, up to 88%!
Now to my story about investing in financial stocks - which focuses on an exceptional and similarly timed opportunity in history (which produced spectacular investment returns), back in 1982 with savings and loan stocks.
But before I get to it, I want you to all remember that bear markets are borne out of good news and bull markets are borne out of bad news.
Specifically, the difficult (and short term) conditions that currently face the banking industry (business/economic conditions, growing (but one time) loan losses and a flat yield curve) signal the sort of conditions and seeming almost exact point in history that investors have been paid off handsomely.
My story begins in late 1981.
This is a story that I have partially written about in the past, but I am expanding it for the purpose of discussing financial stocks.
At that time I co-managed Glickenhaus & Co.'s investment management business. Our firm was growing rapidly and we had one of the top performing investment returns of all independent money managers over a three-year period. (There weren't many hedge funds in those days)
In 1978 I began to attend Scarsdale Fats (aka Bob Brimberg) Harmonie Club luncheons. I met a number of money managers that were to become legends over the next few decades, including George Soros.
In 1973 Jim Rogers founded The Quantum Fund with George Soros. Seven years later Jim "retired" and spent the next few years on his motorcycle going around the world. Soros sought a replacement. Without getting too much into the details, George interviewed me for the job. I turned him down once and he asked me to meet him for lunch in London. He sent me tickets on the Concorde and I had lunch with him and we took a walk in Hyde Park. I had asked him to bring a computer printout of his holdings His portfolio was imploding, as I recall he was down by about -20% year to date. I quickly analyzed his portfolio (which to me was all over the place) and turned the job down for the third time. I recalled this experience in my book, "Doug Kass On The Market: A Life on The Street", was by far the biggest investment mistake in my life as George Soros went on and became one of the greatest investors of all time and among the most wealthy people in the world.
Soon, thereafter (in late 1981), unable to find a replacement for Rogers (and after I turned the Quantum job down), he started to give out money to outside managers. I was one of the first managers Soros gave money to. Over lunch, at The St. Moritz, I asked George what sort of portfolio he wanted, diversified or concentrated. He responded by saying just one, "your best idea."
I thought that this was crazy but it was his money and I obliged.
I chose the stock for Soros - First Charter Financial which, at the time, was the largest thrift in the country, based in Los Angeles and run by the legendary financier Mark Taper.
I purchased about 3% of the outstanding shares of First Charter Financial (FCF) for Soros. (I had a history following savings and loans as back in the 1970s, and I had earned my stripes as a financial sector analyst at Putnam Management. In the mid seventies I got "The Chief" - who ran Putnam's aggressive funds - to put over 25% of his funds into savings and loan stocks. He made a lot of money by getting out in a relatively short period of time).
Back to Soros and my purchase of First Charter Financial.
For perspective, similar to the current day for banks, at the time of my purchase it was a bad time for thrifts. The Fed was tightening, interest rates were sky high (sending thrifts' cost of funds above the fixed mortgage rates they were receiving), inflation was rising rapidly (worsened by an oil price shock) and mortgage originations were virtually non existent.
Stagflation and slow growth devastated S&Ls. Their enabling legislation set caps on the interest rates for deposits and loans. Depositors found higher returns in other banks. That caused a recession in 1980.
At the same time, slow growth and the recession reduced the number of families applying for mortgages. The S&Ls were stuck with a dwindling portfolio of low-interest mortgages as their only income source.
The situation worsened in the 1981 and into early 1982 - it got so bad that the Wall Street Journal routinely carried cover stories on how many months left of capital remained for the thrift industry.
Money market accounts became popular. They offered higher interest rates on savings without the insurance. When depositors switched, it depleted the banks' source of funds. S&L banks asked Congress to remove the low-interest rate restrictions. The Carter administration allowed S&Ls to raise interest rates on savings deposits. It also increased the insurance level from $40,000 to $100,000 per depositor.
By 1982, S&Ls were losing $4 billion a year. It was a significant reversal of the industry's profit of $781 million in 1980.
In 1982, President Reagan signed the Garn-St. Germain Depository Institutions Act. It completely eliminated the interest rate cap. It also permitted the banks to have up to 40% of their assets in commercial loans and 30% in consumer loans. In particular, the law removed restrictions on loan-to-value ratios. It permitted the S&Ls to use federally-insured deposits to make risky loans. At the same time, Reagan cut the budgets of the regulatory staff at the FHLBB. This impaired its ability to investigate bad loans.
Though the future looked bleak to many, with plunging stock prices, interest rates peaking and more favorable legislation, I sensed the worse was behind for the industry and for First Charter (who's shares moved to a "hat size.")
Unfortunately George Soros didn't see it my way. He asked me to make a presentation of First Charter and the savings and loan industry at a Quantum Funds Board meeting at his New York City apartment. Nearly every Board member greeted my First Charter Financail with a Bronx cheer, though they were mostly from Switzerland. George made me liquidate the portfolio the following week for a small loss.
The rest was history.
The short story is that the S&L industry began a remarkably positive period for asset growth, profitability and share price gains. Between 1982 and 1985, S&L assets increased by 56%. Legislators in California, Texas, and Florida passed laws allowing their S&Ls to invest in speculative real estate. In Texas, 40 S&Ls tripled in size.
First Charter's stock went up five fold in less than a year period and was ultimately acquired by Financial Corporation of America in 1983. (Meanwhile Golden West Financial, run by Herb and Marion Sandler, had an equally robust share price gain as it became one of the most important growth stocks - financial or otherwise - extant).
And, that is, as Paul Harvey used to say, "the rest of the story."
"The hardest thing over the years has been having the courage to go against the dominant wisdom of the time, to have a view that is at variance with the present consensus and bet that view. Courage and the ability to withstand pain are required.
Time and again, in every market cycle I have witnessed, the extremes of emotion always appear, even among experienced investors.
In order to win as a contrarian, you need the right timing and you have to put on a position in the appropriate size. If you do it too small, it's not meaningful. If you do it too big, you can get wiped out if your timing is slightly off. The process requires courage, commitment and an understanding of your own psychology."
- Michael Steinhardt
Today, buying bank stocks is the quintessential contrarian investment.
Contrarian investing (and avoiding "Group Stink") is simple but not easy.
An intelligent and contrarian investor sometimes gets satisfaction from the thought that his investing is exactly opposite to those of the crowd. The contrarian's credo is to buy when most people are pessimistic as often the best values today are found in the stocks that have gone cold.
As I have frequently observed in my Diary, humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.
The most compelling investment opportunities are often borne out of bad news and unusual (but relatively short-lived) adverse business/economic circumstances that are likely to be remedied in a reasonable period of time.
With such low valuations (and large discounts to book value) today - outsized market gains could lie ahead for the large money center bank stocks and leading investment banking equities.
Just as the savings and loan stocks - facing stagflation, high interest rates and plummeting mortgage activity in 1980-81 - provided a unique entry point in 1982, the large money center banks (with a war chest consisting of healthy and growing deposits, good reserves, robust and underleveraged balance sheets and sizable earnings power) may provide a uniquely timed investment opportunity today.
But there is an important difference - bank industry secular fundamentals and the value of their franchises (scale and technology) are a lot more solid than thrifts were in the early 1980s.
I wanted to end this column by emphasizing that it might be time to pivot from growth to value.
Today I suggest buying bank stocks and other selected financial shares at the sound of cannons.
(This commentary originally appeared on Real Money Pro on April 20. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)