Saturday, May 14, 2011

The Folly of Sector Focus: "The Case for Bank Stocks"

Randall Smith of the Wall Street Journal wrote a weekend edition column entitled The Case for Bank Stocks. It's a fine example of why you should be wary of people who write columns on investing in media for which you pay. I don't follow Smith's writing in the Journal, so I don't know if his piece was a one-off piece that represents his big break in writing at the Journal, or a frequently-appearing column. It doesn't have a clever heading, so Smith probably hasn't yet attained the status of his fellow Journal investment columnist whom I also find dangerously naive and narrow-minded, James Stewart.

Now that I think of it, the only two routinely-appearing Journal writers in the Money & Investing section which I find generally sound and interesting are Kelly Evans and Dennis Berman. Neither is confined to a single sector or topic.

Just like their actual kindred spirits in sell-side analysis or sector portfolio management, journalists who focus solely on either investing, or a sector, have a recurring problem. They must publish tantalizing pieces on a fixed schedule, and the pieces must at least appear to provide some fresh insight or value, regardless of whether, for sector-focused analysts and portfolio managers, it's just a bad time to be in that sector.

But this flies in the face of legendary Vanguard Group founder John Bogle's dictum,

'Don't just do something- stand there,' which captures his well-regarded and  empirically-proven contention that passive index investing will provide most retail investors with comparatively better returns at lower risks for the long term.

However, in keeping with why I originally began this blog, I decided to read and dissect Smith's article to see what sort of sense it makes. Passages from his piece are in italics.

Bank stocks rocketed out of the financial crisis in 2009, helping to ignite a bull market that has lasted more than two years.

This sort of anthropomorphizing of "the market" is an old journalist's trick to get you to regard equities emotionally, and actually believe they possess some sort of animus of their own. They don't. It's also an attempt to portray what may be simple correlation as causation, which also takes much more work to prove.

But in the past year, they have lagged the broader U.S. market. While the Standard & Poor's 500-stock index has risen 15.6%, a widely watched measure of bank stocks, the KBW Bank Index, has fallen 10%.

Now, as the economy moves from recovery mode to full-fledged expansion, some market strategists and advisers say bank stocks should outperform once again.

Christ, is it me, or does Smith sound like the pitchmen on the frequently-appearing 'invest in gold' ads on cable business channels? Does it get more hackneyed than "some....strategists...say banks stocks should outperform once again?"

"As the economy improves, we're seeing capital-markets activity picking up, credit trends improving dramatically, problem loans and delinquencies falling, and loan demand picking up—all the classic signs of an early-stage recovery," says William Tanona, a bank-stock analyst at UBS AG.

Wow, I'm impressed with Tanona's insights. But, wait....he's a bank-stock analyst! At UBS. Which really means he's a bank-stock sales support publicist at UBS. If bank stocks become uninteresting, Tanona's going hungry. So I'm sure his remarks are always totally objective.

The case for bank stocks has three main prongs. First and foremost, banks look cheap. On average, bank stocks trade at just 0.9 times their book value per share, while their average for the seven years before the meltdown of 2008 was about two times, Mr. Tanona says.

While current valuations reflect investors' fears about new regulations and higher capital requirements, Mr. Tanona says multiples should rise "once asset quality normalizes and firms adjust for all the regulatory, legal and capital requirements."

Seriously, I had to stop laughing at this point before continuing my comments. First, we have the old 'they sure look cheap historically' argument. Meaning past is prologue. Except that all investment literature must state that prior performance is no guarantee of future performance, etc. Then that second paragraph, which essentially disguises the truth that nobody knows how Dodd-Frank will hobble these leviathans.

My longtime financial business colleague B, and I, both believe that the largest remaining US banks are now slow-moving utilities incapable of surprising growth for extended periods of time. They are essentially heavily-regulated, quasi-governmental finance arms which are so heavily insured and regulated as to be pointless as investments.

J.J. Schenkelberg, an investment adviser at CLS Investments LLC in Omaha, Neb., says her firm has put about $50 million of its $8 billion of client assets into an exchange-traded fund tracking the KBW Bank Index because the stocks are "quite attractively valued" based on their price-to-book ratio. "With these types of valuations, they are still overly punished" for the financial system's near-meltdown, she says.

I love it when sell-side, or even buy-side analysts stumping as sales people for their funds, use P/E ratios as causal, rather than consequential. My proprietary research found P/E ratios to be meaningless and unrelated statistically to consistently superior performing companies as measured by total return.

The prospect of rising interest rates in the next few years also bodes well for banks, say some strategists. In that scenario, banks' so-called net interest margin, a measure of the money banks earn by making loans, would increase, says analyst Chris Kotowski of Oppenheimer & Co. That's because, in a rising-rate environment, banks can usually raise the rate on their loans faster than they have to raise the rates on their deposits.

Some banks also say they can reinvest some of their assets more profitably once rates rise and regulators loosen controls over their reserves. Two of the largest banks by assets, Bank of America Corp. and J.P. Morgan Chase & Co., "are both positively positioned for rising rates," Mr. Tanona says. Others say Citigroup Inc. is, too.

At Wells Fargo & Co., redeploying just half of a $100 billion short-term cash trove could boost pretax profits by $880 million a year, analyst Chris Mutascio of Stifel Financial Corp. told Wells executives on a conference call last month. "I would not disagree with your math," replied Wells Chief Financial Officer Tim Sloan.

Other potential beneficiaries of rising rates include Bank of New York Mellon Corp., Charles Schwab Corp., and Federated Investors Inc., all of which would be able to recapture fees waived due to rock-bottom interest yields on money-market funds. "These companies automatically get a benefit when rates go up," says Frederick Cannon, director of research at Keefe, Bruyette & Woods.

As profits improve, banks are likely to boost their dividend payments, say analysts. Banks slashed their payments during the financial crisis to preserve capital. Now that the crisis has ebbed, regulators are allowing banks to return more cash to shareholders. Nineteen banks have raised their payouts so far in the second quarter, on top of the 39 that did so earlier in the year. Among those that did so after regulators approved their capital plans: J.P. Morgan Chase, Wells Fargo and U.S. Bancorp.

As a result, while the KBW Bank Stock Index currently yields about 0.9%, KBW's Mr. Cannon expects it to increase to 1.9% over the next year. He says that, in turn, should attract buyers to the stocks.

Not all banks are likely to boost their payments at the same time. Investors were surprised in March when one bank, BofA, saw its dividend plan rejected by regulators.

It's true, and I've written about this in prior posts, from my own knowledge as a Chase Manhattan officer years ago, that most people don't realize banks generally benefit from higher rate environments. But this is the sort of thing that the thousands of sell-side and buy-side bank analysts all spend their time estimating. So it's not on the order of, say, surprise growth at Apple or Priceline. And you'd be basically, according to Smith and his sources, buying now, to hope that, sometime after Helicopter Ben raises rates, or things go wrong in the US economy and nervous investors cause risk-free Treasury rates to soar as they shun debt auctions, these large banks will benefit from some liquid assets redeployed at higher rates.

Never mind that, in this economic environment, those higher rates might actually choke off economic growth and demand for loans. A trivial concern, I am sure.

The banking sector isn't a cakewalk these days. Some analysts warn that banks must adjust to a new lending reality that includes a retreat from the wild-west days of mortgages with zero down payments, no income documentation and other loose lending standards.

"It will take banks years to adapt" to an environment of mortgages with 20% down payments, says bank analyst Nancy Bush, a consultant with SNL Financial Corp.

I'm old enough to remember Nancy Bush as a young sell-side analyst, along with Tom Brown and Mike Mayo. She's seen a lot, and her cautionary words are appropriate. By the way, if it does take banks "years to adapt" to this new environment, doesn't that suggest that resulting profits could be lower and later than the (smirk) totally objective sell-side analysts contend?

One drag on banks' loan growth in recent years has been the need to shed legacy portfolios of toxic assets they either inherited from previous management, in the case of Citigroup, or acquired in acquisitions, in the case of J.P. Morgan Chase, Wells Fargo and BofA. One bank with a big slug of for-sale assets, Citigroup, is only about halfway through that runoff.

Ah, yes. Those pesky "legacy portfolios." That's what sell-side analysts and bank managements like to call the resulting toxic relics of their last big errors in judgement. But don't worry. Really. They've learned all their lessons and nothing remotely like those mistakes will ever happen again. Really. Everybody agrees- the sell-side analysts, the bank managements, the regulators caught napping lasting. Everyone! Even Randall Smith!

So, go ahead, invest already!

Still, Todd Green, chief investment officer at Alesco Advisors LLC in Rochester, N.Y., which owns $15 million of the same KBW bank fund, the SPDR KBW Bank ETF, expects bank stocks to rally as lenders reinstate or raise their dividends, mergers pick up and valuations bounce off their recent lows.

Bank stocks, he says, represent "an attractive opportunity in this market to buy high-quality companies at low prices, in an industry that's essential to the functioning of capitalism in the U.S."

Let's see....Todd Green's funds own a big chunk of bank ETFs. Todd would like you to believe, as he does, that banks will be hot. So Todd's investments, bought at lower values, will benefit from your stampede into, well, hopefully the very same ETFs that Todd's firm bought for its clients.

No lack of objectivity there, huh?

Mind you, these so-called "high quality" companies are the same ones which accepted government bailouts and heavy consequent oversight. Are these low prices? Why?

If the prices rise due to equity index rises, maybe the S&P500 is safer.

Then there's the real proposition that would likely infuriate John Bogle.

This entire article, and all the supportive material, argue for market timing. Pure and simple. But market timing is notoriously unreliable and largely the province, when successful, of seasoned professionals who also have the benefit of legal market intelligence that retail investors lack.

It's always curious to me that analysts expect people to buy and hold in hopes of some future gains, while they know that what investors want is gains now...and in the future. I know of no professional fund managers who believe that telling investors to just wait through poor or negative returns now for future better returns will retain their capital. Market timing propositions, which is what Smith's piece is, fly in the face of seeking consistently good investment performance.

Finally, Green engages in a bit of suspect logic. Banks may be "essential to the functioning of capitalism in the U.S.," but that does not mean they will provide consistently superior returns.

Airlines are "essential to the functioning of ....the U.S." Would you like to buy and hold one? Or are they, too, market-timing equities?
Railroads were "essential" for the opening of the West, yet British investors lost nearly all their capital lending to and investing in them in the late 1800s.
Just because a sector is essential for something doesn't mean it's a worthwhile investment, when other alternatives are available.
In its totality, Randall Smith's piece displays, in one place, many errors of logic and biases which tend to characterize this type of investment journalism.
Proving to me, once again, why the financial sector's continuing insistence on sector-based analysis and investment provides such a helpful confusion to many investors. Meanwhile, other investors, like me, focus on firms of any sector which simply have prospects of providing consistently superior total returns now and in the near future.

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