Banks and Book Value

Financials are either the hardest kind of companies to analyze or the easiest.

* They’re hard because they’re in a lot of different lending businesses–mortgages, credit cards, personal loans, business loans–for all kinds of customers, from blue chip to sub-prime.

*The assets they hold, that is, the loans on their books, can have long lives.  Some loans will doubtless go bad, so there’s always the question of how quickly the bank catches them and how accurately it marks them down to realizable value.

*In addition, since the repeal of Glass-Steagall, the banks have been able to do extensive proprietary trading and other investment banking activities, which present more complicated management control and reporting issues.

 

 For smaller financials, limiting themselves either to only a few products, or dealing with a small range of customers, or operating in a limited geographical area, a generalist analyst can probably get his arms around the main issues.  For the largest, multi-line, multi-customer, maybe multi-national firms, even a financial company specialist may have his hands full.

 

 

The structural opacity of financial companies has always bothered me and has generally kept me away from investing in financials, except for in emerging markets, where the institutions tend to be simpler and much less mature than their counterparts in the OECD.  These companies present their own set of issues, but that’s not what I want to write about today.   

 

Suppose you want to buy US-listed financials.  An institutional money manager can do his own reading and  then call in a specialist analyst from a brokerage house to explain the ins and outs of the major firms in the industry.   But everyone believes (correctly, I think) that industry analysts form strong biases in favor of the areas they cover.  So at the very least you’ve got to give a sanity check to what they say.  But not everyone is big enough to have in-house analytic help to guide them.  And, of course, not everyone is able to get a sell-side analyst to come to visit.

 

 So what can you do?  –what portfolio managers always do.  Simplify.  Try to describe in the most general terms what the companies do and find a variable that, conceptually, should correlate well with stock price.  In this case, use book value.  Why?

Financials are middlemen in the purchase and sale of a commodity, namely, money.  Money is money.  It stays money.  It doesn’t get old, or wear out or become obsolete, like a machine or a building can.  So, assuming–and this may be a big “if”–the company, assisted by its auditors, accounts roughly correctly for unrealized gains and losses, then the value stored up in the firm should be the money it originally started with, plus profits not paid out in dividends, plus any new equity raised along the way.  In other words, shareholders equity or book value.   As a further support for this view, one might remember that this is (or at least is supposed to be) a heavily regulated industry.  So even if the managements and the auditors don’t keep good records, the regulators will find this out and fix the problem.

Book value, then, could serve the same function that a PE ratio would in another industry. One could compare the profits of companies in the industry as a percentage of book and award higher or lower multiples of book value to the better or weaker competitors.

 I think that this is actually the way non-specialist portfolio managers look at financials.  One refinement:  we should use tangible book value, i.e.,  exclude brand names or other “intangible” things that find their way onto the company’s balance sheet as a result of acquisitions.  We’ll factor in these sources of value through the multiple of book value we decide to pay for the stock.

 

What do we get if we do this?

 

This chart lists a a number of big financial companies and compares their stock prices with book value, as taken from the company’s latest filings:

 

                                recent price            recent book value                price/book         

Goldman                   80.00                        108.00                                    74%                         

Morgan Stanley      18.82                            30.25                                    62%                         

Wells Fargo              11.50                            12.70                                    91%                       

JP Morgan                19.51                            38.00                                   51%                         

Citigroup                    2.14                             12.50                                   17%                           

Bank of Amer. 1       3.91                             11.40                                   34%                          

Bank of Amer. 2       3.91                              9.00                                    43%                           

 

(I’ve shown Bank of America in two ways:  the BofA1 book value is the company’s reported tangible book at 12/31/08, shortly after the Merrill acquisition was announced.  BV has no impact from Merrill in it.  BofA2 book value assumes BofA issues 1.25 billion new shares, but that the value of Merrill ends up being precisely zero.   This isn’t a forecast.  I have no reason to believe that this will be the outcome of the acquisition.  Positive value to Merrill would make BofA2’s book value higher and its price/book lower than I’ve shown above.)

 

 

What does looking at book suggest the market is saying about these stocks?

 

Starting with the most straightforward comment,

 

*The price to book numbers are very low, across the board, relative to patterns of the last ten years.  Good banks have traded in the past at more than 2x book.  The “value line” for Goldman used by the Value Line Investment Survey is 1.3x book.  Less than six months ago, BofA and its investment bankers thought Merrill Lynch, a second-tier franchise in my opinion, was worth buying at 1.8x book.

*The market thinks brokers are more valuable than banks, which is a reversal of traditional form.

*They all look like closed end funds, trading a discount to net asset value.

*Extending the closed end fund analogy, most would in theory get a price boost if they announced they were going to liquidate and return assets to shareholders.   Taxable investors would be better off in all cases, except maybe Goldman and Wells Fargo, but tax exempt investors, like pension funds, would clearly benefit in all instances.  

*The numbers are all over the map.  Some figures, like those for Morgan Stanley, are audited; most are not, since their reporting year ends in December.  It may be that price to book will rise, once the annual audit results are known.

*Information may be in the “bad” numbers, not the “good” ones.  Citigroup really stands out.  If you could wave a magic wand and liquidate the company right away and get the balance sheet value for the assets, you’d get almost 6x your money.  It seems to me that if the balance sheet is a picture of the company, the market is saying Citi’s is a Dali or a Pollock, not a photo.

*A weird thought–Citigroup might be cheap, not necessarily on the value of tangible assets, but on “intangibles,” the value of its brand name and retail distribution network.  For this to be so, however, you’d have to believe that the tangibles have a value as high as zero and that the firm would be held in management hands that  know how to exploit the brand.    Irrelevant but interesting, I think–Let’s say tangible assets are worth minus $1/share.  If the government takes a 40% stake in a firm at a price of, say, $1/share, then the existing shareholders are better off, in that they’re only underwater on the tangibles by 25 cents.  But the government now owns 40% of the brand name.

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