Many have died over the last year or so, trying to catch the falling knives known as bank stocks. A big bet on their turnaround is what felled the legendary Bill MIller, and there are plenty of pundits who wish they could delete various “Banks are too cheap to ignore!” columns from the archives of financial publications. That doesn’t mean, however, that at some point banks won’t turnaround. Eventually, someone will call the bottom in banks, and that person — by dint of their own skill or merely good luck — will be right!
Author and hedge funder Eric Falkenstein isn’t calling a bottom in bank stocks necessarily, but offers an argument for why they might legitimately be cheap:
A common bank profitability metric is Return on Assets (ROA). On average, a bank makes 1% on assets, historically. Now, if you look at the entire financial sector, (say using S&P/MSCI Barra’s GICS from 5000-5280), you see the average NetIncome/Assets of 0.78% since 1989, including the most recent year. The graph shows the ROA for all US banks since 1984 as estimated by the St.Louis Fed, and this independently corroborates this mean result. That is, aggregate earnings in the financial sector included a lot of large write-offs, but the net for the year 2008 was near zero earnings, not something that returned total earnings for the sector to zero from the beginning of recorded history.
Currently, bank stocks have a forward P/E of around 13, meaning, using the current price, and the estimates for earnings next year, the ratio is 13. But this average ignores the fact that the largest stocks have the lowest P/Es: KeyCorp, National City, Citigroup, Wachovia, Comerica. If all the banks had a forward earnings equal to 0.78% of assets (its historical average over the past 20 years), and the P/E were then equal to the median P/E, the bank sector’s market cap as a whole would rise 150%. That is, if all banks earned 0.78% of assets going forward, and if they all had P/Es of 13, the total sector market cap would be $519B for the top 50 US banks, not $204B. This is an example of what Warren Buffet calls a ‘low risk’ idea, because the expected return is so great, you have to have a lot of wrong assumptions to underperform a benchmark of say, 12% annual return.
He also makes the contrarian argument that major banks are not insolvent, and that writedowns have actually been too aggressive. He doesn’t say why, however, other than cite a desire among bank management to start clean and position themselves for outperformance vs. past management. And, he notes, that the decline in financial market prices is nearly two years old, and that eventually, the bad news will be baked in.
Or maybe the sky really is falling and nationalization is the only path forward.
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