Long-time readers of this blog know that I am always interested when the owners of the Dow Jones Industrial Average (DJIA) announce a change to one or more of the index’s 30 components (do a search for “Dow” on this site to see past articles). Usually it is a very good lesson in sentiment-based investing and happens at a time that will only hurt the index’s future performance (take out the losers and replace them with high-flyers). The latest change announced late last week might take the cake though. Intel (INTC) is out after 25 years and is being replaced by Nvidia (NVDA).
Intel was added to the Dow on November 1, 1999, just months before the tech bubble peaked in March 2000, which is yet another data point supporting the idea that Dow changes can serve as strong contrarian indicators (changes to large indices are mostly based on market cap, whereas since the Dow only has 30 companies, it’s basically a handful of people making a discretionary call on their own).
So where was Intel trading when it was added in late 1999 versus where it is today? On a split-adjusted basis INTC shares closed at $21.99 each the day before being added to the Dow. Now 25 years later, INTC closed at $21.52 just before the change was announced. Sure, there were some dividend payments made to shareholders along the way, but that just means the stock has compounded at barely above zero precent a year for nearly three decades since being added to the Dow.
As if there weren’t enough buyer beware signals for NVIDIA stock already (e.g. massive stock sales by the CEO constantly), this is yet another sign of extreme public sentiment. Much of it may very well be deserved… the question is simply whether all of it is.
As an active manager of debt and equity investment portfolios it will come as no shock that I do not believe in the efficient markets hypothesis (EMH).
From Investopedia.com:
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all available information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
While there are numerous examples that clearly debunk EMH, periodically we stumble upon one so prodigious that it is worth sharing. This week that example is MBIA, an insurance comapny that is seeing its share price rise by a stunning 75% today alone:
What makes this stock, which closed yesterday at $7.38 worth nearly $13 today? A special dividend announcement from the company itself:
You read that correctly - an $8.00 per share dividend to be paid two weeks from now. You don’t see that kind of announcement every day for a $7+ stock.
Full Disclosure: No position in MBIA shares at the time of writing (unfortunately)
Recession forecasters tend to jump on any financial datapoint they can find to justify their predictions of imminent financial doom and one of the those that bothers me the most is definitely our “record level of credit card debt.”
Before we get too concerned, consider the following:
1) Credit card “debt” is measured by simply combining all of the balances of every active card in the U.S. at any given time. So, if you use a credit card for everyday spending in order to get rewards and delay the cash outlay for the stuff you buy, that is considered “debt” even if you pay the balance in full every month and never owe a dime of interest. Considering how many people do this every month, and what percentage of overall credit card spend would come from such consumers, it is highly misleading to characterize every dollar of credit card balance each month as “debt.”
2) The financial media usually highlights the total amount of this so-called debt because it’s a big number. $1 trillion!!! Far more helpful would be per-capita data since the country’s population grows each year. If you don’t make that adjustment, most years will be a new record high.
3) As many financial professionals out there know, debt is one thing (sorry, for this one I am going to pretend the entire $1 trillion+ is debt) but what really tells the story of overall financial health is both assets and liabilities, income and expenses. Having debt is not a big deal (sometimes even quite beneficial) if your assets and income can easily support it.
With those ideas in mind, let me reframe the chart shown above to put credit card “debt” in better context:
a) Although total credit card balances have grown by 56% from 2013-2023, the U.S. population has grown by 24 million people during that time. Thus, on a per-capita basis, credit card balances average $3,029 per person in 2023, up only ~45% since 2013 ($2,089 per person).
b) As previously mentioned, the $3,029 figure does not represent true debt like a student loan or auto loan balance would. I don’t have data to indicate what fraction of card balances are carried over month-to-month, but it is safe to assume it is materially lower than $3,029.
c) How do we know if credit card spending has really been growing at problematic rates? Easy, let’s look at income data. According to the U.S. Department of Housing and Urban Development, median family income nationally has grown from $64,400 in 2013 to $96,200 in 2023 - an increase of 49%.
To summarize, $1 trillion in total U.S. credit card balances might appear to be concerning in the absence of any other information. If we adjust the data for population growth and compare it to income growth, we see that over the last decade incomes have risen 49% while credit card balances have risen 45%. Additionally, as credit card rewards programs have become more engaging over the last decade, it has become more common for consumers to use cards as a way to benefit financially by using them for most purchases and paying their balances off each month.
And so, there doesn’t appear to be a credit card debt problem at all.
That is not to say we will avoid a recession in 2024 (nobody knows that) - but rather simply that credit cards will not be a contributing factor if we don’t.
Given the dramatic events of the last week in regional bank land, I will share a few points that I think are interesting given where we stand right now.
1) The $250,000 insurance limit is a mirage
There is a lot of discussion about the FDIC insured deposit limit of $250,000 (whether it is high enough, should be raised, etc) but let’s be honest, the limit is meaningless. The U.S. government has repeatedly shown it is willing to take extraordinary steps to prevent cracks in the financial system from cascading into catastrophe. It only took a weekend for leadership to guarantee 100% of all deposits held with Silicon Valley Bank and Signature Bank. Thus, in this political climate, there does not seem to be any reason to worry about which bank your personal cash is held with.
2) Government-backed bonds are generally safe, but still carry risk
Despite the fact that everybody in the industry knows that long-dated bonds carry plenty of interest rate risk if you are forced to sell them before the maturity date, problems still arose here. After the Great Recession of 2008-2009, banks were encouraged to park deposits in safe securities like treasury bonds and government-backed MBS - securities that were considered safe and got you high marks during stress tests. SVB seems to have taken that to heart, in the sense that they bought lower risk stuff, but they ignored the fact that their liabilities were mostly short-term in nature and thus could very well be in position to be forced to sell them early at a loss.
The problem here was simply mismanagement - or the lack of risk management. Matching short-term deposits (VC and tech companies need to rely on short-term cash reserves much more than larger, mature, profitable businesses) with 10, 20, or even 30 year debt makes absolutely no sense. The blow could have been muted had they hedged the interest rate risk (somehow they didn’t) - or rebalanced their bond portfolio after it was clear the Fed was not slowing down the rate hikes. The fact that the yield curve was inverted during most of this period is even more shocking - as it means they were getting paid less in return for holding the riskier, longer dated bonds.
3) Contrary to the political narrative, this is definitely a bank bailout
The government announcement over the weekend was quick to highlight that any losses incurred by backstopping 100% of bank deposits at the failed institutions will be covered by the insurance fund and not the taxpayer. While true, this ignores the other part of the rescue plan. For banks that remain operational, but hold underwater positions in the same types of long dated bonds that tripped up SVB, the Fed will lend against that collateral at 100 cents on the dollar. This will minimize future bank failures by letting banks realize full value for an investment that is currently marked well below par value. Of course, this is a bank bailout using taxpayer funds (via the Fed). It may very well make a profit for the government - a la TARP - assuming they charge interest on these collateralized loans, but make no mistake - this is not private capital creating a solution but rather than Fed using its power as lender of last resort.
Much like 15 years ago, when the Fed accepted bad assets as collateral when nobody else would, SVB and Signature were the first to fail (a la Lehman and Bear) and in response those who lasted longer will reap the benefits (the other regional banks today are like Goldman and Morgan back then). So yes, it’s accurate to say the management and shareholders of failures like SVB will not get a government bailout, but their competitors will by being allowed to access newly created government-backed financial resources to keep them afloat.
4) It is likely that the Fed’s rate hiking cycle has indeed “broken something” in the economy.
But it’s not what we might have thought (the job market or GDP growth) but rather the balance sheets of the banking sector. After having been told they should hold more “good assets” like treasuries, the banks now require financial support to prevent these very securities from rendering them insolvent - even if sound risk management would have prevented problems. If this means the Fed hiking cycle will quickly come to an end, we might avoid an even bigger economic shock down the road, which could be the preferred alternative. If they keep raising rates now that banks have enhanced financial backing, well, then we’ll need to watch out for what else they will break.
Ever since software companies transitioned away from selling software by requiring a large upfront investment and instead offered a cheaper, recurring monthly subscription, the investor community has cheered and rewarded public software firms with much higher valuations. It is very common for “software as a service” businesses to fetch 10 times annual revenue (perhaps double their prior valuations) and less mature high growth subsectors within enterprise software are getting multiple of 20, 30, or even 40 times revenue. Heck, Zoom Video (ZM) currently sports a 46x price to sales ratio based on expected 2021 sales.
Unsurprisingly, anyone who is trying to raise venture capital or goose their stock price is trying to make the case that they offer a recurring revenue, subscription model. What I find odd is that some of the oldest, most mature businesses in the world actually operate this way, but they get ignored. Why shouldn’t Portland General Electric Company (POR) trade for 10 times sales rather than 1.5x? What about Verizon (VZ) and its meager multiple of 1.9x sales? Do they not provide investors with ideal examples of predictable, recurring revenue, monthly subscription business models?
I could shout from rooftops about how all of these businesses should be valued based on their profits rather than sales and that Wall Street has rewarded companies with predictable revenue (fewer quarterly surprises relative to expectations) with higher valuations for decades. “It’s 2020, baby, get with the program dude,” others would yell back. Yes, I guess I am a dinosaur.
With the market doing well, overall valuations extended (the S&P 500 now trades for 22x pre-pandemic earnings) and relatively few undervalued stocks to be found, it has been easier to find overvalued securities. Even if many folks don’t get into the short selling game, I still like to highlight examples of overpriced names, so maybe at least the bulls will consider taking some profits or minimizing their exposure.
There are plenty of candidates, but my choice today is Trupanion (TRUP), a pet insurance company based right here in Seattle. TRUP shares went public in 2014 at $10 and currently trade for $92 each, having made a new all-time high today. The company’s market value is $3.4 billion; a valuation of roughly 5.7x estimated 2021 revenue of $600 million.
If you are blown away by the fact that an insurance company can trade for nearly 6 times forward projected revenue, you are not alone. Oh, well, surely this company has some pretty impressive profit margins to warrant such a premium valuation, right? Not so much…
For the first six months of 2020, TRUP’s revenue was $229 million and net income was $220,000. That was generously rounded up to earnings of 1 penny per share (it actually comes out to 0.6 cents).
So what’s the deal? Well, you guessed right. Trupanion is not an insurance company at all, but rather it’s a recurring revenue monthly subscription service for your pet. Sorry, how could I be so stupid… it says it right there in the company’s income statement:
Let’s not be fooled by terminology. They sell pet insurance and the average monthly policy premium right now is $59 per pet and rising much faster than inflation. I have to wonder how many new pets they will sign up as the price keeps rising towards $100 per month.
However, we should not ignore the company’s growth. Pet insurance was not a big thing in the U.S. a decade ago and younger people seem especially open to the idea now. As of June 30th, TRUP has more than 740,000 enrolled pets (five years ago that figure was below 300,000). Annual retention rates are north of 98% (Author edit 10/15/20: A reader has pointed out that the company actually reports retention in monthly terms, not annual terms. Sorry, I did not catch that. Therefore, >98% monthly retention is more like a mid 80’s annual retention rate).
I am not saying this is a bad business. Rather, I think it is an insurance business and should be valued as such. To illustrate the lunacy of the current stock market valuation, we only have to refer to the company’s own long-term financial guidance (15% operating margins before factoring in marketing costs, interest expense, and income taxes) to deduce that like other insurance products, this business model will ultimately earn net margins in the mid to high single digit range.
Even if one wants to give them a high multiple on those profits (let’s use 40x since they are growing revenue north of 20% per year) and assume a bullish long-term net profit margin (8%), you arrive at a fair value of 3.2x annual revenue. It gets more dire if you instead use a 5% margin and a 30x P/E ratio (1.5x annual revenue).
But don’t take my word for it. Trupanion actually publishes a metric every quarter called “lifetime value of a pet” and the most recent quarterly report pegged this number at $597. This metric factors in the costs of running the business, the monthly cost of the insurance to the pet owner, and the expected number of months each owner will pay based on the demographics of their animals, etc.
If we simply take $597 per pet and multiply that by their current customer base of ~745,000, we arrive at Trupanion’s own estimate of the lifetime value of their current book of business; $445 million.
TRUP’s current market value is more than 7.5 times higher than that, which surely seems to factor in a crazy amount of growth in the future. I have to think that a large chunk of that premium valuation is simply due to the bizarre notion that selling pet insurance is more similar to selling software than to selling human insurance. That seems to be quite a stretch to me, but such is the investing climate these days.
It seems that startups bringing free trades and app-based investing to the uninformed masses might need to be reined in a bit. The narrative in recent years has been that investing can be a low-cost, do-it-yourself kind of thing, where paying professionals a fee is a complete waste of money and only eats into your returns. Of course, that is only true if the small investors have as much knowledge and experience as the professionals and therefore would get zero value from the professional advice (that caveat is rarely mentioned in the same conversation).
Now yes, I am an RIA so I have a dog in this fight and you might say I am just talking my book here. But assets managed by RIAs are growing, not shrinking, and it’s not because the professionals are taking advantage of anyone. There are simply millions of people out there who know they won’t be very successful on their own because they lack the knowledge, time, and/or ability to take emotions out of the equation enough, and therefore they would rather outsource the bulk of the investing work to a pro (and gladly pay for that service). That is not to say that everyone will, or should, fall into that bucket. But many will and if you do not, then great, by all means manage your own portfolio.
Apps like Robinhood that have turned investing into more of a game like Candy Crush are making it easier for novices to venture into waters that are too deep given their background and skill set. As we saw in the story linked to above, such services probably need to have more risk controls in place and higher thresholds for advanced trading strategies (like dabbling in options and penny stocks). Instead, the opposite seems to be happening and they don’t seem to want to take responsibility (at least not yet - maybe that will change).
It reminds me of the social media companies who have created sites where anyone can sign up for an account (without verifying their identify), and then can post anything they want to the world (even anonymously). If bad things happen, the companies claim they are only serving as a platform for free speech and can’t control what people do or say. It seems pretty obvious that such a business model could pose real societal problems, but there was no plan to deal with that side of the equation.
While I can’t control what apps like Robinhood do, I can give advice. And on that front I say that only educated and experienced investors should manage their money entirely on their own without any help. That help can take many forms and does not have to mean you hire an RIA to manage your account for you while you close your eyes and pray for good results. I know myself and many pros that would gladly serve as sounding boards for investing ideas and/or in the role of a second opinion for those who want to make the final calls and actual trades themselves. If you have others to bounce ideas off of and to give you the opposing side of an investing thesis (or explain the downside risks in more speculative waters like options or penny stocks), I suspect your returns over the long term will be higher than they would otherwise. And that is even after you account for any advisory fees you might pay for such advice.
Just some food for thought… please be careful out there everyone.
My last post highlighted the fact that the U.S. stock market in recent times has tended to find a lot of support around 15x trailing earnings. It appears that equities have calmed down a little in recent days, with a bottom having been made (perhaps temporarily) on March 23rd. On an intra-day basis (2,192) the valuation at the bottom was 14.0x 2019 S&P 500 profits. On a daily closing basis (2,237) it comes to 14.2x and on a weekly closing basis (2,305) the figure is 14.7x.
I am not going to predict that we have seen the lows. Even the experts in the field are merely guessing as to Covid-19’s ultimate infection path and even scarier to me is that I doubt health and government officials even have a plan for a slow loosening of social distancing guidelines, so we really don’t know what to expect from a economic rebound perspective. On one hand, I am comforted that the market did find a bottom around similar levels to recent years’ corrections, but on the other hand this situation is so much different than prior instances that I am not sure it is a very strong comparable event.
So rather than try and guess these things, like so many pundits in the media insist on, I think it is more helpful to think about where fresh capital could be deployed on a long-term basis as we wait this whole thing out. I am finding it too early to average down on more controversial existing holdings (travel-related, for example) because companies have not given us much data yet. Most have disclosed cash balance and credit line availability, but without knowing cash burns rates that only tells us so much.
So then the attention turns to businesses that are publicly traded, beaten down, and are less reliant on credit availability even if they are shut down. Essentially, high quality businesses that are on sale now but typically are not. Sure, there are examples in sectors where headwinds abound (Starbucks down 35%, for example), but there are more obscure ideas too. How about the few publicly traded professional sports teams? How confident are we that sports franchise values will continue to rise over the next 5 years? Even if seasons are cancelled, will the franchises lose 25-35% of their value for a significant amount of time? How often can small investors buy into sports teams at a big discount? Not often.
I know rental income in the near-term is problematic, but seeing owners of hard assets like real estate down 50-70% in a month is startling (and likely an opportunity). And you don’t need to go out and buy mall owners if you don’t feel inclined. How about Ventas, one of the leading owners of medical facilities? The stock is down 65% since February.
How about the big banks that were forced to be well capitalized so they could weather something like this? Jamie Dimon just went back to work after emergency heart surgery and JP Morgan Chase is widely considered the best-run bank in the world. It’s stock is down 40% from its 52-week high.
There are many companies I feel like I need for information from before I can decide whether to cut them loose or buy more shares. There are others where I feel like I can get comfortable given the low price, no matter how the next few months shake out. If you find unique situations where the franchise value is likely very secure and yet the stock is still down far more than the market itself, take notice. You might be surprised what you find. I mean, honestly, should Target stock be down 30% in this environment?
Happy hunting!
Full Disclosure: Long shares of Starbucks at the time of writing, but positions may change at any time
Although the equity market had a quick and violent negative reaction to the news that Charles Schwab (SCHW) would be proactive in driving online trading commissions down to zero for the bulk of the industry, I actually think the move was aggressive, made from a point of strength, and does not hinder their ability to grow from here.
Much was made in the press that SCHW had to do this to avoid losing material share to upstarts like Robinhood, but that view ignores the fact that Schwab's core business is not to provide young people with relatively low account balances a limited set of free services. Simply put, as the world's largest custodian for RIAs, the Schwab and Robinhood customer bases don't typically overlap much.
What Schwab was able to do was distance itself further from other traditional online brokerage firms like E*Trade and TD Ameritrade, which get a much larger portion of their revenue (25-35%) from trading commissions than Schwab does (less than 5%). Peers have had to quickly match the zero price point and will now have to reevaluate their business models after losing a huge portion of their revenue. Schwab, meanwhile, can easily withstand a 3-4% hit to revenue and will continue to focus on their core business of asset gathering.
Interestingly, Schwab stock has fallen 15% on the prospect of losing less than 5% of their revenue by moving to free online trading:
The narrative has been that this puts the company now much more in the "bank" category, as it will need to rely even more on net interest income to generate profits. As such, with interest rates falling and the yield curve flattening, the near-term outlook for their business is muted and investors should value the shares accordingly.
While I think that view is likely to be correct near-term, I don't think it alters the chances that Schwab can continue to be a dominant franchise in their category and grow nicely in the future. If one looks out 3-5 years or longer, there are few peers who can match their service offerings and I doubt they will stop making bold moves when opportunities arise. However, the stock price today is hardly reflective of that after the latest sell-off.
In recent years, SCHW has traded for around 30 times annual earnings, likely due to their standing as one of the most dominating franchises for investing. From 2013 to 2017, the stock ended each calendar year in a relatively narrow valuation band between a 30x to 32x P/E ratio. This also equated to a price-to-book ratio between 3.2x and 3.8x (ROEs of 10-12%).
Given a more interest rate sensitive business model recently and a slowing economy since the one-time jolt we saw from the tax cuts in early 2018, we definitely should expect that valuation to contract. In fact, today SCHW shares fetch just 13.8x 2019 forecasted earnings and 2.3x book value (despite ROEs now around 16% thanks to lower tax rates).
So what is the "right" valuation for Schwab? Should we simply treat it like any other large bank, such as Bank of America and JP Morgan, which both trade for 11x earnings?
Schwab's profitability ratios suggest to me it should trade at a premium, with returns on equity of 16% in 2018 and earnings set to grow 6% this year. At a 15x P/E ratio, still a discount to the market, we would project a fair value of 2.4x book value. That would put the stock today at an 8% discount to fair value, which is a pretty good price considering that Schwab's future growth outlook is unlikely to be stunted.
Just how can a business with the size and scope of Schwab grow from here? Well, total company revenue has doubled between 2013 and 2019 despite near-record low interest rates for the bulk of that time period. That kind of growth cannot be matched by large traditional banks. If Schwab continues to maintain its leadership position in the industry, even if it grows at half that rate in the coming six years (or 6% annually), earnings growth could push 10% annually during that span.
Add in a near 2% dividend yield and a stock that appears to be at least 8% undervalued today and one can quickly make an argument that Schwab shares are worthy of no less than a detailed look by contrarian-minded, value-oriented investors focusing on the long term.
Full Disclosure: I have started to nibble at SCHW stock for some clients in recent days and could very well build larger long-term positions over the near to intermediate term
Don't bother counting me in the camp that thinks they can predict when the next recession will hit. The current consensus from those who try to do such things seems to be sometime in 2020, but I don't think anybody really knows.
But that does not mean that keeping an eye out for economic signals is not worth doing. If the consumer credit cycle, for instance, is nearing a top, it very well may impact what multiple of current earnings you are willing to pay for shares of financial services companies. When you see strong return on equity metrics for full year 2018 this earnings reporting season, you might consider the notion that further expansion could be minimal.
In recent months I have come across a couple of interesting press reports that help shed some light on where we are in the current consumer credit cycle, both from the Wall Street Journal.
"Most lenders tightened standards dramatically after the 2008 financial crisis, and have been in intense competition for the most creditworthy borrowers ever since. And while most large banks have limited appetite for the subprime borrowers they lent to in the runup to the financial crisis, some have been eyeing customers with thin borrowing histories as a new revenue stream, a sign the lenders believe the good economy still has room to run."
So rather than scare their investors and regulators by accepting lower credit scores when considering new borrowers, why don't we ask the credit scoring bureaus to find ways to raise credit scores so that more people qualify. Yikes.
And cell phone bills are not the full extent of the changes. The article goes on:
"Fair Isaac Corp. , creator of the widely used FICO credit score, is close to launching a new credit score in partnership with Experian that will factor in consumers’ history managing their checking and savings accounts, which will give a boost to most consumers who keep at least several hundred dollars in their accounts and don’t overdraw."
Given that the credit reporting companies get paid by the lenders, not consumers, it stands to reason that when approached by their customers to refine their scoring methodologies, they were amenable to the idea. Kind of reminds me of the scene in the movie The Big Short when the Standard and Poor's employee explains why they rated all of those sub-prime mortgage bonds triple A; "because if we didn't give them the ratings they wanted, they would go down the street to our competitor."
"Aryanna Hering didn’t have pay stubs or tax forms to document her income when she shopped around for a mortgage last year—a problem that made it tough for her to get a loan. But the nursing student who works part time providing home care for children and the elderly eventually hit pay dirt: For a roughly $610,000 home loan, a mortgage company let her verify her earnings with 12 months of bank statements and letters from clients. Ms. Hering said money she collects from roommates and from renting to Airbnb guests covers more than two-thirds of her roughly $4,300 in monthly payments, and her earnings cover the rest."
While not a large proportion of the overall home lending pool, these types of loans are growing quickly:
"Lenders issued $34 billion of these unconventional mortgages in the first three quarters of 2018, a 24% increase from the same period a year earlier, according to Inside Mortgage Finance, an industry research group. While that makes up less than 3% of the $1.3 trillion of mortgage originations over that period, the growth is notable because it came as traditional home loans declined. Those originations fell 1.2% over the same period and were on track for a second down year in 2018."
So what exactly were the terms of the loan Ms. Hering received? Tell me if this sounds familiar:
"Ms. Hering, who is 30 years old, received a loan at a rate of just over 6% for the first five years; it adjusts after that."
Do these stories mean that the economy is about to collapse a la 2008? Of course not. All it means is that the business cycle is alive and well and that consumer lending has reached the point where prime borrowers have reached a level of debt they are happy with and lenders are now stretching a bit to grow. This happens every cycle, frankly. What it tells me is that delinquency rates are probably troughing out and overall credit quality and lender returns are probably peaking.
While these are important tidbits to consider when valuing financial services companies on multiples of book value or normalized return on equity, it is probably not going to help pinpoint the next recession. Leave that job to the economist community that has correctly called ten of the last five recessions, or the Federal Reserve, which has never (and will never) predicted one at all.
I was underweighted bank stocks heading into the 2016 presidential election and proceeded to watch as they soared immediately following. I didn't jump on the bandwagon because although the reasoning was solid (less regulation, higher interest rates) the stocks seemed to get way ahead of the actual fundamentals (in terms of timing). Below is a chart of the KBW bank index during that time:
As is often the case when upward moves appear a bit too steep, the stock have since leveled off and moved sideways for the last year or so. I have gotten more interested lately, not only because valuations are more attractive, but because the regulation relief is indeed occurring now and more normal levels of financial market volatility bode well for banks with exposure to the investment side of the business.
To figure out the best companies to focus on, I decided to see what the valuations today we saying about the profitability of the large banks, relative to the return on equity metrics posted for the first quarter, which is the first period where tax rates have come down to the new, lower level.
Oftentimes investors simply look at price-to-book ratios (the most common valuation metric for banks) and assume that the highest ones are fully valued and the lowest are most attractive. While this may be true sometimes, I am more interested in how the market is valuing these banks relative to their profitability outlook. To judge on that level, I prefer to see where price-to-book ratios are, versus where I think they should be based on each bank's fundamentals. To do so, I look at return on equity and look for relative mismatches in the data.
Below are current metrics for six of the largest U.S. banks:
If we only look at price-to-book, we would want to buy Citigroup and short JP Morgan. But since JPM is a best better managed bank, and earns 50% more on its equity (15% vs 10%), those two banks should not trade at similar P/B ratios.
To balance out the data, I calculate what I call "Implied P/E" which tells us what valuation the market is pricing in, assuming current ROE's remain constant. On this metric, we see that JPM is trading at 10.9x earnings (if they earn 15 cents for every $1 of equity, a P/E of 10 would equate to a price-to-book ratio of 1.50x). Similarly, Citi trades at 9.8x implied earnings.
All of the sudden, JPM doesn't look as expensive relative to Citi. The price-to-book premium is 67%, but since their returns are different, the premium us really more like 11%. Framed that way, investors who might have balked before could very well decide they prefer JPM at ~11x earnings, to Citi at ~10x.
The chart above resulted in me being less interested in WFC, even though their recent troubles on the surface appeared to provide long-term investors a good entry point for the stock. Of the entire list, I would say GS and JPM are the best-run companies. To see GS at the top of the list on my preferred "implied P/E" metric really got my attention. Their long-term track record as a public company (since 1999) is quite impressive and as a result, I am quite intrigued by the stock at current prices.
Full Disclosure: Long shares of Goldman Sachs at the time of writing, but positions may change at any time without further notice.
