I just wanted to thank the folks over at 24/7 Wall St. for once again naming this blog one of the 25 best financial blogs on the web. In case you are curious about the others that were recommended, here is a link to their list, which links to each of the 25 blogs:
Capital One: Book Value Down 3% in 2008, Stock Down 60%
When I construct an equity portfolio, I focus on individual companies rather than sector allocations. My thought process is that if I can pick the winners and avoid the losers in any given sector, I don't have to predict which sector will do well and which won't.
Now, I could go out on a limb and avoid all energy stocks, for instance, if I thought demand for oil (and therefore prices) would decline. But what if I was wrong? Energy stocks could soar and I would have no exposure whatsoever. Personally, I find it far easier to identify strong energy companies than to predict where energy prices will go.
If the energy stocks I choose to invest in are better than average, then the energy portion of the portfolio will outperform the S&P 500. If I can replicate that in more sectors than not over the long term, then I can outperform the benchmark index. In a nutshell, that is how I try to beat the market over the long term.
It sounds simple enough, but in unique times (such as today) rationality completely goes out the window, and that makes my job as a long term investment manager very difficult. I will use Capital One (COF) as an example. If you believe in efficient markets, this will serve as some evidence against that hypothesis.
I have followed Capital One for a long time and have written about it extensively on this blog over the years. In my view, it is one of the best managed and financially strong banking companies around. As a result, when faced with a choice of paying 10 times earnings for Citigroup (C) or the same price for COF, I chose COF.
My analysis has been mostly correct. Capital One has avoided huge losses on packaged securities of sub-prime loans and purchased various deposit banks before the credit crisis hit, which allowed it to maintain appropriate capital levels without begging the government for cash. As a result, the company's tangible book value per share in 2008 dropped from $29.00 to $28.24, a loss of 2.6% in a year when many banks went out of business or were bailed out by the government and larger competitors.
As you can see from the chart below, however, Capital One's stock price has fared far worse than their book value deterioration would suggest. It has dropped 60%, from over $50 to under $20 as of this morning. Fundamental analysis has gone completely out the window lately.
Sellers of Capital One will tell you that as the unemployment rate rises, Capital One's loan losses will increase throughout 2009 and their earnings will decline, if not turn negative. I completely agree! Everybody knows this, including the company (management is forecasting $8.6 billion of loan losses in 2009, a dramatic increase from 2008).
Still, that does not justify a 60% drop in share price coinciding with a 2.6% drop in tangible book value. Let's say book value falls 10% in 2009 (nearly four times the 2008 rate), reflecting an even worse year. At the same rate (20% decline in stock price for each 1% loss in book value), COF shares would drop 200% in 2009. Fortunately, a stock can't go down more than 100%!
The market is behaving as if larger loan losses and a temporary disappearance of earnings threatens the survival of Capital One, although the company has a very strong balance sheet and can withstand these recession-related shocks, unlike many of their weaker competitors. Because such an assumption is off base, it makes very little sense for a long term investor to shun strong bank stocks in the current market environment.
Capital One may trade at two-thirds of book value today (how that figure is justified, I don't know), but when the recession ends and the unemployment rate begins to drop, the odds are very good that the stock trades at two times tangible book value or more, which means the stock could triple in value, even ignoring any increases in book value which would certainly result as time went on.
Until then, the market will continue to only focus on the short term and conclude that a bad 2009 means companies like Capital One somehow have bad business models or are broken in some way. In actuality, they are simply riding the economic cycle. Finance companies make good money when times are good and do poorly when they aren't. Fortunately, the good times far outlast the bad times.
Full Disclosure: Peridot Capital was long shares of Capital One at the time of writing, but positions may change at any time
Pfizer Might Finally Move to Help Cushion Lipitor Blow
The relatively new CEO at drug giant Pfizer (PFE) has been focusing on cost cutting, not major acquisitions, since he arrived but investors have wanted more. The company's blockbuster cholesterol treatment, Lipitor, represents 25% of Pfizer's $48 billion in annual sales, but the drug faces patent expiration in 2011. Fears over how the company would replace such a loss has been hampering its share price for a long time. Despite a dividend yield north of 7%, investors have been uninspired, as the stock only fetches 7 times 2008 expected earnings.
We now hear that Pfizer is in talks to acquire Wyeth (WYE) for about $60 billion. While most large deals are met with initial skepticism (Pfizer shares are down in pre-market trading to $16 and change) a large deal is very important for an industry facing large scale patent losses and limited R&D pipelines. If this deal does come to fruition, it shows that Pfizer management actually did have a plan, they just weren't going to be rushed into it by Wall Street. With a P/E of 7 and a dividend yield of 7.5%, Pfizer shares are very cheap and at the very least have limited downside. If the Wyeth deal happens and works well, the announcement of the deal could easily mark the bottom in the stock.
Full Disclosure: Peridot Capital had a long position in Pfizer at the time of writing, but positions may change at any time
Two Suggestions for Apple's Board of Directors
As an Apple (AAPL) shareholder, the recent handling of disclosures regarding the health of CEO Steve Jobs has me upset like most other investors. For some reason, Apple's board of directors believes that a CEO facing a potentially fatal cancer is not "material" piece of news.
They didn't tell us right away when Jobs was diagnosed with pancreatic cancer several years ago, despite a five year survival rate of less than 50%, and they have refused to update us on his health. Now we have to rely on tech-related blog sources to update us and when finally forced to give more details, the Apple board said he was fine, only to announce his six month leave of absence days later.
As if this is not difficult enough for shareholders, the company is currently sitting on $28 billion of cash in the bank. Apple's cash hoard would rank it the 55th most valuable company in the S&P 500 even if it had no operations whatsoever. Why on earth is Apple keeping this much cash on its books?
They will tell you they want to keep money available to make strategic acquisitions and to weather economic downturns. Has Apple ever made a large acquisition? Did they not just announce better than expected earnings for the fourth quarter despite this severe recession? There is simply no reason for them to have $28 billion just sitting there.
I have two suggestions for Apple's board of directors. Not only will both moves boost Apple's share price, but more importantly it would simply show some desire on their part to be fair to their shareholders, the same people who pay their salaries.
1) Announce a Management Succession Plan
How hard is this, really? Apple has plenty of competent managers. All the board has to do is announce what the management hierarchy would look like if Jobs left the company for personal reasons. With that knowledge in hand, he can stay as long as he wants as far as I'm concerned! The board knows this is a crucial issue (the stock plummets each time the health issue appears troubling), but simply ignores it for some reason.
Personally, I do not believe that a Jobs-less Apple would be in trouble. The idea that he is the entire brains behind the company and its products, and not the other 35,000 employees is pretty silly. Jobs is certainly a very good CEO, but the idea that Apple lacks the talent to innovate without him seems far fetched to me.
2) Announce a Stock Buyback Plan and Repurchase 20% of the Company
At current prices they could retire 20% of the company's outstanding shares and still have $12 billion of cash in the bank (and that number would grow every quarter from there). Can anyone really make the argument that Apple needs more than $10 billion of cash? I guess if you think they are going to buy Dell for cash or something than you could, but large tech acquisitions rarely are successful and more importantly, Apple has no history of even attempting them. A large buyback would be significantly accretive to earnings per share and could get the stock rolling again after the latest Jobs-related hiccups.
Neither of these moves would hamper the future outlook for Apple whatsoever. They would simply show that the board of directors is actually doing their job; working for the shareholders of the company.
Full Disclosure: Peridot Capital was long shares of AAPL at the time of writing, but positions may change at any time
The Market Now Believes All Banks Are The Same
For months I have been in the camp of investors arguing that there are distinctions between U.S. banks. The comparisons have been made for a long time. JPMorgan Chase (JPM) is better than Citigroup (C). Wells Fargo (WFC) is better than Wachovia. The market seemed to agree with this premise until recently, and Tuesday's market action in the banking sector was startling. Once again we have fierce and indiscriminate selling of all banks.
The drops in these stocks in recent days signals than many market players believe that all of these banks are in serious trouble, regardless of whether they have or have not done things such as loaned to sub-prime borrowers, accumulated lots of structured products on their balance sheets, maintained strong underwriting standards, or focused more on businesses rather than consumers.
The fear now is that the stronger banks who bought up the troubled institutions for pennies on the dollar actually did not get a good deal. Instead, the bad assets they took on will cripple them. The government will be forced to bail them out, common stock dividends will be eliminated, equity holders diluted, share price values decimated, and the companies eventually nationalized.
While this may be true in certain instances, I still do not believe that every large U.S. bank is on the brink. The market though, disagrees right now. After all, people thought State Street (STT) was safe because its main business was not lending, but rather back office and custodian services. And yet somehow they have managed to amass an $80 billion investment portfolio with $6 billion of unrealized mark-to-market losses so far. Maybe it isn't safer.
Fourth quarter earnings reports released in coming days and weeks will shed more light on whether banks that have been able to post relatively better financial results this far in the cycle can continue that trend. Maybe all of the number-crunching people like me have done in recent quarters, trying to identify the better banks, was a worthless endeavor. I sure hope not.
If last quarter marks the end of that relative out-performance, there might not be a single bank stock that qualifies as quality. That would be a sad day, but the market is losing patience and is spooked by that possibility, as Tuesday's trading brought with it 20, 30, even 40 percent losses for some banks on relatively little or no news.
One of the better banks in the eyes of many, U.S. Bancorp (USB), released earnings today and recorded a fourth quarter profit of $330 million. The market has greeted the news by sending the stock down 12% today, bringing the year-to-date loss to -46 percent. The culprits appear to be worries over increasing credit losses and the possibility of a dividend cut.
These two issues are interesting because many of us believe that increasing credit losses and dividend cuts are to be expected. As the economy worsens, credit losses rise and in order to cover those losses and reserve for future ones, earnings will drop below dividend rates and dividends will be cut. These things should be obvious by now.
For a company like U.S. Bancorp though, it appears manageable and investors should not own the stock just for the dividend. USB is an excellent franchise and the long-term earnings power of the company is what should drive the share price. As a shareholder, I don't mind if USB has to cut or eliminate their dividend for a year or two in order to cover credit losses from loans made during the boom.
Looking at USB's losses and reserves, I don't see a reason to be panicky. Charged off loans in Q4 were $632 million. The company covered those, set aside another $635 million for future losses, and still earned a profit of $330 million for the quarter. Total allowance set aside for future credit losses sits at more than $3.6 billion. USB's gross earnings (before credit losses) was $1.66 billion for Q4, so between that and the $3.6 billion already set aside, the bank has plenty of capital to cover increased losses throughout 2009.
While there are no banks, strong or weak, that are going to be able to avoid increased credit losses over the course of 2009, there are certainly banks that are better positioned to withstand the losses than others. Although the market is no longer giving them credit for being one of the stronger institutions, companies like U.S. Bancorp are the favorites to survive the current economic downturn and be stronger on the other side of it with fewer competitors. Investors looking at bank stocks need to take that kind of longer term view. If you are looking to make a killing over the next three or six months, bank stocks are not the place to look.
Full Disclosure: Peridot was long USB at the time of writing, but positions may change at any time.
How To Bet Against The U.S. Dollar
It is easier than you think. There is an exchange traded fund, PowerShares DB US Dollar Index Bearish (UDN), that shorts futures contracts on the U.S. dollar versus other currencies. As the Treasury continues to borrow money from China and lend it to U.S. banks, the long term outlook for our currency is bleak, to put it nicely.
The Idea That Banks Aren't Lending Anymore Is Ridiculous
One of the worst parts of being a money manager is that in order to stay on top of financial news one should really have CNBC on in the office constantly. There are many people on CNBC that I thoroughly enjoy (David Faber and Erin Burnett, to name a couple), but I say this because you also have to hear a bunch of garbage that people continually spew out of their mouths.
One of the things you constantly here nowadays is that "banks aren't lending anymore." Whether it is a politician who is upset about how the government's money is being spent, or an economic doomsayer, this statement is simply untrue based on actual reported data (sorry, I'm a stickler for actual data). Depending on how strong a bank is right now, lending for the most part has either been increasing modestly, staying flat, or dropping modestly. Claiming that banks aren't lending anymore implies that loan volumes have simply fallen off a cliff, but nobody making these accusations ever can back it up with any facts when pressed.
Take the fourth quarter earnings report from JPMorgan Chase (JPM) released today. Despite an economy that shrunk during the quarter, JPM's total consumer loans rose by 2% or $10 billion, to $483 billion, between September 30th and December 31st. This is not an aberration. As we will see (and I will add more data to this post as it comes in) most banks will show similar numbers for the latest quarter.
Given that economic growth is negative and unemployment is rising, one could easily understand if lending dropped during a recession. After all, if the core problem was lax lending standards and those standards are being revised upward, lending should be going down, not up. Evidence of increases or simply a stagnation in loan levels goes against exactly what many are claiming (that the banks are hoarding capital).
It is certainly true that someone with a FICO score of 500 or 600 (sub-prime) might not get a loan in today's environment, but that does not mean that banks aren't lending. Instead, it means that banks are not giving money to people who likely won't be able to pay it back. Isn't that exactly what we want, given that the sub-prime mortgage crisis is what got us here in the first place?
Remember, numbers don't lie but people do. For some reason too many people seem to want to blame the banks for more than their fair share, and that is saying a lot given that these institutions don't exactly have impressive operating track records recently.
Full Disclosure: No position in JPM at the time of writing, but positions may change at any time
Update (1/16/09):
Consumer Loans Q4 2008 vs Q3 2008
Bank of America -2%, Citigroup -4% vs JPMorgan +2%
Makes sense given the relative strengths of each bank. In all three cases, loan growth is rising faster than GDP. Banks are lending, you just need to be a prime borrower to qualify (and the majority of U.S. consumers are in prime territory).
Despite Capital Infusions, U.S. Government Should Not Dictate Bank Behavior
With at least a mini Citigroup (C) break-up plan coming to fruition, there is chatter that the U.S. government has a hand in some of these decisions. The justification is that the TARP program has resulted in the government directly injecting capital into banks like Citigroup, and as a result they are shareholders and have a large influence on guiding future operational decisions.
This is an interesting assumption because the government does not own common shares in Citigroup or any other U.S. bank, and therefore has no controlling rights like other shareholders do. The preferred shares the government bought carry no voting rights, as that is a core characteristic of preferred stock. The government does have warrants to buy common stock in the future, but those warrants are under water and as long as they are not exercised, they don't bring with them any rights of control.
If the government really is behind much of Citigroup's decision making, it may signal that the bank knows it will need more financial assistance down the road and therefore feels it must comply with government requests. If not, I would tell them to buzz off.
As for the break-up plan itself, does it make me bullish on Citigroup stock? Not really. While it is a step in the right direction, Citi still has one of the weakest balance sheets in the industry. It is practically impossible to know what their assets are worth and how high future losses will be. As a result, trying to accurately value the company is extremely difficult. The stock is cheap, but that alone is not enough of a reason to buy it.
Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time
Brokerage Joint Venture With Morgan Stanley Is Positive Step For Citigroup
I have written previously, as have numerous other investment managers, that in order for Citigroup (C) to have the best chance of being nimble enough to grow and be managed efficiently it needed to be broken up. The vast number of businesses they have, coupled with the dozens of countries they conduct business in, would make it extremely difficult for anyone, including current CEO Vikram Pandit, to successfully manage the company.
It now appears we are a day or two away from hearing from Citigroup that they are contributing their Smith Barney retail brokerage division to form a joint venture with Morgan Stanley's retail business. The combination would have more than 21,000 brokers, making it the largest brokerage firm in the world.
Although a dramatic shift from prior assurances from Citigroup CEO Vikram Pandit that he would not break up the company, I think this joint venture makes a lot of sense from their perspective. Under the rumored terms of the deal, Morgan Stanley would own 51% and manage the joint venture. Citigroup would own 49% and receive a ~$2.5 billion equalization fee (to account for the fact that Smith Barney has more brokers than Morgan Stanley).
Initial press reports had Citigroup selling 51% for $2.5 billion, which made little sense since it would only value the unit at about $5 billion. However, it appears they are getting $2.5 billion in cash and a 49% stake, which sounds more like it. In addition to the cash, Pandit downsizes Citigroup and makes his job of managing it a whole lot easier.
While this deal does not put an exact dollar value on Smith Barney (the joint venture will not trade publicly), which would have helped Citigroup shareholders more easily justify the current $6 stock price, it does give Morgan Stanley the option to buy out Citi's 49% stake in the future. While I would not suggest Citigroup sell the entire thing (it is doing far better than their banking businesses), this deal does manage to raise capital and make the large bank more manageable.
While not a life saver, this deal does make some sense, which is more than we can say about Citigroup's business decisions in recent memory.
Full Disclosure: No position in Citigroup or Morgan Stanley at the time of writing, but positions may change at any time
Fourth Quarter Earnings Will Be Horrible, But We Already Know That
Aluminum giant Alcoa (AA) kicks off fourth quarter earnings season after the closing bell today and there is little doubt that they will be the first in a series of profit reports over the next few weeks that will be absolutely brutal. Fortunately, most investors already know that, so the market's reaction is unlikely to mirror the dramatic sell-off we saw in October and November. The fourth quarter could prove to be the weakest quarter of the entire recession in terms of GDP growth (a 5 or 6 percent decline is both possible and probable), which would imply that corporate profits have no chance of exceeding expectations this quarter.
The key, however, is not what the numbers are but rather how the market reacts to them. With sentiment so negative on the earnings front, there will be instances where stocks actually do not drop, or even rise slightly after poor profit reports are announced. Since the stock market is forward looking, a company reporting a lousy number, if no worse than expected, will actually bring smiles to investors' eyes because it alleviates the concern that things could be even worse than many believe they are.
How the market reacts during this earnings season will be very telling for the near-term dynamics of Wall Street. If numbers come in weak as expected, but not a lot worse than the already low expectations, technical analysts will be quick to point that out as a positive sign. This would be a key signal that the market has reached a short term bottom. Such action would tell me that the market is truly looking ahead to possible economic stimulus and other actions that could help make the fourth quarter the worst quarterly GDP reading we ultimately see.
Conversely, a poor market reaction to these profit reports could mean a retest of the November lows. The market has done pretty well in recent weeks as it looks ahead to an Obama administration, but its patience will certainly be tested over the next couple of weeks. Personally, I think we will see a modestly negative reaction over the short-term, only because we have already seen a decent level of bargain hunting prior to earnings season.
Full Disclosure: No position in Alcoa at the time of writing, but positions may change at any time