Will The Real Value Investor Please Stand Up

[txlaw]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

But, Ben, aren't you making the same mistake you described with CAT with US financials?  Let's say you are correct that the market is valuing many of these companies incorrectly based on a current earnings multiple that incorporates peak earnings rather than mid-cycle earnings.

 

The same is certainly not true of the US banks.  If anything, the markets are valuing US financials as though they will forever have EPS at trough earnings. 

 

Forget BAC because clearly you are worried about a big hole in the balance sheet there due to legal problems.  But what about a WFC, BK, or a GS?  Don't you think the market is valuing them as though their earnings will collapse for the next decade?

 

Unless you believe there are humongous write downs to occur in the future, isn't now the time to buy US financials in aggregate in terms of pricing?  (Note that I'm just talking about US financials, not financials in Europe or anywhere else.)

[ERICOPOLY]

Those of you who are worried about the profit margins collapsing.  Your reasoning is something along the lines where capitalism will fail in theory if these margins hold up -- thus competition will move in for sure.

 

Well, lets say a company makes a widget where he's got these huge margins.  And given that the entire market taken as a whole trades at these fat margins, you are worried about competition springing up anywhere and everywhere, essentially.

 

Just remember.  In order for a competitor to spring up, then people need to be hired to create this duplicate competing product, and factories need to be built.  Offices need to be occupied.  But you are worried about the margin for the entire market coming down, so this is going to be the mother of all economic expansions.

 

In other words, it's all good news for the US banks.  Oh, and the US banks don't have record margins right now.

 

Hmm... we're all terrified of this roaring future economy where new companies are formed left and right to create competing products?

 

Or do I have it wrong.  What are your thoughts on how the margins will be squeezed if not from new company formation and job creation?

 

Is it possible that the low employment and high margins are correlated?  I mean, it seems like a logical link that if traditionally there were more competition then traditionally there were more employed in order to create that competition.  So what's bad for everything else (margins), is going to be good for the banks (employment).

 

Or if that doesn't make any sense then explain.

[Munger]

Excellent Vinod -- very well said...although I am not yet willing to make any meaningful investment in a bank.

 

I believe I have posted this link before but here goes...Mr. Buffett on the Stock Market -- one of his best essays.  Must read in this environment.

 

Buffett discusses the risk of investing with corporate profits at peak levels.  He also discusses the risk of investing with interest rates at depressed levels -- unlike some seem to imply on this board, rising interest rates are not good for stock prices even if triggered by sharply rising GDP.

 

On the positive side, valuations are much lower than when Buffett gave this speech.  So money can be made in this environment but you should demand a very high margin of safety and invest in great businesses run by honest and able managers, who are also smart about capital allocation.  Unfortunately there are a lot of smart managers who are clueless about capital allocation, which can ruin an otherwise great investment opportunity -- unfortunately have learned this lesson from experience.

 

http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

 

 

 

[moore_capital54]

Vinod I think you said something very important here that I haven't seen before mentioned on this board. The most important line from your post, in my opinion is this:

 

I came from a very poor family, and I do not every want to be that poor again.

 

Everyone here should understand that each investor has a different financial background, base of capital, and expectations for long-term returns. Some of us here are in a position where we must guard our capital as it is newly formed and constitutes a huge portion of our net worth's, others may be fiduciaries for more aggressive capital. When adding this layer of perspective, I can see why everyone on this board may be right as it relates to their individual situation.

 

The capital I invest is 100% risk capital, and I have a very long horizon. I don't need to touch this capital for years even decades. That is why I may appear a little more aggressive to some of you. I did not come from a poor family and was blessed in that regard, that does not mean I am prone to risk, but that may be why I am more optimistic about the future and and able to sleep at night with significant volatility and paper losses.

 

The thing about the market for me is that I am a big believer in human potential and the stock market is essentially a monopoly on capital flows, so over-time if I buy the right companies I will do very well. Some of you here may do better by timing the market buying the same stocks I buy, but over-time my experience with timing markets has not been great. While buying things on the way down has generated some handsome profits.

 

The way I see it, most of this capital will end up being inherited by my daughters and so I truly don't need to worry about daily fluctuations or perfect entries/exits.

 

So with Bmichaud for example, if you are right you may compound at an additional 5-10% over the next 5 years. Which will really be awesome for you. But if I am right, you may miss an entry point all together, and most definitely compound at inferior rates. Now there are plenty of ways to skin the cat, but incidentally, I have gotten to this point by deploying capital this way for nearly two decades, so I am comfortable waiting another year or two if I am wrong.

 

Oh one more thing - about the money printing, I think I deserve some credit here for calling the long-dated security buys. We have already established that buying 30 year treasuries is essentially printing money.

 

Albert Friedberg's letter will be out next week. He has absolutely nailed it these last two months up 30% on a 2 billion dollar fund. I pasted his last letter and will do the same if you guys are interested but this week I heard that he is betting heavily on inflation. You can bet your arses the fed will get it's inflation.

[Munger]

To supplement the Buffett essay with recent figures on corporate profits.

 

After-tax corporate profits % of GDP

The measure peaked in 1929 at approximately 8.9%.

From 1951 on, the measure has primarily ranged between 4.0-6.5%.

In 1981, the measure trended toward the bottom of the band.

In 1982, the measure tumbled to 3.5%

During the late 1990s, the measure moved back toward 6%.

In 3Q10, the measure was approximately 8.2%.

In 4Q10, the measure was approximately 8.4%.

In 2Q11, the measure was approximately 10.1%.

 

[moore_capital54]

Munger when Buffet wrote that piece the S&P 500 Market Cap was nearly identical to today's, while aggregate earnings are significantly higher.

 

Another great part of this essay is this:

 

Perhaps by now you're mentally quarreling with my estimate that $100 billion flows to those "helpers." How do they charge thee? Let me count the ways. Start with transaction costs, including commissions, the market maker's take, and the spread on underwritten offerings: With double counting stripped out, there will this year be at least 350 billion shares of stock traded in the U.S., and I would estimate that the transaction cost per share for each side--that is, for both the buyer and the seller--will average 6 cents. That adds up to $42 billion.

 

Move on to the additional costs: hefty charges for little guys who have wrap accounts; management fees for big guys; and, looming very large, a raft of expenses for the holders of domestic equity mutual funds. These funds now have assets of about $3.5 trillion, and you have to conclude that the annual cost of these to their investors--counting management fees, sales loads, 12b-1 fees, general operating costs--runs to at least 1%, or $35 billion.

 

And none of the damage I've so far described counts the commissions and spreads on options and futures, or the costs borne by holders of variable annuities, or the myriad other charges that the "helpers" manage to think up. In short, $100 billion of frictional costs for the owners of the FORTUNE 500--which is 1% of the 500's market value--looks to me not only highly defensible as an estimate, but quite possibly on the low side.

 

It also looks like a horrendous cost. I heard once about a cartoon in which a news commentator says, "There was no trading on the New York Stock Exchange today. Everyone was happy with what they owned." Well, if that were really the case, investors would every year keep around $130 billion in their pockets

 

I can only imagine what the fees are today with 75% of all trading being done by robots. I would love to see what this market would look like without HFT. Liquidity providers my ass.

[Munger]

No doubt valuation is much more compelling today but risks related to peak margins and depressed interest rates are probably greater.  And I think you can make money (in some cases a lot) in the right opps -- just need to be careful...I don't think we've reached an "all in" given peak margins, low interest rates, and deleveraging -- not sure how it all settles out but these three factors create meaningful risk IMO.

 

I can only imagine what the fees are today with 75% of all trading being done by robots. I would love to see what this market would look like without HFT. Liquidity providers my ass.

 

Share your view re the above.

 

I'm done for the night.

 

[Parsad]

To supplement the Buffett essay with recent figures on corporate profits.

 

After-tax corporate profits % of GDP

The measure peaked in 1929 at approximately 8.9%.

From 1951 on, the measure has primarily ranged between 4.0-6.5%.

In 1981, the measure trended toward the bottom of the band.

In 1982, the measure tumbled to 3.5%

During the late 1990s, the measure moved back toward 6%.

In 3Q10, the measure was approximately 8.2%.

In 4Q10, the measure was approximately 8.4%.

In 2Q11, the measure was approximately 10.1%.

 

 

Munger, what you are excluding from those comments is the cost of capital.  The cost of capital for companies to borrow is now at lows not seen since the 30's.  Based upon economic conditions, including unemployment, it does not seem as though interest rates are going to rise anytime soon...perhaps for at least a couple of years.  If the cost to borrow capital is so low, profit margins can remain elevated for several more years...maybe even a decade if they are borrowing for ten years. 

 

How many businesses do you know of that have refinanced their debt for the next 5-10 years at recent rates?  How many mortgages are being refinanced today?  How many new mortgages are being issued at low long-term rates?  How many automobile loans are being issued at low rates?  I bet 25-30% of U.S. homeowners on this board, that aren't in penalized mortgages, are refinancing if they qualify.  Hundreds of businesses that can qualify, and require long-term capital for their operations, are refinancing every day. 

 

Think about banks and how they operate.  What is BAC's cost of capital today?  What are they lending the money out at?  How about Caterpillar?  Even if demand is slow, what is their cost of capital today...for the next 5 years?  It is true that corporate profits will shrink significantly at some point.  But probably not for at least a few years.  Cheers!

[Uccmal]

I am pretty much standing pat right now.  I'm all in and cannot find anything new thats better than what I hold.  I upped my stake in FFH before the recent runup.  Due to every other stock in my holdings being down, except a small stake in BCE,  FFH now makes up 50% of my holdings.  From my perspective FFH offers nearly as much downside protection as Cash and certainly has huge upside.  I would argue that in a normalized environment it would be trading at at least 600. 

 

Also waiting for 2014 leaps to come out on BAC, BBY, and GE.  Would like to buy more SSW which will likely raise its dividend to $1 shortly.  Would like to buy more CFX, MTL, and a couple of others.  I was a little early to the party as usual.

[seshnath]

I believe that the only logical way to "enter" the market is to be or near fully invested at this time. There should be enough bargains out there to fill one's portfolio quite easily. Then if the market drops further, you need to sell your cheap stocks for cheaper ones. It is tough to do, but the only way that makes sense IMO.

 

Hedging with cash, puts, short sells, etc. is speculation. You never know when to pull the plug. There is no signal telling you that it is time to unload unlike a stock that approaches your estimate of fair value on the way up. What is capitulation? When are the sovereigns issues going to be resolved and what does it look like?

 

If you are short now, what do you do? Take all, some or no profit?

 

I guess if your definition of a cheap stock is 3 times earnings or half of net cash, then you will enter the market after me, but you should still sell these stocks for the ones at 2 times earnings and 1/4 of net cash as the market moves against you.

 

Cardboard

 

Again, well said. I do feel that cash is a great hedge as well, but when you see companies you like dropping 50-70% as we have seen over the past 2 months that is what you had your cash for in my view.

 

I remember a berkshire annual meeting, I think it was 2009, where Buffett or Munger said that any Manager who was all cash in 2008 was not someone they would even waste their time on.

It was 09 meeting.  That was the last one I attended and ever will during Buffett's time.

[bmichaud]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

But, Ben, aren't you making the same mistake you described with CAT with US financials?  Let's say you are correct that the market is valuing many of these companies incorrectly based on a current earnings multiple that incorporates peak earnings rather than mid-cycle earnings.

 

The same is certainly not true of the US banks.  If anything, the markets are valuing US financials as though they will forever have EPS at trough earnings. 

 

Forget BAC because clearly you are worried about a big hole in the balance sheet there due to legal problems.  But what about a WFC, BK, or a GS?  Don't you think the market is valuing them as though their earnings will collapse for the next decade?

 

Unless you believe there are humongous write downs to occur in the future, isn't now the time to buy US financials in aggregate in terms of pricing?  (Note that I'm just talking about US financials, not financials in Europe or anywhere else.)

 

It's getting close to the time to buy fins as a group, and WFC specifically. I think the time it takes to get to "normalized" earnings power is going to be longer than many investors expect due to the environment we're in. There is ZERO demand for loans bc the private sector is deleveraging massively. WFC and USB will probably be the only large US banks that actually can increase their core intrinsic value through this environment, but I would venture to say that gain will be lower than many believe. We just spent 10 years over-borrowing - the only logical conclusion out of that is that the banking system over-earned for the past ten years. Thus I do not believe current "trough" earnings are in fact trough - perhaps slightly below mid-cycle. I'm not saying banks aren't becoming more attractive, they are, and I am certainly closer to buying (as a group) now than I was 20% ago on the XLF.

[bmichaud]

Vinod I think you said something very important here that I haven't seen before mentioned on this board. The most important line from your post, in my opinion is this:

 

I came from a very poor family, and I do not every want to be that poor again.

 

Everyone here should understand that each investor has a different financial background, base of capital, and expectations for long-term returns. Some of us here are in a position where we must guard our capital as it is newly formed and constitutes a huge portion of our net worth's, others may be fiduciaries for more aggressive capital. When adding this layer of perspective, I can see why everyone on this board may be right as it relates to their individual situation.

 

The capital I invest is 100% risk capital, and I have a very long horizon. I don't need to touch this capital for years even decades. That is why I may appear a little more aggressive to some of you. I did not come from a poor family and was blessed in that regard, that does not mean I am prone to risk, but that may be why I am more optimistic about the future and and able to sleep at night with significant volatility and paper losses.

 

The thing about the market for me is that I am a big believer in human potential and the stock market is essentially a monopoly on capital flows, so over-time if I buy the right companies I will do very well. Some of you here may do better by timing the market buying the same stocks I buy, but over-time my experience with timing markets has not been great. While buying things on the way down has generated some handsome profits.

 

The way I see it, most of this capital will end up being inherited by my daughters and so I truly don't need to worry about daily fluctuations or perfect entries/exits.

 

So with Bmichaud for example, if you are right you may compound at an additional 5-10% over the next 5 years. Which will really be awesome for you. But if I am right, you may miss an entry point all together, and most definitely compound at inferior rates. Now there are plenty of ways to skin the cat, but incidentally, I have gotten to this point by deploying capital this way for nearly two decades, so I am comfortable waiting another year or two if I am wrong.

 

Oh one more thing - about the money printing, I think I deserve some credit here for calling the long-dated security buys. We have already established that buying 30 year treasuries is essentially printing money.

 

Albert Friedberg's letter will be out next week. He has absolutely nailed it these last two months up 30% on a 2 billion dollar fund. I pasted his last letter and will do the same if you guys are interested but this week I heard that he is betting heavily on inflation. You can bet your arses the fed will get it's inflation.

 

The beautiful thing about this business is that we can all be right at the exact same time. Berkowitz will claim he's right in 10 years when BAC reaches $30, while at the same time I can claim I was right by holding off on BAC at $15 as it cratered to $6.

 

As Prem Watsa so elegantly explained in his interview with Gurufocus, he is very, very worried about the "second leg down" in this environment. Yes the US is moving along at essentially flat growth, with the large risk that it falls back into recession in and of itself - BUT, the huge external risk NOBODY is taking into account is the austerity measures currently being put in place over in Europe and the slowdown in emerging markets. We truly have seen nothing yet in Europe - if one understands sectoral balances within an economy, one can only conclude that Europe is teetering on the brink of depression, yes depression NOT recession. The Europeans despise the American deficits, and they do not want to be labeled as such. To the penny, public sector deficit equals private sector surplus, and public sector surplus equals private sector deficit. The ONLY way to smooth out private sector deleveraging is for the public sector to run a deficit - when a public sector does what the USA did in the Depression (cut deficits and raise rates) and what Europe is doing now, not only must the private sector pay down debt, but they also must PAY THE GOVERNMENT b/c the government is pulling assets out of the private sector's hands. It's a double whammy - saving to pay down debt AND paying the government.

 

So forgetting the US economy right now, and ignoring the fact that the ECRI says there is a 100% chance we're going back into recession, we have an economy the size of the USA heading into depression (the EU) and emerging markets slowing down. Let's not forget, China NEVER took a break - they stimulated their way right through the global recession. No economy goes straight up, none - especially one that is in bubble territory.

 

All of that was far too macro for any value investment discussion - the single most important thing I am trying to convey is WHY there is a strong possibility the market as a whole (and dragging all things down with it) can not only get below fair value (950 according to Grantham) but STAY below for an extended period of time. It all comes down to valuation. If the market was at 800, you wouldn't hear a single word from me regarding the macro environment b/c the undervaluation would be discounting all of this. As Buffett said in the November 1974 Forbes article, "AT THESE PRICES, I am not worried about recession, war, etc...etc...". Even when Buffett was finding bargain stocks selling for 50% of liqudiation value, he was still hedging his overall portfolio exposure to the general market via controls and workouts. The blueprint for managing general market risk is laid out in all of his BPL letters - his way of managing money now behind a corporate veil is not prudent for those of us managing a fixed amount of money. IMO, his BPL days represent the epitome of how money managers should be leery of hte general market and take appropriate action.

[ERICOPOLY]

not only must the private sector pay down debt, but they also must PAY THE GOVERNMENT b/c the government is pulling assets out of the private sector's hands. It's a double whammy - saving to pay down debt AND paying the government.

 

That's my only reasoning for finally supporting the "tax the rich" angle.  They're not going to be spending the money anyway, so there is no "double whammy".

 

For starters, eliminate the tax deduction on IRA and 401k contributions for a few years (and tax the corporation's contribution as well).  Explain how that would reduce present consumption or reduce debt repayment?  This is by definition money that is being saved in excess of debt repayment and consumption -- just eliminate the government subsidy.  They will still be motivated to contribute on an after-tax basis because there is still tax-deferred compounding benefits of such plans.

 

It's fair anyhow.  Why is the government subsidizing the retirement of the rich while they are reducing the social security for the poor?

 

I also find it peculiar that the government is effectively subsidizing savings at a cost to the Treasury while at the same time trying to boost spending to keep the economy going. 

 

Republicans always want to reduce entitlement spending.  Isn't this savings subsidy an entitlement for the rich?

[mranski]

When I look at screaming bargains that are apparently available, and the market crash the media is relating, i don't see it on the large cap blue chips that i mostly follow. Nothing like 2008. Down but not screaming bargains. If anything, alot of them seem to be holding. I fell like we are on different planets.

 

I think the depressed interest rate environment is a real risk longer term.  Not as interesting as Greece bashing, but malingering nevertheless.  I see some utility type dividend payers trading at close to 20 x. This is really high compared to historicals. There has to be a risk of loss of capital if interest rates rise and there is a movement to alternatives to dividends.

[vinod1]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

The way I see it we either

1. See a pretty severe economic crisis - which I think would crush all the stocks, but banks would suffer really severely. In which case I would deploy some of my cash which should produce satisfactory returns.

2. Escape without a severe economic crisis but muddle through - in which case financials would likely provide satisfactory returns.

 

Either scenario would leave me satisfied. Not a very scientific way to invest but it minimizes regret and allows me to sleep well.

 

If we really see something like the Great Depression, we are going to be counting if the losses are 90% or 95%. To me they both feel the same even though you end up with twice the money in one case. Hence my barbell strategy.

 

Vinod

[vinod1]

Those of you who are worried about the profit margins collapsing.  Your reasoning is something along the lines where capitalism will fail in theory if these margins hold up -- thus competition will move in for sure.

 

Well, lets say a company makes a widget where he's got these huge margins.  And given that the entire market taken as a whole trades at these fat margins, you are worried about competition springing up anywhere and everywhere, essentially.

 

Just remember.  In order for a competitor to spring up, then people need to be hired to create this duplicate competing product, and factories need to be built.  Offices need to be occupied.  But you are worried about the margin for the entire market coming down, so this is going to be the mother of all economic expansions.

 

 

I do not think that is the only way for margins to collapse. I can think of two examples

 

1. Take PG. Many of its brand products sell at a premium price to more generic ones. If consumers are feeling poor, they can switch to non premium brands and margins would collapse at PG. This can occur at any company - actually more likely at other companies that do not have moats like PG.

 

2. Take Apple. Profit margins of iPhone, iPad etc are going to come down as rivals just catch up just enough in quality to erode margins. At some point say iPhone 12, the androids and windows phones of the world are going to be pretty close to iPhone to reduce the premium Apple was able to charge.

 

No huge spending boom needed for either case.

 

Vinod

[ERICOPOLY]

Those of you who are worried about the profit margins collapsing.  Your reasoning is something along the lines where capitalism will fail in theory if these margins hold up -- thus competition will move in for sure.

 

Well, lets say a company makes a widget where he's got these huge margins.  And given that the entire market taken as a whole trades at these fat margins, you are worried about competition springing up anywhere and everywhere, essentially.

 

Just remember.  In order for a competitor to spring up, then people need to be hired to create this duplicate competing product, and factories need to be built.  Offices need to be occupied.  But you are worried about the margin for the entire market coming down, so this is going to be the mother of all economic expansions.

 

 

I do not think that is the only way for margins to collapse. I can think of two examples

 

1. Take PG. Many of its brand products sell at a premium price to more generic ones. If consumers are feeling poor, they can switch to non premium brands and margins would collapse at PG. This can occur at any company - actually more likely at other companies that do not have moats like PG.

 

2. Take Apple. Profit margins of iPhone, iPad etc are going to come down as rivals just catch up just enough in quality to erode margins. At some point say iPhone 12, the androids and windows phones of the world are going to be pretty close to iPhone to reduce the premium Apple was able to charge.

 

No huge spending boom needed for either case.

 

Vinod

 

We're not in boom times right now.  What's going to force the switch to generics?  You say "if consumers are feeling poor".  Well, aren't they?  Are they delevering because they feel rich or something?

 

Regarding tech:  well, I have to say you're right.  And the tight labor market for tech workers is to show for it.  When this hits the rest of the labor market, then that's what I'm talking about.

 

[vinod1]

 

We're not in boom times right now.  What's going to force the switch to generics?  You say "if consumers are feeling poor".  Well, aren't they?  Are they delevering because they feel rich or something?

 

 

You are right they should be feeling poor right now, but many homeowners still have expectations (or hope) that their home values would recover. It might take a few more years of low prices along with sustained high unemployment to change behavior. 

 

Vinod

[txlaw]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

But, Ben, aren't you making the same mistake you described with CAT with US financials?  Let's say you are correct that the market is valuing many of these companies incorrectly based on a current earnings multiple that incorporates peak earnings rather than mid-cycle earnings.

 

The same is certainly not true of the US banks.  If anything, the markets are valuing US financials as though they will forever have EPS at trough earnings. 

 

Forget BAC because clearly you are worried about a big hole in the balance sheet there due to legal problems.  But what about a WFC, BK, or a GS?  Don't you think the market is valuing them as though their earnings will collapse for the next decade?

 

Unless you believe there are humongous write downs to occur in the future, isn't now the time to buy US financials in aggregate in terms of pricing?  (Note that I'm just talking about US financials, not financials in Europe or anywhere else.)

 

It's getting close to the time to buy fins as a group, and WFC specifically. I think the time it takes to get to "normalized" earnings power is going to be longer than many investors expect due to the environment we're in. There is ZERO demand for loans bc the private sector is deleveraging massively. WFC and USB will probably be the only large US banks that actually can increase their core intrinsic value through this environment, but I would venture to say that gain will be lower than many believe. We just spent 10 years over-borrowing - the only logical conclusion out of that is that the banking system over-earned for the past ten years. Thus I do not believe current "trough" earnings are in fact trough - perhaps slightly below mid-cycle. I'm not saying banks aren't becoming more attractive, they are, and I am certainly closer to buying (as a group) now than I was 20% ago on the XLF.

 

The banks certainly over-earned over the last ten years, especially because a lot of those earnings disappeared through massive write downs.  But I have to disagree on whether bank earnings have much further to drop -- I think we will find in the next few years that the US banks are at trough earnings right now.

 

Additionally, you have to look at both P and E.  Right now P relative to E is ridiculous for the financial sector as a whole and for particular companies that I believe the market is misjudging as zeros.  As WEB has said the decline in US bank stocks hasn't made much sense.

 

http://money.cnn.com/video/news/2011/10/04/n_co_buffett_banks_selloff.cnnmoney/

[bmichaud]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

But, Ben, aren't you making the same mistake you described with CAT with US financials?  Let's say you are correct that the market is valuing many of these companies incorrectly based on a current earnings multiple that incorporates peak earnings rather than mid-cycle earnings.

 

The same is certainly not true of the US banks.  If anything, the markets are valuing US financials as though they will forever have EPS at trough earnings. 

 

Forget BAC because clearly you are worried about a big hole in the balance sheet there due to legal problems.  But what about a WFC, BK, or a GS?  Don't you think the market is valuing them as though their earnings will collapse for the next decade?

 

Unless you believe there are humongous write downs to occur in the future, isn't now the time to buy US financials in aggregate in terms of pricing?  (Note that I'm just talking about US financials, not financials in Europe or anywhere else.)

 

It's getting close to the time to buy fins as a group, and WFC specifically. I think the time it takes to get to "normalized" earnings power is going to be longer than many investors expect due to the environment we're in. There is ZERO demand for loans bc the private sector is deleveraging massively. WFC and USB will probably be the only large US banks that actually can increase their core intrinsic value through this environment, but I would venture to say that gain will be lower than many believe. We just spent 10 years over-borrowing - the only logical conclusion out of that is that the banking system over-earned for the past ten years. Thus I do not believe current "trough" earnings are in fact trough - perhaps slightly below mid-cycle. I'm not saying banks aren't becoming more attractive, they are, and I am certainly closer to buying (as a group) now than I was 20% ago on the XLF.

 

The banks certainly over-earned over the last ten years, especially because a lot of those earnings disappeared through massive write downs.  But I have to disagree on whether bank earnings have much further to drop -- I think we will find in the next few years that the US banks are at trough earnings right now.

 

Additionally, you have to look at both P and E.  Right now P relative to E is ridiculous for the financial sector as a whole and for particular companies that I believe the market is misjudging as zeros.  As WEB has said the decline in US bank stocks hasn't made much sense.

 

http://money.cnn.com/video/news/2011/10/04/n_co_buffett_banks_selloff.cnnmoney/

 

How do we know what "normal" is when loan demand and growth continues to decline? What does a "normal" loan book look like for WFC in a normalized environment? Its current loan book is still running off in a sense.

 

I have an extremely rough guess as to what that normalized number may be, but regardless, I think it is going to take awhile to reach that normalized state. So if we think WFC is worth $50 in a normal environment, but we won't reach that environment for 3 years, then we have to discount that back two years at a 10% cost of equity for a current FV of $41.

 

I want to buy a bank at 50 cents on the dollar - when WFC reaches that, I'll buy. The example above is purely for demonstration. IMO the FV could arguably be lower than $50 in a normal environment, and could take longer to reach normal. Thus I am going to demand a greater margin of safety than 50% of $41.

 

Some may call it timing, other may call it making a macro call - I call it valuation and demanding a MOS. All of the so called "macro" debate really comes down to the varying degress of MOSs we demand and our valuation. That's what makes a marketplace and what makes the debate on this board so valuable!

[txlaw]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

But, Ben, aren't you making the same mistake you described with CAT with US financials?  Let's say you are correct that the market is valuing many of these companies incorrectly based on a current earnings multiple that incorporates peak earnings rather than mid-cycle earnings.

 

The same is certainly not true of the US banks.  If anything, the markets are valuing US financials as though they will forever have EPS at trough earnings. 

 

Forget BAC because clearly you are worried about a big hole in the balance sheet there due to legal problems.  But what about a WFC, BK, or a GS?  Don't you think the market is valuing them as though their earnings will collapse for the next decade?

 

Unless you believe there are humongous write downs to occur in the future, isn't now the time to buy US financials in aggregate in terms of pricing?  (Note that I'm just talking about US financials, not financials in Europe or anywhere else.)

 

It's getting close to the time to buy fins as a group, and WFC specifically. I think the time it takes to get to "normalized" earnings power is going to be longer than many investors expect due to the environment we're in. There is ZERO demand for loans bc the private sector is deleveraging massively. WFC and USB will probably be the only large US banks that actually can increase their core intrinsic value through this environment, but I would venture to say that gain will be lower than many believe. We just spent 10 years over-borrowing - the only logical conclusion out of that is that the banking system over-earned for the past ten years. Thus I do not believe current "trough" earnings are in fact trough - perhaps slightly below mid-cycle. I'm not saying banks aren't becoming more attractive, they are, and I am certainly closer to buying (as a group) now than I was 20% ago on the XLF.

 

The banks certainly over-earned over the last ten years, especially because a lot of those earnings disappeared through massive write downs.  But I have to disagree on whether bank earnings have much further to drop -- I think we will find in the next few years that the US banks are at trough earnings right now.

 

Additionally, you have to look at both P and E.  Right now P relative to E is ridiculous for the financial sector as a whole and for particular companies that I believe the market is misjudging as zeros.  As WEB has said the decline in US bank stocks hasn't made much sense.

 

http://money.cnn.com/video/news/2011/10/04/n_co_buffett_banks_selloff.cnnmoney/

 

How do we know what "normal" is when loan demand and growth continues to decline? What does a "normal" loan book look like for WFC in a normalized environment? Its current loan book is still running off in a sense.

 

I have an extremely rough guess as to what that normalized number may be, but regardless, I think it is going to take awhile to reach that normalized state. So if we think WFC is worth $50 in a normal environment, but we won't reach that environment for 3 years, then we have to discount that back two years at a 10% cost of equity for a current FV of $41.

 

I want to buy a bank at 50 cents on the dollar - when WFC reaches that, I'll buy. The example above is purely for demonstration. IMO the FV could arguably be lower than $50 in a normal environment, and could take longer to reach normal. Thus I am going to demand a greater margin of safety than 50% of $41.

 

Some may call it timing, other may call it making a macro call - I call it valuation and demanding a MOS. All of the so called "macro" debate really comes down to the varying degress of MOSs we demand and our valuation. That's what makes a marketplace and what makes the debate on this board so valuable!

 

Take a look at the numbers for WFC though.  What have total interest bearing liabilities done YoY compared to total interest earning assets?  Yes, NIM compression is there, but is the market correctly judging what the earnings will be going forward?  And aren't both the assets and liabilities on the balance sheets much less riskier than they were pre-financial crisis?

 

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

[Grenville]

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

 

How are you guys getting comfortable with the derivative risk on Wells Fargo's balance sheet?

[bmichaud]

Vinod - other than holding fins, I don't know if you could have worded what I am thinking any better. Im even around 80pc long right now!

 

I'm surprised you are comfortable holding BAC (guess it depends on position sizing too, since a big position to me is 10pc) given ur view on where the economy could ultimately end up. IMO, if even half of the Great Depression scenario plays out, banks will get crushed.

 

But, Ben, aren't you making the same mistake you described with CAT with US financials?  Let's say you are correct that the market is valuing many of these companies incorrectly based on a current earnings multiple that incorporates peak earnings rather than mid-cycle earnings.

 

The same is certainly not true of the US banks.  If anything, the markets are valuing US financials as though they will forever have EPS at trough earnings. 

 

Forget BAC because clearly you are worried about a big hole in the balance sheet there due to legal problems.  But what about a WFC, BK, or a GS?  Don't you think the market is valuing them as though their earnings will collapse for the next decade?

 

Unless you believe there are humongous write downs to occur in the future, isn't now the time to buy US financials in aggregate in terms of pricing?  (Note that I'm just talking about US financials, not financials in Europe or anywhere else.)

 

It's getting close to the time to buy fins as a group, and WFC specifically. I think the time it takes to get to "normalized" earnings power is going to be longer than many investors expect due to the environment we're in. There is ZERO demand for loans bc the private sector is deleveraging massively. WFC and USB will probably be the only large US banks that actually can increase their core intrinsic value through this environment, but I would venture to say that gain will be lower than many believe. We just spent 10 years over-borrowing - the only logical conclusion out of that is that the banking system over-earned for the past ten years. Thus I do not believe current "trough" earnings are in fact trough - perhaps slightly below mid-cycle. I'm not saying banks aren't becoming more attractive, they are, and I am certainly closer to buying (as a group) now than I was 20% ago on the XLF.

 

The banks certainly over-earned over the last ten years, especially because a lot of those earnings disappeared through massive write downs.  But I have to disagree on whether bank earnings have much further to drop -- I think we will find in the next few years that the US banks are at trough earnings right now.

 

Additionally, you have to look at both P and E.  Right now P relative to E is ridiculous for the financial sector as a whole and for particular companies that I believe the market is misjudging as zeros.  As WEB has said the decline in US bank stocks hasn't made much sense.

 

http://money.cnn.com/video/news/2011/10/04/n_co_buffett_banks_selloff.cnnmoney/

 

How do we know what "normal" is when loan demand and growth continues to decline? What does a "normal" loan book look like for WFC in a normalized environment? Its current loan book is still running off in a sense.

 

I have an extremely rough guess as to what that normalized number may be, but regardless, I think it is going to take awhile to reach that normalized state. So if we think WFC is worth $50 in a normal environment, but we won't reach that environment for 3 years, then we have to discount that back two years at a 10% cost of equity for a current FV of $41.

 

I want to buy a bank at 50 cents on the dollar - when WFC reaches that, I'll buy. The example above is purely for demonstration. IMO the FV could arguably be lower than $50 in a normal environment, and could take longer to reach normal. Thus I am going to demand a greater margin of safety than 50% of $41.

 

Some may call it timing, other may call it making a macro call - I call it valuation and demanding a MOS. All of the so called "macro" debate really comes down to the varying degress of MOSs we demand and our valuation. That's what makes a marketplace and what makes the debate on this board so valuable!

 

Take a look at the numbers for WFC though.  What have total interest bearing liabilities done YoY compared to total interest earning assets?  Yes, NIM compression is there, but is the market correctly judging what the earnings will be going forward?  And aren't both the assets and liabilities on the balance sheets much less riskier than they were pre-financial crisis?

 

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

 

When I can get Pepsi at 60-cents on the dollar with 1) pricing power, 2) organic growth and 3) a 5%+ dividend/buyback payout, I'm going to take that all day versus buying an American banking balance sheet that has overstated assets and undersetated liabilities (the US banking system as a whole) or WFC at 70 or even 60-cents on the dollar that has low growth, modest payout and the same discount to fair value.

 

Again, this is all what makes a market  ;D

[bmichaud]

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

 

How are you guys getting comfortable with the derivative risk on Wells Fargo's balance sheet?

 

I think that comes down to comfort with managent - as Buffett says, the CEO needs to be the Chief Risk Officer.

 

I'm comfortable with WFC b/c they don't have a black box prop trading unit. Its I-banking unit is primarily fee-based revenue.

[txlaw]

Our disagreement is not necessarily in the timing aspect of it, but on the MOS.  The MOS of US bank investments in aggregate has become even greater because of a collapse in prices.  In fact, there is no other sector that I can see that has a greater MOS.  Downside protection is there.

 

WFC may not currently be a 50-cent dollar, but if it is a 70-cent dollar that increases IV at a rate of, say, 6% over current IV (just throwing out numbers), that gets you a damn good return over three to five years when Mr. Market realizes his mistake.  It's all about lengthening the time of your thinking.

 

I think it's a mistake to completely pass up some of these financials in the hopes that prices will collapse even further, although you can certainly base position sizing on what you think the market will do.  But as you say, this debate is what makes a market.

 

How are you guys getting comfortable with the derivative risk on Wells Fargo's balance sheet?

 

I think that comes down to comfort with managent - as Buffett says, the CEO needs to be the Chief Risk Officer.

 

I'm comfortable with WFC b/c they don't have a black box prop trading unit. Its I-banking unit is primarily fee-based revenue.

 

I would add that the thread on US derivative exposure provides some good detail on why an AIG-like risk is likley off the table, at least with US banks.

 

http://www.cornerofberkshireandfairfax.ca/forum/index.php?topic=5312.0

 

Ultimately, it comes down to whether you believe the mechanisms and legal documents associated with these derivatives trades have changed post-financial crisis.  To analogize a US bank's netted out derivatives book now to what it was pre-crisis is wrong, IMO.  Same with analogizing the assets and liabilities of the banks now versus the pre-crisis days.