Valuing Financials

In James Montier’s "Value Investing: Tools and Techniques for Intelligent Investment" book, he has an article on whether Financials are a good opportunity at that time or are they a value trap (previously in Mind Matters (13 August 2008) from his time at Societe Generale).

It has some good statistics about the banking sector, and some funny stuff about John Thain (ex-CEO of Merrill Lynch) that I thought would be great to jot down.

Valuing Financials

One way to view bank valuation is to use the ratio of market capitalization-to-deposits (which is effectively an unlevered balance sheet). Historically, the ratio tends to bottom out between 3% and 4%. Of course banks on their way to bankruptcy will go through the bottom(e.g. Northern Rock).

Another measure is the P/B. Since 1927,

  • The average P/B for U.S. financials is around 1.38x.
  • Bargain valuations is between 0.5x to 0.75x. During the Great Depression, P/B of financials dropped to 0.5x. P/B dropped below 1x during the Great Depression, World War II, and between 1973 – 1984.
  • Maximum P/B reached was during 1997-1998 at around 3x.
  • Apart from the 1997-1998 period, P/B maxed out at 2x, just before the Great Depression, 1961, 1963, and 1967.

A warning, P/B being low could mean that the market expects the book value to drop significantly, e.g. the book value of financials during the Great Depression actually halved.

Investing during Asset Deflation Periods

There was also some good quotes from Seth Klarman on investing during asset deflation periods:

  1. Investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or hold current positions. This means that normally selected investors would probably let even more pitches than usual go by.
  2. The prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or not you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause to diminish become moot.

Contradictions Galore

During the credit crisis, John Thain really showed what is meant by contradictions. Below are some of his comments vs. actions taken (merged Montier’s stuff with those from here):

12/25/2007 “One of my first priorities at Merrill Lynch was to strengthen the firm’s balance sheet, and today we have made great progress towards that by bolstering our capital position through these investments and our announced sale of Merrill Lynch Capital.” (said the same day Merrill raised $6.2B in capital)
1/15/2008 “These transactions make certain that Merrill is well-capitalized.” (said the same day Merrill raised $6.6B in capital)
1/18/2008 “We are very confident that we have the capital base now that we need to go forward in 2008”
1/25/2008 “I don’t think we are struggling… we are very well positioned to go forward into 2008.”
2/24/2008 Merrill raises nearly $600M in capital.
3/16/2008 “We have more capital than we need, so we can say to the market that we don’t need more injections.”
3/18/2008 “Today I can say that we will not need additional funds.”
4/3/2008 “We have plenty of capital going forward and we don’t need to come back into the equity market.”
4/8/2008 “We deliberately raised more capital than we lost last year… we believe that will allow us not to have to go back to the equity markets in the foreseeable future.”
4/10/2008 Merrill cash reserve “is sufficient for the foreseeable future.”
4/22/2008 Merrill Lynch raises $9.5B in sale of debt and preferred stock.
5/7/2008 “We have no present intention of raising any more capital.”
7/17/2008 “Right now we believe that we are in a very comfortable spot in terms of our capital.”
7/18/2008 “I don’t think we want to do dumb things. We have been pretty balanced in terms of what we sold, and at what prices we sold them. We have not liquidated stuff at any prices we could get.”
7/28/2008 Merrill sells $8.5B in stock, unloaded CDOs at 22 cents on the dollar.


In addition, from October 2007 to July 2008, Merrill Lynch wrote down their capital 5 times, gradually accumulating more than $40B of write-downs.



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