Wednesday, December 20, 2006

Gauging Risk in Financial Stocks Using Price/Book

Thoughtful commentators are often questioning why some investors have a virtual total reliance on ROE and price/book for financials or stocks in closely related industries (insurance brokers, student lenders/facilitators). The reasoning is simple; it provides way of gauging risk otherwise virtually unavailable to buyers and sellers who have real limitations as to what they may really know about the market. While it won’t get you on board runaway stocks (and you might as well use charts for them anyways; fundamentalists never get them right), it will put realizable sector returns in context, especially over a relative modest time frame (usually a few years; sometimes more). Assessing the probabilitity of improving (or deteriorating) ROE can only be done using a real comparative knowledge advantage (there are a few sector strategists that certainly have that capability). And making the right call (or at least not getting the direction wrong) on a major move in interest rates is also somewhat crucial (as can be seen by the recent interest-rate driven sector and broader market move). But knowing what the odds are of attaining valuations far in excess of what is mathematically reasonable based on deliverable economic value, will go a long way to reducing risk and managing outsized gains obtained over a short time period

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