Wednesday, December 20, 2006

Case Studies in Bull Market; C and GE

The considerable number of “cautious” analysts covering GE and C will struggle through the New Year’s celebration trying to cope with the fact that these behemoth stocks got away from them. In fact, with virtually no change in earnings estimates or forward looking ROE's as a consequence of the last analyst meetings, the barely 3.5% yield today ( C ) , now looks less much interesting than the 4.4%-plus yield on offer a mere few weeks/months ago. (Both GE and C charts look rather similar as well; coincidence??). What does the “unexpected” move say about value added research which doesn’t provide context for price action? At least one thoughtful analyst (AG Edwards) did raise the “conviction level” of his buy, a reasonable attitude that contrasts with the intellectually inadequate revisionist research being spewed out of the brokerage house printing presses focusing on next quarters margins, NII, and revenue growth, as well as cost takeouts, with virtually no mention of market related valuation pickup. While that detailed discussion is good and well, the regular posturing for elbow room in the “bull” camp by analysts awakening from their slumber, whom now suggest that infinitesimal moves in margins are sufficient to kick start the largest financial service firm in the world is nothing short of comical. Any highly paid value-added research shouldn't rely unnecessarily on internal projections and tiny model adjustments to make a case for a stock (stocks) that are so representative of the economy. In fact, one can sympathize with the associates slamming away at their laptops, having to revise earlier model assumptions (input with apparently the greatest eagerness and conviction) every time old research pieces are cast aside because a bad trade in Greenwich sends ripples through the bond market. Readers will likely continue scratching their heads looking for explanations to the surprising stock price action, or be content with the fallacious arguments offered in the published research
We recently noted that the outperformance of C was coming courtesy of a switch from other big names in the sector (BAC, WFC; previous outperformers), in a rotational strategy that firmly underpins a still near-term bullish view of the sector as well as broader market. That said, I would be rather cautious on the FIG sectors with historically high margins and returns (p/c insurance and broker dealers) though somewhat more constructive on the secondary "mortgage sector". As far as C is concerned "the late buyers" of C at year end are bound to be disappointed (over twelve to eighteen months) given unusual near term outperformance.

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

Monday, December 18, 2006

Financial Institutions; Risk versus Reward

While frothy may be a bit too hyperbolic, the excesses in some financial institution stock valuations begs the question of realistic risk-adjusted returns expected by investors from this sector going into 2007 and through 2008. We speak of stocks like GS, AXP, and others sporting cyclically high price/book valuations. These names have provided substantial relative outperformance over the broader Financial institutions group and their relevant sub-categories in recent quarters. One thing we do know is that most investors don't know much about how/where money is/will be made (case of GS). For one, the earnings surprise factor for GS is off the charts and the highest among all Financials. If Street analysts (at least one former Ibank CFO) with their ears as close to the action as possible can't estimate earnings reasonably, who can???? For AXP, the case is different, but the current valuation discounts unusually good things too far into the future (more on this in future dispatches).
If you strip out the added p/e or price/book premium (now firmly priced into the broader market) that investors have been convinced is merited based on the bond markets scorching rally from the high in yields, the potential alpha associated with incremental recurring earnings, cash flow, and/or ROE (for GS and AXP for example) is quite modest. By my estimation, its less than100 basis points (for GS) and even less for other financials. The stories of the "story" stocks don't provide sufficient explanatory power for future incremental ROE (the only justification for improving valuations) unless one takes the position of Bill Gross, and one puts a 3 handle on yields by early to mid 2007. Being rather agnostic on yields and more inthe camp (lower rates are coming at the expense of a weaker dollar), those still trumpeting the "bull market"in financials are being somewhat disingenuous since a considerable portion of incremental $ returns are are being erased in currency depreciation. Something has got to give.
Take institutional conviction on Citigroup. Just when everyone was bashing C for allowing BAC catch up (its market cap exceeded C not more than one month ago) while grossly underperforming the whole unicverse, the stock proceeds to launch itself almost 6 points in two weeks. It appears that some institutional investors are gaming the bond trade, using the most sensitive (and liquid) FIG stocks as proxies for the long end (of bonds), a game that can end badly for stocks companies dependent on "unusually tight spreads" for financing growth. Using the poker analogy, what are the odds of winning this hand by "calling" today versus just "folding"?

Can AFLAC regain its luster

The past three years have proven to be trying times even for the normally patient AFLAC loyalists, in the midst of a scorching environment for financials in general and life insurance stocks in particular. Will the next quarter bring more bad tidings and show the recent pattern of a sales shortfall and an immediate selloff to the stock? We don't know the answer to that one, but we do know that the same manic behavior benefiting the market in general has affected AFLAC, in the opposite way. Why should investors feel comfortable owning a stock like AFLAC (or buying on bad news) for the next ten years as opposed to a stock like AXP, which is making new highs every day, with considerable more intermediate term risk? Because the quality of the earnings stream virtually assures the company will report compounded growth in book value of 15% through 2012, while it is a virtual certainty that the payments/credit business will see a cyclical downturn (a decline in earnings and trough ROE) in the next three years
Granted the company will no longer assure the market of the 15% to 17% earnings growth investors have been accustomed, but there are several arrows in the quiver that could make this a lower risk alternative in a market for financials that now is priced for perfection. We've always thought the countercylcial nature of its earnings sources, and hedging and investment income flexibility (courtesy of AFLAC Japan) to be undervalued (we always thought being fully shareholder equity hedged to be too conservative a strategy in the Nineties). The risk with AFLAC is being out of the stock, as the yield curve in Japan shifts up wards (gradually) through 2010. In fact the parallel is with the rather gradual upwards shift in the US yield curve since the post 9/11 events. That gradual rise in reinvestment rates we expect in Japan will allow the company to incrementally boost margins offsetting some of the slowdown in sales that now seem adequately factored int othe stock price. The option is that Japan Inc. rises again as a regional powerhouse, with demand for financial and insurance products. The persistence of erratic sales is the primary reason for the steep drop in the absolute and relative valuation versus peers. At 2.8 book value, the stock now seems as "cheap" as it has been in years, given the higher probability (70%/30%) that yields will move up several hundred basis points by 2010. That should give the company some time to "fix" some sales issues as the CEO in training (young Amos) gets up to speed.