On Financial Stocks and Portfolio Risk
Tom Brown recently posted a rebuttal to Jason Zweig's Wall Street Journal column. Geoff Gannon also wrote a great follow-up article with more on Benjamin Graham. I suggest reading all three articles. In this post, I wanted to comment on a few aspects of Tom Brown's argument, some of which I have been thinking about lately. The following is a quote from Tom's post:
True value investors, by contrast, tend not to worry what might happen in the interim. Instead, they come up with their best estimate of a financial company's intrinsic value by estimating the magnitude of likely losses along with its "normalized" earnings level two or three years out. They then compare that estimate of intrinsic value with the stock's price today. Zweig says such estimates are impossible. I disagree.
I have always enjoyed Tom's posts, but I can see a few problems with the above statement. (As a disclaimer, I know relatively little about financial companies, as they are out of my circle of competence. I hold no interest in any financial beside Berkshire Hathaway.) First observation: With highly leveraged financial companies, what happens in the "interim" can not only hurt you, it can kill you. Compare a bank to a retailer. Let's say that you find a cheap retailer, where you estimate normalized earnings a few years out to derive its value. Assuming your estimate is correct, you should be able to ride out any short-term volatility to obtain the long-term value of the company. Like Tom says, that is the foundation of value investing. But with a bank stock, which may be leveraged 15-to-1 (or much more, as was the case with Bear Stearns), even a conservative estimate of future earnings power may prove to be worthless. Despite my lack of experience in the sector, I know that it is extremely difficult to know exactly what's on the balance sheets of many modern-day financial companies. Even a small decline in these unknown assets can wipe out the equity base completely. One commenter on Tom's article quoted Bruce Berkowitz in a recent interview with Morningstar:
...during the last crisis—early nineties, late eighties—I would be buying Freddie Mac, MBIA, Wells Fargo. But today, you just can't understand, and you haven't been able to understand what these companies own or who they owe.
Once you lose all your money in an investment, it's game over. There's no "long-term" to make up your losses—at least for that investment. If mark-to-market holdings of a bank show significant short-term losses (despite their true values in the future), resulting panic could lead to bankruptcy. Second observation: Despite my above statements, I'm not trying to say that you shouldn't invest in anything with 100% downside. Most equity investments have a small chance of total loss (especially when considering fraud or other issues with management). The true value of a company should be the expected value of all possible scenarios. Therefore, when coming up with an intrinsic value estimate, you must factor in the downside risk involved. I'm going to veer a little bit of course here to discuss something that is somewhat related. The Kelly formula shows investors the optimal amount that should be placed in an investment. Even in situations where there is a fair probability of total loss, the formula can say to place a very large portion of your portfolio in that single opportunity. It all depends on the amount of upside and the probability of loss. Those familiar with the Kelly formula know that its use will grow a portfolio at the maximum possible rate regardless of volatility. That is, assuming all your inputs of probability and outcomes are correct (a big assumption in investing). There is one problem with the Kelly formula in "real-life" scenarios: you must consider how much losses you can actually bare. Here's a quote from Robert Rubin on the subject:
Even when the expected value for additional risks is positive, every trader or investor—from the smallest individual to the largest commercial or investment bank—must decide, as a separate matter, how much loss he or it can tolerate, financially and psychologically.
The Kelly formula may say to put 50% of your portfolio into ABC Bank, even if there is a 10% chance of losing the entire investment. In a perfect world (where the same portfolio continues to invest using the Kelly criterion), that's fine. Any loss should be made up for over time. But a 50% portfolio loss can take a huge psychological toll on an investor. In a fund, the average investor will probably be unable to bare it, and withdraw their stake. My point is that an investor (especially with a concentrated portfolio) must be extremely careful when purchasing anything that has a chance of total loss.
I will agree that there may be a handful of financial companies that could be relatively safe bets. Wells Fargo is an often cited example. The major component in the thesis of buying any financial stock must be its management. Excellent management is an absolute must, but even then, doesn't completely protect an investor. A good quote from Warren Buffett in the 1990 Berkshire report:
The banking business is no favorite of ours. When assets are twenty times equity—a common ratio in this industry—mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
Investors in Bear Stearns, IndyMac Bank, and countless other mortgage companies will never be able to recoup their losses. That's the risk an investor must take when purchasing financial companies. I'll close by including the rest of Bob Rubin's discussion on risk:
As an additional complication, there is one type of financial risk, the risk of remote contingencies—which, if they occur, can be devastating—that market participants of all kinds almost always systematically underestimate. The list of firms and individuals who have gone broke by failing to focus on remote risks is a long one. Even people who think probabilistically, and are highly analytical and systematic, often dismiss remote contingencies as irrelevant.