Bank Stocks Shunned by Money Managers Turned Off by DerivativesCharles Stein
“Above all stick with what you know,” Warren Buffett cautioned investors in a 1974 Forbes magazine interview. “Don’t get too fancy.”
Banks, in the view of some of today’s best-performing money managers, are too fancy -- their businesses and finances too complicated to understand even as regulators have tried to make them more transparent. Investors owning few if any of the stocks in the group include Clyde McGregor, who runs Oakmark Equity and Income Fund, Delafield Fund’s John Delafield and Donald Yacktman of Yacktman Focused Fund.
The fund managers said they are frustrated by complex balance sheets stuffed with derivatives that make it hard to evaluate bank assets and how they will fare under different economic scenarios. They are also concerned that profits may be hurt by a slowdown in the economy, litigation over mortgage bonds and foreclosures, and new fee-crimping rules.
“We find it hard to believe the banks have cured all their bad asset problems, and they aren’t transparent enough for us to understand the risks,” McGregor, whose $20.5 billion fund beat 99 percent of peers over the past decade, said in a telephone interview from Chicago.
The 24-stock KBW Bank Index fell 8.6 percent in the past year, compared with the 13 percent increase by the Standard & Poor’s 500 Index, a benchmark for the broader market.
The bank index is priced at roughly book value, or the value of total assets minus liabilities, which makes bank stocks cheap by historical standards, said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine. At the end of 2006, the index traded at two times book value, according to data compiled by Bloomberg.
Banks earnings in the first quarter provided few reasons for bearish investors to change their view. Net revenue at the six largest U.S. lenders -- Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley -- fell 13.3 percent from a year earlier, according to Bloomberg data. Profits excluding taxes, loan-loss provisions and one-time items slid 40.2 percent.
Bank stocks, as measured by the KBW index, fell 50 percent in 2008 and then more than doubled from March 9, 2009, when stocks reached a 12-year low, to the end of the year. 2009. Bank shares gained another 22 percent in 2010, Bloomberg data show.
McGregor’s Oakmark Equity and Income held no bank stocks as of March 31, according to Bloomberg data. He and co-manager Edward Studzinski got out in 2006 on concern that mortgage lending had gotten too aggressive.
The fund, which buys stocks and bonds and is part of part of Chicago-based Harris Associates LP, returned 8.7 percent annually in the past 10 years, almost twice the average gain by balanced mutual funds, data from Morningstar show.
“Can you still make money in banks?” McGregor, 58, said. “Maybe. But we can build a portfolio that doesn’t demand owning them.”
The problem, he said, is the complexity of the banks, especially their use of derivatives. Derivatives are contracts whose value is based on stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather. Options and futures are the most common types of derivatives.
Unlike traditional loans, which can be studied and evaluated, derivatives are described by banks in general terms that makes it difficult to determine the quality of the underlying assets, McGregor said.
In its 10-K annual report filed in February, Bank of America listed its credit derivatives, securities that let buyers guard against a borrower’s missed debt payments. The filing doesn’t say which specific debts the bank is buying protection for, and it describes the counterparties to the trades as “large multinational financial institutions.”
“We don’t know what we are being exposed to,” McGregor said.
It’s not a question of requiring more disclosure, which regulators have done in the past several years, according to George Shipp, manager of the $694 million Sterling Capital Special Opportunities Fund in Virginia Beach, Virginia.
“You need to be a rocket scientist to understand it,” Shipp, 52, said in a phone interview. He said he recently read through Goldman Sachs’s annual report and, even with pages of disclosure, “it is not something the layman is going to be able to figure out.”
His fund, which beat 97 percent of peers over the past five years, holds one bank, Boston-based State Street Corp.
Buffett, who once called derivatives “financial weapons of mass destruction,” doesn’t consider all banks too fancy. Berkshire Hathaway Inc., the Omaha, Nebraska-based holding company he has run since 1970, is the largest shareholder of Wells Fargo, according to Bloomberg data. His $10.1 billion stake in the San Francisco-based bank is Berkshire’s second-largest, after Coca-Cola Co. Buffett is the third-largest shareholder in U.S. Bancorp of Minneapolis, with $2 billion of stock at year-end.
“U.S. banking profitability will be considerably less in my view in the period ahead than it was in the early part of this century,” Buffett said April 30 at the annual meeting of Berkshire shareholders in Omaha. Buffett said profits would diminish as regulations forced banks to reduce leverage.
At the same meeting he described Wells Fargo and U.S. Bancorp as “very good operations.”
Delafield, who has been managing money since 1970, can’t remember the last time he owned a bank stock.
“It’s impossible from the outside to know the value of what they hold,” Delafield, 75, who runs the $1.4 billion Delafield Fund from New York for Tocqueville Asset Management LP, said in a phone interview.
The fund had 30 percent of its money in industrial stocks, 28 percent in basic materials and none in financials as of March 31, according to Morningstar data. It has gained 12 percent a year for the past decade, ranking first among midcap value funds.
The $1.4 billion FPA Capital Fund, the best-performing diversified U.S. stock fund over the past 25 years, owned no bank stocks as of March 31, Bloomberg data show. The fund gained 15 percent annually over that stretch, according to Morningstar.
“Back in 2007 many investors weren’t paying attention to the huge risks embedded on the balance sheets of financials,” Dennis Bryan, 49, co-manager of the Los Angeles-based fund since 2007, wrote in an e-mail. “Today more investors are closely monitoring those risks.”
Berkowitz the Bull
One of the biggest bulls on bank stocks is Bruce Berkowitz, manager of the $20 billion Fairholme Fund. He began buying lenders in the fourth quarter of 2009, convinced an improving U.S. economy would lift the banks along with it. Berkowitz, who in January 2010 was named Morningstar’s domestic stock manager of the decade, now has more than two-thirds of the fund’s equity in financial stocks, including Citigroup and Bank of America.
“The balance sheets look better than ever, the banks are making money and they are dealing with their issues,” Berkowitz, 52, said in a telephone interview from Miami, where his firm, Fairholme Capital Management LLC, is based.
Fairholme Fund fell 3.2 percent this year through May 2. In addition to Citigroup and Bank of America, its top 10 holdings as of Nov. 30 included New York-based banks Goldman Sachs and Morgan Stanley, Bloomberg data show.
Goldman Sachs is a favorite holding of billionaire investor Michael Price, who said some large banks stocks are “great” values.
“Some of the worst-performing things are big financials this year, which is kind of surprising,” Price said yesterday in a Bloomberg Television interview on “Surveillance Midday” with Tom Keene. “We own Goldman, we buy Goldman on dips. I think Goldman’s a great large-cap financial value guy’s stock.”
In an April 15 interview with Bloomberg Television, Bank of America CEO Brian T. Moynihan said that while the bank was making progress in many areas, “the mortgage business continues to push us back.”
Like other banks, the Charlotte, North Carolina-based company has tangled with investors, state and federal regulators, and mortgage insurers over claims that it owes money for loans made during the housing boom and for its handling of foreclosures. State attorneys general negotiating a settlement of foreclosure practices have reached agreements with lenders on some terms while failing so far to reach an accord on payments by the banks, a person familiar with the talks said this month.
The battles will be resolved, possibly by the end of the year, Berkowitz said. “It is only a matter of time before everyone settles up.”
That’s not enough of a reason to buy for Yacktman, whose $2.9 billion Yacktman Focused Fund returned an average of 13 percent a year in the past decade, topping 99 percent of rivals. He held one large bank, U.S. Bancorp, as of March 31, Bloomberg data show.
“With a bank you create assets with a stroke of a pen,” Yacktman, 69, said in a telephone interview from Austin, Texas. “You’ve got a black box.”
Paul Singer, founder of hedge fund Elliott Management Corp., held one bank stock as of Dec. 31, a $65 million stake in Flagstar Bancorp Inc. of Troy, Michigan, according to Bloomberg data. Singer, 66, whose New York-based firm oversees $17.1 billion, said in a March interview with the Wall Street Journal that the “opacity” of bank financial statements means he can’t assess their strength or sensitivity to changes in interest rates and asset prices.
Break Them Up
“You don’t know the financial condition of Citigroup, JPMorgan, Bank of America, any of them,” said Singer, whose fund gained 14.3 percent a year since 1977 compared with the 11 percent increase for the S&P 500 Index, according to company data. Scott Tagliarino, a spokesman for the firm, said Singer wouldn’t comment beyond the interview.
Simon Johnson, a professor at Massachusetts Institute of Technology’s Sloan School of Management in Cambridge, Massachusetts, has pushed for breaking up the biggest banks as a way to make the financial system safer. It would also be a plus for investors, he said in a telephone interview from Washington.
“Shareholder value has been destroyed by the opaqueness of the big banks,” he said. “If you are a shareholder you want to see them split up. The added transparency would be a virtue.”
Sterling Capital’s Shipp said that while splitting off businesses such as investment banking would make big banks easier to understand, the remaining traditional lending business wouldn’t be too appealing.
“Garden variety banking, with all the competition and cheap money available, is not very attractive right now.”
Given all the problems facing banks, there are more compelling places to invest today, he said.
“Who needs the aggravation when I can buy Pepsi or McDonald’s.”
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