Denton Record-Chronicle (Denton, Tex.), Vol. 113, No. 288, Ed. 1 Wednesday, May 17, 2017 Page: 25 of 36
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MAY 2017
3
PIBI£
Denton Record-Chronicle
Enterprising V oices
Are the big banks still a bargain?
‘Too Big to Fail has been
solved:
— Jamie Dimon, CEO of
J PM organ Chase, in his
2017 letter to shareholders
:
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Hi
r
0*
e recently held a
conversation with a
prospective investor
who was curious about the
values we were seeing in the
context of a broader market
that seems fully valued. We
outlined our thesis on several
holdings.
When we began discussing
our interest rate plays, the
prospective investor asked
how Bank of America could
be a bargain after its huge run
over the past year:
“It seems once the Federal
Reserve hiked rates in Decem-
ber everyone jumped on
board the big-bank bandwag-
on. How can a value investor
believe they are getting some-
thing like Bank of America at
a discount today?”
Great question. Let’s spend
some time reviewing from
where Bank of America has
come and what may still lie
ahead.
In 2011, Bank of America
was at a crossroads. The econ-
omy was beginning to emerge
from the recession and in-
vestors believed the Federal
Reserve might begin to nor-
malize interest rate policies.
The stock price of Bank of
America was marching higher
in response.
Then two forces slammed
the bank — regulatory fines
for sins that spawned the
financial crisis and systemic
fears tied to the breakup of the
eurozone, the countries that
use the euro for currency. This
1-2 punch pummeled Bank of
America, whose shares that
were nearly $18 in early 2011
fell below $5 later that year.
The regulatory fines were
tied to bad mortgages sold by
Countrywide Financial, the
subprime lender bought by
Bank of America in the throes
of the crisis. Many of the early
policies by the Federal Reserve
helped the banks restore prof-
itability and shore up their
balance sheets. But after a few
years, the regulators sought
massive penalties from com-
panies that packaged and sold
the toxic mortgages that
sowed the seeds of the crisis.
Early estimates pegged the
penalties for Bank of America
close to $200 billion, nearly
equal to all of the bank’s equi-
ty capital. Our analysis in-
dicated the fines were more
likely to be in the $60 billion
to $70 billion range and likely
would be paid over several
years, rather than a much
larger penalty due all at once.
Given the profits the company
was earning, we saw this low-
W
er penalty as meaningful but
not disastrous.
But then these fears were
compounded by European
woes. Greece was on fire,
threatening to break apart
from the eurozone as it could
not afford the conditions of its
own bailouts. The rest of the
continent was still in reces-
sion, and the threat of a euro-
zone collapse placed huge
pressure on the large Europe-
an banks. They had not taken
the medicine of raising capital
like their U.S. counterparts
had over the preceding years,
and the European banks were
coming under pressure from
investors.
In response, European
regulators banned “short
sales” of European bank
stocks. If you were keen to
exploit the European banking
fears but could not short the
European banks, the next best
thing was to short a large U.S.
bank like Bank of America.
Eventually Bank of America’s
stock bottomed out in the
mid-$4 range. We bought a
lot of stock at those levels. Our
thesis was fairly simple.
We believed the U.S. fi-
nancial system was much
stronger than it had been
going into the recession, the
eurozone fears were overdone
and the bad mortgage fines
would be less than initially
thought. Bank of America’s
tangible liquidation value was
$13 per share, which became
our initial valuation anchor.
Over the next two years,
the eurozone fears abated and
the $200 billion of potential
bad-mortgage fines came in
closer to $65 billion — in the
middle of our original esti-
mate. These fines were paid
over a number of years, so the
tangible liquidation value
actually grew even as the fines
were paid. Eventually the
share price converged to this
level and we drastically cut
our position.
But something else hap-
pened during this time. The
management team put to bed
the legacy issues of the past
while also cutting costs and
growing the deposit base.
Bank of America emerged as
one of the strongest, safest
banks, and the reality that it
could generate sustainable
profits led us to believe its full
/
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■V
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Paul Morigi/AP
Jamie Dimon, CEO of JPMorgan Chase, discusses his annual letter to shareholders April 4 in Washington.
book value (all assets minus
all liabilities, or roughly $24
per share) was a more appro-
priate valuation anchor. Rath-
er than fully exiting our posi-
tion in the teens, we kept a
smaller holding.
This worked well in 2014
and 2015, as shares climbed
into the high teens. But then
the collapse of oil prices began
to panic investors with worries
Bank of America made too
many loans to the oil patch
players. The bank’s manage-
ment team went to great
lengths to explain how these
risks had been contained, but
shares still fell back below the
tangible book value of roughly
$13 per share. We loaded up
again, anchoring our valuation
to the $24 target.
As oil prices rebounded
and the general economy
continued to chug along, the
Federal Reserve finally began
to raise short-term interest
rates. This is a huge boon to
Bank of America because with
each quarter-point hike they
gush hundreds of millions in
incremental profit each quar-
ter. When rates were hiked a
second time, and investors
became excited about the
prospects of a stronger econo-
my under a Donald Trump
presidency, investors bid Bank
of America shares over $25
this spring.
Accordingly, we dramat-
could finally collapse. Euro-
zone instability could re-
emerge. Back home, mount-
ing pressures tied to massive
student loan debt or subprime
auto loans may create eco-
nomic waves. The Federal
Reserve may have waited too
long and additional rate hikes
will not come to fruition.
There are a lot of scenarios
that can unfold, but big-bank
valuations do not seem expen-
sive at these levels. They are
not the screaming-cheap
bargains they were a year ago,
but we don’t own as much
today as a result. Even so,
many of the big banks are
linked to the investing theme
of rising rates, so focus on the
ones with good management
teams that are executing share
buybacks, growing their divi-
dends and running their busi-
ness to exploit the prospects in
front of them.
ically reduced the position we
built up the year before. But
could a big bank like Bank of
America still be intriguing?
Historically, banks’ stock
prices have traded at 11/2 to
two times book value. This
implies a fairer valuation for
Bank of America’s stock price
could be north of $30 per
share. The broader S&P 500 is
trading at roughly 17 to 18 times
consensus earnings estimates. If
investors applied a more mod-
est 15-times-earnings multiple
to Bank of America’s earnings,
this too might imply a valuation
well north of $30 per share.
Given our thesis that in-
terest rates are more likely to
go up than down, and the
company continues to drive
loan growth at a modest but
steady clip, earnings should
continue to climb in the quar-
ters ahead. None of this antici-
pates huge benefits that could
also be unleashed by modest
regulatory reform.
As JPMorgan Chase CEO
Jamie Dimon outlined in his
2017 letter to shareholders, the
U.S. financial system is on a
much stronger financial foot-
ing than it was 10 years ago.
Banks hold more than two
times as much capital to pro-
tect against future losses.
There are also a host of
new rules that would prevent
the collapse of a Lehman
Brothers today related to
capital requirements, deriv-
ative exposures and forced
conversion of unsecured debt
into equity in the event of
solvency concerns.
The vast majority of these
rules make 100 percent sense,
but there are a few that could
be reconsidered. Namely,
those tied to operational risk
capital.
Some of the rules coming
out of the recession are tied to
operational risk capital. These
rules penalize firms that made
stupid decisions in the past. At
Bank of America, most of the
firm’s operational-risk expo-
sure stems from its purchase
of Countrywide Financial.
Those past sins have been
atoned, but the bank is still in
purgatory on this front.
According to The Wall
Street Journal and analysts at
Barclays, over $200 billion in
capital is tied up in opera-
tional-risk buffers at the four
biggest U.S. banks. Given the
10-to-l capital ratios that
banks must hold today, if this
operational risk capital was
freed up to make new loans,
over $2 trillion of potential
new loans could be made to
propel the economy further.
You combine this with a lower
corporate tax rate, and this
nine-year expansion may still
have room to run.
So, what could go wrong?
China’s massive credit bubble
JONATHON FI TE is a
managing partner ofKMF
Investments, a Texas-based
hedgefund. Jonathon is a
lecturer with the College of
B us i n ess at the University of
North Texas. This column is
provided for general interest
only and should not be con-
strued as a solicitation or as
personal investment advice.
Comments may be sent to
email (a KM FIn vest me n Is.
com
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WASHINGTON - Amer-
ican industry expanded pro-
duction last month at the
fastest pace in more than
three years as manufacturers
and mines recovered from a
March downturn.
The Federal Reserve said
Tuesday that industrial pro-
duction at U.S. factories,
mines and utilities shot up 1
percent in April from March,
the biggest gain since Febru-
ary 2014 and the third
straight monthly gain. The
increase was more than twice
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The overall U.S. economy
grew at a lackluster 0.7 per-
cent annual pace from Janu-
ary through March. But econ-
omists expect growth to pick
up the rest of the year as con-
sumers ramp up spending.
A healthy job market bol-
sters consumer confidence.
Employers last month added
211,000 jobs and unemploy-
ment fell to 4.4 percent, low-
est in a decade.
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Rogelio V. Solis/AP file photo
A Greenwood Utilities lineman works on power lines May 1 in Durant,
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Factory production rose 1
percent after declining 0.4
percent in March. Mine
production increased 1.2
percent after falling 0.4 per-
cent in March. And utility
output rose 0.7 percent after
surging 8.2 percent in
March.
Factory production has
risen three of four months this
year. Manufacturing has re-
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Parks, Scott K. Denton Record-Chronicle (Denton, Tex.), Vol. 113, No. 288, Ed. 1 Wednesday, May 17, 2017, newspaper, May 17, 2017; Denton, Texas. (https://texashistory.unt.edu/ark:/67531/metapth1131532/m1/25/?q=%22%22~1: accessed August 15, 2024), University of North Texas Libraries, The Portal to Texas History, https://texashistory.unt.edu.; .