Would Benjamin Graham Buy Financials? (No!)

Jason Zweig has an interesting column today in the WSJ:

Inquiring minds want to know: What would Graham do?

This column, named after Benjamin Graham’s classic book on value investing, launched only two weeks ago — and several readers have already asked whether Graham would be loading up on financial stocks now. Unfortunately, I can’t ask the great investor directly. Graham died in 1976. But a close look at his writings suggests that the answer is unambiguous: No.

That may seem surprising. After all, by mid-July, the Dow Jones Wilshire Financials index was down 46% from one year earlier. It’s such big red numbers that get value investors licking their chops.

Even after rising over 30% in the past week, the 1,001 financial stocks tracked by Dow Jones Indexes are trading at an average of just 1.1 times their book value (assets minus liabilities). Before bank stocks climbed part way out of the crypt, you could buy Wachovia Corp. for 51% of reported book value. If that isn’t Ben Graham territory, what is?

To see why I think Graham would sit on his hands, you need to understand his crucial distinction between investment and speculation. "An investment operation," he wrote in his first book, Security Analysis, "is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Trained as a mathematician and Greek and Latin scholar, Graham crafted his definition with the stark rigor of a Euclidean theorem. He wanted no weaseling about what he meant. All three, not just one or two, conditions have to be met: Your analysis must be thorough, your principal stay safe and your expectations be reasonable. "Thorough analysis" demands "the study of the facts in the light of established standards of safety and value," while "safety of principal" means "protection against loss under all normal or reasonably likely conditions or variations."

You cannot even pretend to be protected against loss while real estate prices — the wobbly foundation for most financial stocks — are still crumbling.

Nor can you study the facts when it’s unclear what the facts are. Each quarter, the banks set money aside in reserve against losses on their loan portfolios and say they believe those reserves should be adequate. The next quarter, they find out they were wrong. Loan-loss provisions at Washington Mutual, for example, have mushroomed from $967 million to $1.5 billion to $3.5 billion to $5.9 billion over the past four quarters.

The timely Graham admonition that "You must never delude yourself into thinking that you’re investing when you’re speculating" is a reminder that no one really knows when the real estate crisis ends, or what the true situation of the financials firms balance sheets really are like.

As Zweig states, "For many banks, the nightmare has only begun."

 

Source:

Is It Time to Tiptoe Into Financial Stocks?


The Stocks May Look Cheap, But Bank on it: These Are Treacherous Waters.
Jason Zweig
WSJ, July 26, 2008
http://online.wsj.com/article/SB121700939198285307.html

Free version at Yahoo
http://biz.yahoo.com/wallstreet/080726/sb121700939198285307_id.html?.v=9

See also:
Financials Are Still Reeling
Even Firms That Avoided Worst of the Credit Crunch Face Threat From Slowdown
Antony Currie and Robert Cyran
WSJ, July 26, 2008; Page B18   
http://online.wsj.com/article/SB121701903083685671.html

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  1. DL commented on Jul 26

    I would pose a somewhat different question.

    Since October 10th (2007), the XLF has fallen about 41%. During the same period, the QQQQ has fallen only about 15%. So which is the better short between the two?

    If we’re going to have the global slowdown that many are predicting (particularly the oil bears) then it would seem to me that QQQQ has got to start going down at some point.

  2. Stormrunner commented on Jul 26

    One can not calculate the odds of holding a winning hand, when “jokers” are wild and no one at the table knows just how many there are in the deck. Until transparency returns and such assets as negative “am” are booked as they would be on the street all rules are skewed to the massive transfer of wealth that I have suggested would occur via this “banking system” that was purported to have served us so well, so many threads ago on this board. This has been an obvious train wreck waiting to happen which has only began to accelerate toward the big curve at the bottom of the hill. I’d say the safe bet is derailment. Only when the cranes arrive to pick up the pieces will we be able to identify the survivors, and as the manifest can not be trusted to be accurate we really have no idea who the passengers are.

  3. dukeb commented on Jul 26

    I remember quite some time ago (ages, it seems) when you were flirting with the idea of book reviews on this blog and asked for suggestions about the best investing books. I put THE INTELLIGENT INVESTOR, which still sits in my living room. A comment soon after scoffed at that title as being one of the most boring reads possible. I wonder how well that person has done since then. An understanding and respect for investing should be the perquisite to speculation, and those who lack the former probably end up getting killed by the later.

  4. Ferox commented on Jul 26

    I find the talk of book value somewhat comical when nobody knows what the assets are worth.

    Any analysis is only as good as the underlying data (just ask Barry about inflation rates), and I think the data we currently have here is shit. That might even be generous.

  5. The Financial Philosopher commented on Jul 26

    It is quite easy to say that Graham would not buy “financials” as a sector. Taken as a whole, most would agree that buying the sector today is more speculative than fundamentally sound; however,what little I know of Graham is that he did not buy sectors as a basket, such as an ETF — he bought individual stocks.

    I would venture to guess that, if Ben Graham were alive today, he would find a nice little handful of financial stocks that have been punished purely for “guilt by association;” which would fit a key ingredient that makes a “value stock.”

  6. wally commented on Jul 26

    To really look forward, look backward and ask: what would have been the bank profits if there had been no HELOC bubble and if house prices had not bubbled and if the Fed had not held rates at a record low and if there had been no deluded securitization values and if reasonable leverage had been applied and if the US had not been awash in foreign cash representing return of our own trade deficit. Then from that answer subtract the obligations now incurred to pay the fines from that multi-year drunk. Then cross off the institutions for which those penalties will exceed their ability to survive. Then factor in a likely worldwide slowdown of one or several years duration. Then you can look forward and ask whether in the brave new world ahead the current price looks like a value.

  7. Eric Davis commented on Jul 26

    Sweet, Revenge trading financials.

    Say My thesis was that 50% out of the banks wasn’t enough. But that 75% was too much…

    Would it be “rational” or would I trust someone who manages my money, to invest it when in a pure risk reward ratio, they were going after 5-10% more downside, trying to “bottom tick”….

    One can almost say that some of the People on this side of the trade, have stopped doing prudent investing… and are investing more to be right, than to make money.

    That financial adviser would be a fool, There is lower hanging fruit.

    Book Value in financials, by everyones account is impossible to accurately calculate. There won’t be a bell that goes off when “real estate bottoms” or when they have taken enough write-downs.

    The conference calls though, in many financials, many of them are planning for real estate to bottom in 2010… Is that enough?… or do they have to plan on 2020?

    And Yes. Financial aren’t going anywhere until this happens, but that could include down.

    Hopefully we are lucid enough, and not myopic enough to think that “all financials are represented by “WM, C, MS, LEH, WB”

    “People will need and get loans, and will have to go to a bank to get it, and the securitzation model, will have to be replaced(somewhat)… Quite possibly by old fashioned Banking”

    There are guys out there Drooling for WFC in the low 20’s, and JMP in the low 30’s…

    But you may have to clue into the idea that Tons of Dopey Retail guys who loaded into the skf, and took HUGE losses, are going to be unlikely to do it again.

    You may want to remember, Bears are too bearish on the downside, and bulls are too bullish on the upside. The MANIA, that the bears are on about this, indicates a certain amount of irrationality, in this trade.

    So Everyone load into the SKF… Get CRAZY!!!!!!! Short….

    As someone in this thread said, there may be better opportunities in Tech and Retail, Say we followed Sector rotation like most of wall street will.

    But… Sure… Investing is a Crusade to be right…. “the entire Financial sector is ‘Worthless!!!!'”(isn’t this the final chapter in Revelations?)
    *waits cautiously in bunker, with tinfoil hat, and pile of 1980 gold(I’ll break even some day)*

  8. Mike in NOLa commented on Jul 26

    DL:

    My two cents as to the QQQQ.

    I’ve owned QID for several months. It hasn’t done wonderfully, but I think its time is coming. The problem with the QQQQ from a short perspective or the QID is that the NASDAQ 100 is dominated by well-run tech companies who have actual profitable businesses making things that are still in demand. They also sell a fair amount outside the US in areas like Europe and Asia which haven’t slowed yet.

    But, their time is coming. Decoupling is a myth. US borrowing and consumption have pumped up the economies of Asia and the overall effects have helped the EU. This has helped buoy the tech stocks.

    Reports are that the EU is starting to slow.

    While the Chinese economy is still growing, it is showing cracks. It has overcapacity in the manufacturing sector because of lack of US demand. Its stock market is down over 50% in the past year. It has had a real estate bubble which hasn’t yet popped. The banking system is suspect. 20% Y/Y food inflation.

    An interesting stat from a Bloomberg interview is that there are only 110 million Chinese who have incomes over $5,000US. They cannot supply the internal demand to keep their boom going and they can’t continue to supply the revenue stream for the tech sector. See Interview with Gary Shilling (Servers don’t seem to be working well today)

    Another blog I have found interesting is that of Michael Pettis I am sure one reason I like it is that he agrees with me, or vice versa. He recently compared the Chinese economy to that of the US in the 1920’s.

    Another potential weakness of the QQQQ is that it has some anomalies in its weightings. For example, Apple, although having a market cap about 60% that of MSFT, makes up 13% of the average or over twice that of MSFT. Similarly, Apple’s weight is over twice that of Intel’s although it’s only a bit bigger in market cap. I suppose this is due to how the average was originally weighted and to subsequent changes in price since Jobs revitalized Apple.

    Apple’s weight is also based on a trailing P/E of 30, compared to the more more boring but dependable MSFT and Intel which have around half that P/E.

    Apple is much more consumer oriented and its products are higher priced than competitors. I think this could make it very vulnerable to either a contraction in P/E or a drop in revenues in a big consumer slowdown where American Express is reporting that even its wealthy customers are cutting spending. There is also the wild card of Steve Jobs health. I doubt Apple would garner that high a P/E ratio without him.

    Hope I didn’t drone on too long.

  9. Blackhalo commented on Jul 26

    Such astoundingly wonderful comments to an insightful article. I for one am better informed and pleased to see that not everyone get their financial advice from the MSM.

  10. Mark E Hoffer commented on Jul 26

    ..Another potential weakness of the QQQQ is that it has some anomalies in its weightings. For example, Apple, although having a market cap about 60% that of MSFT, makes up 13% of the average or over twice that of MSFT. Similarly, Apple’s weight is over twice that of Intel’s although it’s only a bit bigger in market cap. I suppose this is due to how the average was originally weighted and to subsequent changes in price since Jobs revitalized Apple..

    Mike, some things don’t scroll well on the bottom of the screen..

    The composition of these various Indexes is key to understanding their Performances, and that takes a little longer to spell out.

    As well, for as much ETF chatter going on, I’m surprised that Single-Stock Futures..

    The Chicago Board Options Exchange (CBOE) has teamed up with the Chicago Mercantile Exchange, Inc. (CME) and the Chicago Board of Trade (CBOT) to create OneChicago, LLC, an all-electronic exchange for trading single-stock futures.
    http://www.cboe.com/Institutional/SingleStockFutures.aspx

    http://www.onechicago.com/?p=677

    ..aren’t mentioned.

  11. Mike in NOLa commented on Jul 26

    Mark:

    You can get more leverage with options, but I like the ETF’s because they aren’t time restricted. I have a certain faith in my judgments, but my timeline is often wrong, e.g. buying the DUG in March and its only recently getting above water, buying the SKF at the same time and having to sit on it for months before it turned a pretty decent profit, or buying the QID too soon and having to sit on it because it still hasn’t done much. At least I can sit on them. You can’t do that with options.

    Not to say that I’m not wrong. Thought Google was overpriced at 200 :) Fortunately, I didn’t act on that feeling.

    I think Apple is probably a good short if you have patience. I think the P/E will contract as things get worse. I think much of MSFT’s drop during the past year has been its P/E ratio going from 25 to 15, as it’s earnings actually grew steadily but ploddingly, and probably will throughout the next year. OTOH Apple is a glamor stock, and with an option, you would have to go pretty far out to be reasonably certain of catching the drop. The timing may be dependent on when Asia and EU hit the skids and it becomes obvious not as many people can afford iPhones and iPods.

  12. Mark E Hoffer commented on Jul 26

    Mike,

    see: At expiration the SSF turns into a long or short stock position. Accordingly if you are interested in buying any of the Stocks whose symbol is displayed below you will notice that you can purchase a SSF that is currently trading BELOW the offer on the stock. That is, you can buy the SSF cheaper now and at expiration you will get the stock at a discount to the present underlying purchase price.
    http://www.onechicago.com/?p=931

    Margin Requirements
    The basic margin requirement for security futures is 20% of the underlying value of the contract (initial and maintenance margin)
    This 20% minimum may be reduced for certain types of futures market positions, such as calendar and basket spreads, and for certain offsetting positions in stock options and cash securities, provided the security futures are held in securities accounts
    Margin requirements can be satisfied with cash, margin securities and open trade equity in other futures accounts
    Certain industry professionals (such as qualified market makers) are exempt from these requirements…
    http://www.onechicago.com/?page_id=119

    as well as using these to hedge various contra components found in the Index..

  13. wunsacon commented on Jul 26

    Mike in NOLA,

    I own a little QID. But, consider your statement:

    >> .. the NASDAQ 100 is dominated by well-run tech companies who have actual profitable businesses making things that are still in demand.

    To the extent nations (esp the US) are even slightly “successful” depreciating their currencies in an effort to escape deflation, won’t that help the tech co’s top lines (esp. those based in the US, where workers’ real salaries have the most to fall)?

    If:
    (a) hard assets (energy, ag) rise in price in response to inflation and
    (b) technology helps us be more efficient with those increasingly costly hard assets (e.g., telecommuting saves energy),
    then won’t nations want to buy more technology?

    Maybe QQQQ isn’t getting hit hard for a reason. If QQQQ companies help other companies cut non-tech costs, then QQQQ companies’ output might remain in demand.

  14. lurker commented on Jul 27

    Thanks for the good comments on tech.
    I went long a tech mutual fund about a week ago based on my read of the charts and now I will go back and take another look. I respect the opinions here too much to ignore them but the charts looked good to me not long ago so I better doublecheck and tighten my stops. Thanks.

  15. Mike in NOLa commented on Jul 27

    Mark:

    The SSF seems an interesting concept but probably not available to me in my SEP-IRA where I do my trading. It still to a certain extent still involves timing which makes me a little uncomfortable. While these Ultrashort ETF’s I’m buying might look wild to my wife, I’m actually taking what I think are pretty conservative bets.

    Wunsacon:

    You make a good point if there is some degree of hyperinflation in the US and not in the nations consuming the goods. This may eventually come about if the Treasury printing presses go into and stay in high gear.

    But, while real inflation has been higher than the Fed admits, I think the collapse in house prices and deleveraging going on is going to be deflationary over the short term. I may be wrong in my grasp of banking, but it seems that with the way commercial banks work, every loan written off by a bank decreases its capital and has an inverse multiplier effect on the bank’s ability to lend, since its lending capacity is a multiple of its capital. Banks create money when they lend a multiple of whatever capital they have, so it seems that reducing their capital shrinks the amount of money in circulation.

    While this has been a seat of the pants assumption on my part, your comment has forced me to think about it, although not that hard. A quick Google of “bank write offs capital lending” came up with a paper with this passage, which seems to support my assumption:

    “Bernanke and Lown (1991) use US state-level data on individual banks to argue that, although demand factors might have caused much of the observed slowdown in bank lending during the period, a shortage of equity capital limited banks’ ability to extend loans, particularly in the northeastern part of the country. Lower levels of bank capital seem to have been the result of an increase in loan defaults and write-offs.”

    More thoughts on this concept would be appreciated. Of course, deflation does not necessarily prevent the dollar from being eventually devalued as happened in the 1930’s.

    On top of this, I think Gary Shilling’s views expressed in that Bloomberg inteview about a worldwide recession are correct, which would mean less demand over the short term. While some companies may make out better because of business-to-business services, I think Apple is going to take a hit because it really hasn’t gotten into that sector. It is primarily a consumer company, and a US oriented one at that. It’s a bit early for calculations, but it seems that if Apple’s P/E simply contracted to that of MSFT or Intel, it’s share price would be cut roughly in half and the index could drop by several percent.

  16. Mike in NOLa commented on Jul 27

    lurker,

    Don’t want to be a bore and take over the thread, but note my disclaimer on timing. If the summer rally continues, a tech fund could still work short term.

  17. Mark E Hoffer commented on Jul 27

    Mike,

    I hear ya with this: “I’m actually taking what I think are pretty conservative bets.”

    This: “not available to me in my SEP-IRA”, though, still amazes me. It’s hard to believe that so many SEP/401(k) investment options are proscribed.

    One couldn’t set up a better shooting gallery if they tried.

  18. Mike in NOLa commented on Jul 27

    Mark:

    I have it reasonably good, with a pretty wide range of choices: stocks, funds, EFT’s, bonds.

    My wife has a 403b that had horrible choices, well, maybe not in a bull market. There were a couple of quality long stock funds, but no way right now.

    So I found that they would let us transfer the funds to a Schwab PCRA. She won’t let me do anything fancy, but I figured I could at least get 3%+ on FDIC insured CD’s, which would far outpace what she was getting in the 403b. After we got it all set up, I found that we could not purchase ANY individual securities, even treasuries. I suppose that’s too risky for the individual investor :) I also suppose that VALIC, the original custodian, gets a kickback from mutual funds.

  19. MurrayR commented on Aug 1

    There are two schools of thought on whether or not now is a good time to begin buying bank stocks:

    * Analysts like James B. Stewart at Dow Jones think that bank stocks are a raging buy. In a recent article in The Wall Street Journal, he opined that “The current indiscriminate selloff in the financial sector makes no sense… This simply isn’t rational.”
    * And, indeed, shares of lenders have fallen so far that these stocks look attractive on an earnings, book value and yield basis.

    Bank Stocks: Good Bet or Big Gamble?

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