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It's Time to Bet on Financials, Gingerly
Posted by: Dr. Paul Price (IP Logged)
Date: March 21, 2009 11:05AM
SATURDAY, MARCH 21, 2009
David Ellison, Chief Investment Officer, FBR Equity Funds
By LAWRENCE C. STRAUSS
AN INTERVIEW WITH DAVID ELLISON -- Owning a basket of financial stocks makes sense for the next five to 10 years. But keep the Tums handy.
IN RECENT YEARS THE FBR LARGE CAP Financial Fund has lost a lot of money, but outperformed the vast majority of its peers, in great part because its skipper, David Ellison, ramped up his cash position. The same holds true for FBR Small Cap Financial (ticker: FBRUX), which Ellison also runs. Over the past year, the large-cap fund (FBRFX) was down 31% through Wednesday, while besting the Standard & Poor's 500 by 7.6 percentage points and outpacing 83% of its Morningstar peers. None of this is cause for celebration. But Ellison, 50 years old, whose tenure at Fidelity included learning from the estimable money manager Peter Lynch, maintains there are some very good opportunities in the financials, given their dirt-cheap valuations.
Ellison, who is chief investment officer of FBR Equity Funds, recommends buying a basket of these stocks, rather than picking one or two, though he thinks there is probably downside before things turn around in the sector. To learn more of his views on banks, Barron's caught up with him last week.
Barron's: You have been very aggressive about raising cash in your financial-services funds. How much cash do you have now in those funds?
Ellison: It has come down a bit. It is about 50% in the small-cap fund, and it is in the high-30s for the large-cap fund.
Why the reduction?
Primarily because some of these stocks were so cheap, relative to book value and relative to assets. I figured if they are all going to go to zero, I wasn't going to have a job anyway. So I might as well see what happens.
How far along is the repairing of the banking system?
The big collapse of the system has been taken off the table, primarily because of the trillions of dollars the government has put into it, along with other things that they have done. So we don't have to worry about a collapse, and that is a big step. Now, the question is: Will the government allow these banks enough time to earn their way into the appropriate capital ratios and the appropriate reserve positions? Or is the government going to try to rush it?
In what way?
If you were to mark to market everything that the big banks hold on their books, they would all be technically insolvent in terms of their nonperforming assets. But that isn't how the world works. Not everybody is born a millionaire; they have to earn it. So, in a sense, the banks have to earn their way out of this. If the government makes some adjustments on capital requirements, mark-to-market accounting and a few other things to give the banks more time, they will, in almost every case, be able to earn their way out of this crisis.
What is the outlook for equity investments in the sector?
The government clearly wants to keep as much of the banking system intact as it can, and certainly doesn't have any interest in shutting these big companies down. They want to keep the infrastructure in place. So now the question is: When is new private capital going to start coming into the business? I'm looking for the first bona fide recapitalization where a company comes in and says, "We have taken our losses, we have circled the wagons, we have taken the appropriate charges, and we are really thin on capital. But we have cut our expenses, downsized our assets, and now we need new capital to grow."
There will be plenty of new shares to buy, and you will have a chance to buy on these recapitalizations. If that works, we have a banking system that can now start to grow again. Once that begins, you have a real opportunity because you have plenty of names to choose from. The valuations aren't as good as they were earlier this month, but you have plenty of opportunities in the sector. It is just a question of not being in a hurry.
So the return of private capital to the banking system is crucial?
Absolutely. The problem is that these banks have lost so much, and they need to have private capital come into the system and create the necessary discipline. In a sense, many of the banks have done a lot already, as they have gone from paying dividends to not paying dividends. They have gone from thinking about growth to thinking about growing appropriately, and everybody has cut expenses dramatically. The underwriting process is being examined across the entire industry, which is a good thing for the equity players. That means they are setting themselves up for a period of much better loan quality over the next five to 10 years.
There is a widely held view that there are too many banks in the U.S. and that the industry needs more consolidation. Is that an investing theme to look at?
You are going to see more consolidation. The past five or six years were very quiet because, until fairly recently, everyone had been doing well. Nobody has needed to sell and, of course, the banks that did sell did quite well by getting big prices, which haven't been good for the buyers. If you are a buyer now, you are in position to buy from others' weakness, as opposed to their strength. Their weakness is not having enough capital, pressure from the FDIC [Federal Deposit Insurance Corporation] or whatever.
That is a good thing for people like me because I own the stock. I don't want to see every bank go down, but I see the potential for tremendous opportunities.
Where in particular do you expect to see M&A activity?
For a Bank of America to buy a $2 billion bank doesn't mean much. But for a $3 billion bank to buy a $2 billion bank from the FDIC at no cost -- and therefore it is incredibly accretive -- you probably want to own that $3 billion bank.
Table: Ellison's PicksHow is the first quarter shaping up for the banks?
Nonperforming assets will be up and spreads -- that is, between the yield on loans and the cost of deposits -- will be stable. Fee income is going to be uneven, depending on the type of company. Expense cuts are going to be a little better than expected, because everybody is working really hard to cut expenses. And these banks are going to have to continue to build their reserves. Nobody is going to really care if they make money, because it is really all about repairing the balance sheet and preserving book value. If you can break even and use all of your core profitability to build reserves and take care of severance costs and charge-offs, that is good.
This year is about getting the balance sheet repaired; last year was trying to figure out how bad it was going to be...and it is bad now.
What is your advice to investors when it comes to bank stocks?
This isn't the get-rich-quick option; it is going to take time. If you have patience and are willing to sit with a portfolio of bank stocks, that makes more sense than buying one or two stocks. I would try to buy 10 to 20 stocks. Having said that, we could give back the recent rally, especially if the quarter is worse than expected or unemployment goes a lot higher or the government does something stupid. But with financial stocks, you make most of your money going from bad to good, not from good to great.
The recent rally aside, everybody knows that all of these stocks are near their 52-week lows and that conditions are bad. Everybody is losing money. Companies need government bailouts. So this is as bad as it gets. But things are going to get a lot better. Still, you have to say to yourself that if you buy today, you may go down 20% before you go up 200%.
Where have you been nibbling lately?
In the past couple of months, I have owned and added to names like KeyCorp [KEY]. But as I mentioned, now is the time to buy a portfolio of names, because if I give you one name out of the 10, it would be the one that will underperform. That is the Peter Lynch rule: Give a lot of names, and your chances of being right are pretty good.
Good Advice. So what do you like about KeyCorp, a large regional bank?
KeyCorp isn't quite as cheap as it has been, and the same is true for SunTrust Banks [STI]. But both are true value propositions. There is nothing unique about these companies in the sense that they all have balance-sheet issues and the stocks have come way down. On a price-to-book basis, these banks are trading as low as you are going to get them.
They have cut their dividends, and they have built their reserves. Right now, it is all about what the managements are doing to correct things. They are working on that. A big question for many of these banks is whether their stocks are cheap enough. Another is: Do they have enough capital to survive a severe write-down so they don't have to raise a whole bunch of additional equity that would dilute my equity holding?
What are some other names you like?
JPMorgan Chase [JPM] is in the same boat. It is a little more expensive than KeyCorp or SunTrust, based on book value. But JPMorgan has been very proactive in dealing with reserves. You have heard [CEO] Jamie Dimon speak, as I have, and clearly I want to own that company. I may not want to own the stock right now, but he is doing everything he can to get to the other side. To me, that is the most important part here; there are managements saying, "OK, now it is time to really get to the other side and we are going to do everything we can to get there." You would be surprised what a company's management can do when it is in full survival mode.
Where does JPMorgan Chase trade on book value?
With the stock at around 26.27 last week, it was trading north of tangible book value, which is about 22 a share.
What about Bank of America [BAC]?
I have been nibbling, although it has gone up a lot recently. But they are doing everything they can [to improve]. We can argue about the yin and yang and all the bad stuff there. But Bank of America trades at about half its book value.
That is a huge discount.
Yes, because everybody thinks it is going to zero. Its book value is $10 or $11 a share. The stock was at 3 earlier this month, and now it is over 7. Unfortunately, it has had a significant move recently, which makes things feel a little different. I also like Wells Fargo [WFC], one of the better-run companies historically. They have made an acquisition of Wachovia that they are going to have some issues with, notably problem loans. But everybody knows that. And Wells Fargo's management is fully engaged in saving this company as it is.
What about Citigroup [C]?
Citi is a little more complicated. I own some, but you have to watch it like a hawk. It is sort of the Enron of the financial-services industry; there is a lot of stuff going on there. I would not recommend that anybody own it who didn't understand the industry really well.
But you own it?
Yes, but it is a small position, under 1%. I would encourage everybody to own more traditional names where they can understand what is happening with a company. Plus, the government [basically] controls Citi, so you have to wonder what they will do. I have never seen that in my lifetime. As an investor, you are given another metric to look at, which is unknown.
How does this downturn for the banks compare to the one in the late 1980s and early 1990s?
Back then, the quality of the managers wasn't anywhere near as good as it is today in the industry as a whole. Unfortunately, you could argue that, if today's managers were so smart, why did they get into these issues?
Exactly. So what went wrong?
It is called 10 years of a very good economy. On top of that, it was 10 years of these companies trying to compete with each other on making their numbers and looking good on CNBC and everything else. They had to compete on underwriting, on price, on volume. And they had to compete for people who want to get paid a lot of money. But now we are setting ourselves up for a complete overhaul of the intellectual thought process in the business, which had been corrupted by a good economy. The Fed lowered rates and suddenly everybody could borrow money real cheap. That is when the wheels came off and the regulatory climate became looser and looser.
What does that mean for equity investors?
It is a good thing, because now you are going to see more stable returns, more honest returns, and cleaner returns. For the next five or 10 years, this sector is going to be a good place to be, although it may not be good right now, meaning it could go back down a little bit.