Our equity exposure to financials has increased to 20.5%, up from a net negative exposure in 2008 and higher than the S&P 500’s current weighting of 15.6%. We seek the inexpensive and care not a whit about market weightings. Financials, particularly lenders, meet that hurdle. Citigroup, as an example, traded down to ~60% of tangible equity at one point in the first quarter. We believe tangible equity is pretty solid, even after assuming a higher level of charge-offs. Investors will frequently act as if they are still fighting their last war but the balance sheets of U.S. banks and thrifts are far stronger now than they were in 2008 when many financial institutions were wounded and close to dying.
On the eve of the global financial crisis, Citi (NYSE:C) had just 3% tangible equity propping up its tangible assets whereas today, it has 10.5%, higher by a factor of more than three. Some of Citi’s loans will default and it won’t get full recovery in all cases. When we stress test its balance sheet and assume an unusually bad outcome for its loan book, its capital ratios remain solid. If half of its China, energy and metals & mining loans were to default this year and Citi recovered just 40 cents on the dollar, and if consensus earnings are correct, then Citi would still earn money this year and end 2016 with more than $60 per share of tangible book value and tangible equity to tangible assets of more than 10%. That would mean book value would actually increase despite the write-offs. We, therefore, thought Citi at a 40% discount to its minimum worth was a great risk/reward. We purchased additional shares in the midst of its Q1 downturn along with shares of other lenders that saw similar declines.
From Steven Romick (Trades, Portfolio)'s Crescent Fund first quarter commentary letter.
