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Stepan Lavrouk
Stepan Lavrouk
Articles (139) 

Roger Lowenstein: Beware of Capitalizing Hope

Value investors can learn from the failure of Washington Mutual

April 27, 2019

In their seminal volume on value investing, "Security Analysis," Benjamin Graham and David Dodd talked at length about the danger of “the capitalization of entirely conjectural future prospects,” by which they meant investing in businesses on the basis of assumed growth, with no examination of the underlying financials. In his introductory essay to a section of "Security Analysis," financial journalist Roger Lowenstein uses the example of Washington Mutual, a savings bank that was the largest savings and loan association until it failed during the 2008 financial crisis, to illustrate this danger.

Beware of hidden dangers

Lowenstein begins by explaining the context for Washington Mutual’s collapse. Throughout the 2000s, the bank had steadily increased earnings, and the stock price had risen correspondingly. The vast majority of investors viewed it as a solid investment, not a speculative play. However, not everything was as it seemed:

“‘WaMu’, as it is known, had a large portfolio of mortgages, including subprime mortgages. Across the United States, such mortgages had been extended on an increasingly flimsy basis (that is, to borrowers of dubious credit), and defaults had started to tick up. But WaMu was held in high regard. It was said to have the most sophisticated tools for risk assessment, and its public statements were reassuring”.

Unfortunately, reassuring public statements do not a safe investment make. If shareholders had bothered to examine the bank’s financials, they would have found an alarmingly high amount of subprime loans on its books:

“For 2006, WaMu’s annual report indicated a balance of $20 billion of subprime loans, which (though WaMu didn’t make the connection) was equal to 80% of its total stockholder equity. What’s more, the subprime portfolio had doubled in four years. WaMu had made it a practice of getting such loans off its balance sheet by securitizing them and selling them to investors, but, as it noted, if delinquency rates were to rise, investors might have less appetite for subprime loans and WaMu could wind up stuck with them. And delinquency rates were rising. Subprime loans classified as ‘non-performing’ had jumped by 50% in the past year and had tripled in four years”.

The essay goes on to describe a story that by now is familiar to anyone who has studied the financial crisis: the issuance of loans that went beyond safe lending limits, the large number of adjustable rate mortgages offered to "safer" buyers who ended up unable to meet their obligations when rates rose and a general assumption that housing prices would continue to increase indefinitely. The crucial takeaway is that anyone who had read and truly understood "Security Analysis" would not have been caught out by Washington Mutual’s inevitable collapse.

“No one who took the trouble to read WaMu’s annual report would have concluded that WaMu promised safety. The Graham and Dodd investor therefore would have been spared the pain when home prices fell and subprime losses sharply escalated. Such losses would soon prove catastrophic. Late in 2007 WaMu abandoned the subprime business and laid off thousands of employees. For the fourth quarter, it reported a loss of nearly $2 billion, and over the full year its shares suffered a 70% decline.

Since (as WaMu discovered) market trends can quickly reverse, Graham and Dodd counseled readers to invest on a sounder foundation, that is, on the basis of a security’s intrinsic value. They never—surprise to say— define the term, but we readily grasp its meaning. ‘Intrinsic value’ is the worth of an enterprise to one who owns it ‘for keeps”. Logically, it must be based on the cash flow that would go to a continuing owner over the long run, as distinct from a speculative assessment of its resale value”.

Sticking to Graham and Dodd’s principles means doing the hard work and parsing lengthy financial statements. But once you learn to not take the status quo for granted and simply assume that growth can continue indefinitely, you will be much better prepared for the inevitable downturn.

Disclosure: The author owns no stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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