Financials = 2007's Value Trap

Sunday, July 06, 2008

"There's never just one cockroach in the kitchen." Financial stocks have proven to be an incredible trap for value investors of 2007. The Financial Select Sector SPDR (XLF) currently sits down 45% year over year. Investors buying the XLF one year ago have lost nearly half their investment. This 45% loss in one year requires investors now to make an 82% return to recoup their loses nominally. So, how did financials become such an enticing trap for value investors?

Year over year performance:
US Bancorp (USB): -16%
JP Morgan (JPM): -27%
Wells Fargo (WFC): -32%
Bank of America (BAC): -54%
American International Group (AIG): -63%
Citigroup (C): -67%
SLM Corporation (SLM): -68%
Wachovia Corp (WB): -71%
Fannie Mae (FNM): -71%
Freddie Mac (FRE): -76%

And these are the better of the financials!

Countrywide Financial Corp (CFC): -88% (acquired)
MGIC Investment Corp (MTG): -88%
Bear Sterns (BSC): -93% (acquired)
MBIA Inc (MBI): -94%
Radian Group (RDN): -98%
Ambak Financial Group (ABK): -99%
Thorburg Mortgage, Inc. (TMA): -99% (survival in doubt)

Some of these companies, namely, Fannie Mae, Freddie Mac, American International Group, were recovering from accounting scandals throughout 2005 and 2006. The value investor stepped in to buy these companies at the discounted prices believing that once the accounting issues were resolved the stock prices would begin to reflect the quality of the company itself and not the temporary stain of scandal. Many of the banks suffered from 2006's inverted yield curve creating the belief that banks would have a difficult time growing their earnings. This spurred value investor interest given that the Fed was likely near finished with its campaign of raising short-term interest rates and the curve should then normalize. These reasons, among others, lead investors to believe financials presented a substantial value relative to their intrinsic values.

But, 2007 held quite the different story. We began to see the true effects of the Federal Reserve's campaign of raising the Federal Funds Target Rate. This campaign spelled trouble for the thousands of new homeowners who had procured loans with adjustable rates. Second problem: many of these borrowers were subprime and should never have received the loans in the first place but were encouraged to take the loans because of they could make the then-low monthly payments.

Investment banks believed they had created a product that could provide reasonable risk control while lending money to risky borrowers. They created the mortgage-backed collateralized debt obligation and sold it to the public. Problem being, a bad loan isn't made much safer just because you group it with a bunch of other bad loans. Garbage is still garbage; only modern artists can get away with calling garbage something it's not. By grouping subprime loans and rating the package triple-A, you have amplified the damage if your default estimates are incorrect. Add a Federal Reserve interest rate hike campaign and your default estimates are not much more than guesses.

Clearly, few could have foreseen the extent of the damage from the subprime meltdown and the following tightening of credit markets. Value investors became trapped in these stocks because what they believed were already values became greater values, or so they thought. But, "there is never just one cockroach in the kitchen." When the problems of these derivative products began to surface, the prudent investor needed to exit his positions. While the financials may have been values based on past scandals or yield curve effects, these were entirely new problems cropping up. These entirely new problems were coupled with an incredible lack of transparency. CEOs themselves did not know or understand the risk associated with these products and, plainly, the average investor did not understand the risk.

It seems the moral of the story is that you cannot become married to your positions. While a stock may be a great value given past news stories, the stock may actually be significantly overvalued with future occurrences. Once these new problems begin to surface, value investors cannot begin a offensive wrought with rationalization but rather, must just exit the position. These problems were entirely new and far from transparent. You cannot be invested when you do not understand the problems facing the company.

While this post is written with complete hindsight and may provide nothing worthwhile, it is useful to study the past to see where many brilliant value managers were fooled. Value is only value if you have a margin of safety. If entirely new problems begin to surface, your margin may be gone. Or, if you simply do not know what your margin is, you should probably exit your positions until things become transparent.


Brandon Rowley said...

Amazingly, this post could be renamed:

Financials: 2008's Value Trap

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