Clickworthy: Fair value is still expensive

There’s been a number of articles in recent weeks about how the markets are approaching fair value. Here is the latest by somebody who knows about bubbles — the infamous Hentry Blodget. The article looks at the S&P relative to “cyclically adjusted” PE. Key points:

1. Fair value on S&P between 850-1050
2. Markets overshoot fair value on the way up AND on the way down

I could not agree more with point #2. I’ve been trying to put together a buy list for stocks that I can hang onto for the long run, but I’ve been having a lot of problems. I can’t find many that strike me as cheap. They may no longer be expensive but as far as Canada is concerned, I would not touch bank stocks into a deteriorating economy and commodity producers low P/Es are misleading. I don’t care about fairly valued. I want bargain basement. I want stocks that pay me for the risks should this recession prove to be deep and long. Ideas are welcome…

UPDATE: Great chart that also shows that things can be bad for a very long time…

Bank stock underperformance – only the beginning?

About a month ago, a good friend of mine decided to buy some Citigroup stock. He reckoned since it had fallen 70% it was “cheap.” Since then the stock has deteriorated further, falling from his $15 purchase price to today’s close of $4.71. I don’t know if he still owns the stock, but if he does, he’ll realize that a stock can fall 70% twice.

For years, Canadian investors have thought of bank stocks as a safe haven. Today showed them to be wrong with the sector underperforming the index by 5 percentage points. I’ve actually been amazed at how well bank stocks have held up until now. I’m concerned that recent underperformance could be only the beginning.

Let me give you an analogy:

Let’s say you wanted to invest some money. There’s a long-time established diner just down the street that is for sale. The owner tells you that the business has no debt and typically earns $60,000 per year. He will sell it to you for $500,000. You think to yourself that at this price you are generating an earnings yield of 12% — which is actually another way of saying that you’re paying a P/E of 8x.*

Alternatively you might decide to buy a bank stock. You could for instance buy $500,000 of shares in Canadian ACME Bank. On last year’s peak EPS, your investment would work out to a P/E of 8x. The bank is currently seeing earnings weakness but the share price is also down 45% from its peak. It seems like a good investment doesn’t it? After all you’re only paying 8x “normal” earnings.

You could be sadly disapointed.

The diner’s business could be impaired in a recession, but for the most part it should be OK. It has no debt and other than rent, it has few fixed costs. It generates a nice recurrent income. So as long as it can keep its costs down, it should survive the recession.

Bank stocks though are a different story. They are the riskiest things you can buy into a severe recession for one simple reason:

Leverage

Unlike that diner — which had no debt — banks are laden with debt in the form of customer deposits. These deposits have been loaned out by the bank in the form of business loans and personal loans — some of which are to schmendricks like your cousin Louie.

So when you buy $500,000 worth of Acme Bank, you are not buying a debt-free business. You are buying a piece of a business that is leveraged. This leverage is huge relative to your investment.

The typical Canadian bank has less than $1 in shareholders equity for every $10 in loans. And profits? In 2007, the the typical Canadian bank had less than 20 cents in profits for that same $10 in loans.

So if just a tiny percentage of those loans go bad, your bank’s profits can be wiped out. In a buoyant economy, nobody worries about loans going bad. But in an environment where property prices are falling, it’s easy for pessimists to get concerned about the integrity of those loans. In fact, it doesn’t really matter now accurate the naysayers forecasts are. In a deteriorating economy, investors usually have a tendency to “sell banks now, ask questions later.” After all, if enough assets go bad, not just the profits will be wiped out, but potentially the equity as well — leaving the shareholders bankrupt.

At current levels, Citigroup is down 90% from its peak. So is the stock cheap?

Well — it’s not cheap if it goes bankrupt. You see at $4.71, the company still has a market value of $26bn.^ Is that cheap? You tell me! The company also has borrowings of $2tn that need to be repaid back. If its assets can’t cover it, than the shareholders will be left holding the bag.

The media is plumb with stories about how safe Canadian banks are relative to their global peers. That may well be true — they are as a rule less leveraged. But we won’t know the true extent of Canadian banks’ supposedly better lending practices until this is actually all over. Remember, the US has now been suffering for a couple of years from its housing crisis. Canada is a commodity-based economy so it’s only been the last six months that the stresses are really starting to be felt here. Is our economy going to play catch up? Only then will we see how truly vulnerable Canadian banks really are.

Read an earlier post of mine on this subject here: Clickworthy: Banks Riskier Than We Think

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* $500,000 divided by $60,000

^ $4.71 multiplied by the shares outstanding

Clickworthy: China spending to save TSX?

The only hope the Canadian stock market has to avoid a sustained bear market is if China regains its economic momentum. This is purely my opinion and is something I’ve written about countless times in recent months:

• Is Canada special?
• Portfolio manager with zero weighting in equities
• Evidence of China slowdown
• China wants to keep buying our commodities, it really does

In plain Engrish, the main reason Canada needs China is because of what Canada does: we sell rocks and trees. Canada is a pimple on the ass of the global commodity bubble. And the biggest buyers of global commodities have been China — and to a lesser extent India — who have been doing 2/3 of the buying.

That’s why I often focus on China on this blog. So what’s happened?

Today, China announced a massive fiscal stimulus plan to spur expansion. Key points:

• The funds, $4tn yuan, equivalent to almost a fifth of China’s $3.3 tn gross domestic product last year, will be used by the end of 2010.
• $100 bn yuan is earmarked for this quarter, will go toward low-rent housing, infrastructure in rural areas, as well as roads, railways and airport.
• Few details otherwise were given.

An article in the WSJ questioned how much of this stimulus plan represents new money and how quickly it could benefit the economy.

I’m not sure either how much of this is recurrent spending, but these seem big numbers. If only $100bn yuan is actually coming into play this quarter though, there won’t be a benefit till the new year.

This bears close watching. China’s insulated stock market has yet to benefit from the bounce in global markets over the last couple of weeks. The Shanghai Composite index is still down 70% from its peak one year ago.

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UPDATE: If the market performance in the US yesterday and Asia on Tuesday isn’t evidence enough, most market observers seem to feel the stimulus plan is nothing more than semantics. Click below for details:

Michael Pettis

The Big Picture

Back in Black

I’m referring to the ACDC concert on Friday night at the Toronto Rogers Centre of course, and not to the stock market.

Oh and I’m back too — back to blogging that is. In case any of you have been wondering why I’ve chosen to keep this blog anonymous, you now know the reason. When I started blogging I wasn’t sure if I would be able to sustain it on a regular basis. I’m no longer in the investment game. I didn’t want to attach my name to it because I didn’t want anybody looking over my shoulder and asking “what had happened” if I decided to stop.

In the last month I’ve been simply too busy to write. Not with investment matters thankfully — I’ve been 99% cash for over two years.

But there’s another reason for my absence. I started this blog in part as a vent for what I felt was dangerous and irresponsible advice among many in the Canadian investment community. But what with the carnage of the markets in recent weeks, It’s been hardly necessary for me to keep harping on the risks. Many Canadians have now sadly learned the reality of global market cycles.

We’re now at an interesting juncture in the markets. My opinion — for what it’s worth — is that this market could go either way. In other words — despite what some pundits are saying — this is not a no-brainer. Going forward, I’ll continue to blog about the facts and try to provide a balanced perspective on the risks on the downside and on the upside. But you”ll understand, I hope, if l stay anonymous.