Bank Stocks & The Herd Mentality

The herd mentality gives Warren Buffet and other value investors the greatest opportunities in the worst of times. This is certainly true with quality banks such as Wells Fargo and others.

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Lets take a look at why:

Ultimately it is because the majority of individuals lack knowledge and are missing important pieces of information needed to make sound investment decisions. As Benjamin Graham (Buffet’s teacher) said, this information is widely & freely available. People are just lazy when it comes to investments, especially in the stock market. They refuse to do homework when it comes to investments. They would rather look for an easy way out and listen to the media or analysts, to tell them what the answer should be. Or, they just wing it. Ego sometimes plays a factor, as people think that their expertise in one domain gives them equal success in another domain, but without them having the same level of domain knowledge. These factors lead to emotionally charged decisions. It is no mystery why the market bubbles & bursts, making some rich & leaving others ruined.

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If we look at the headlines, we can see why the herd investor is scared of bank stocks:
– Morgan Stanely earnings plunge by more than half.
– Wachovia Corp. estimates it may lose more than $4.5 billion on adjustable-rate home loans.
– Citigroup has written down $15 Billion to date and warns of billions more.
– Bank Of America sees $3.5 billion writedown at Merril, $7 billion at UBS.

Analysts are contributing to the herd’s fear:
– Equity, Debt Investors Yet to Face Worst of Sell-Off, says Royal Bank of Scotland Group Plc strategist.
– John Paulson, founder of hedge fund Paulson & Co., said global writedowns and losses from the credit crisis may reach US$1.3-trillion, exceeding the International Monetary Fund’s US$945-billion estimate.

Analysts are quick to upgrade & downgrade, and also give partial information which paints a specific picture for the herd. Misinformation is just as bad as no information. Back in December analysts recommended Citigroup because their share price was so low. It was low for a reason though. It was a bank that was losing money and was mismanaged. You wouldn’t recommend a cheap car with head gasket problems would you? Probably not, but it depends. Which brings me to the next point.

Lets look at what JPMorgan said on June 20th:
– JPMorgan also said that Bank of America and Wells Fargo are among lenders with the lowest reserves to cover bad loans. JPMorgan thinks these lenders may raise more money to increase reserves.

Everything is relative, and the size of the bank makes a difference. We can’t just blindly compare numbers. $10 Billion has a large impact on WFC, than for say Citigroup. We need to look at percentages & ratios, in addition to absolute numbers. From reading annual reports we know that Wells Fargo doesn’t have much to worry about in terms of capital and writedowns due to subprime. One reason is that they pretty much avoided most of it as they deemed it too risky for them. As a consequence, their earnings increases during the good times were not as large compared to the other banks. But their losses were also much smaller. For the first quarter of 2008 Nonperforming loans as % of total loans was only 0.84% (not even 1%).

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Lets continue to use WFC as an example and look at other numbers (from the Q1 report, Morningstar, Reuters):

– 2008Q1 Net Income = $2.0 Billion compared to $2.24 Billion in 2007Q1
– 2008Q1 Revenue = $10.6 Billion compared to $9.4 B in 2007Q1
– 2008Q1 Net Interest Margin = 4.69% compared to 4.95% in 2007Q1
Although profit and net interest margin decreased, it was a small. When we compare these percentages to other banks, they are numbers that make an investor smile during a time when other banks post losses and large decreases.

– TTM ROE = 17.4%
– 10yr avg ROE = 17.54% compared to 12.00% for the industry.
– Dividend for at least 20 years in a row with frequent steady increases.
– Annualized book value increase of last 10 years is 12.55%

P/E at $25 for TTM is around 10.5 the lowest in 10 years, well below its 10 year average of 17.6 (including TTM). This is a good indication that this bank stock is cheap. P/E doesn’t work for banks that don’t make a profit, a good indicator that money losing bank stocks are not relatively cheap.

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WFC is a well managed & conservative bank that has avoided most of the subprime and credit problems experienced by most of the US banks, and even by some of the Canadian ones. Analysts are recommending Canadian banks whose track record, and losses due to subprime in comparison are much greater.

For investors who do their homework, the hammered bank stocks is an easy opportunity. There are probably only a handful of quality bank stocks that can be had at cheap prices. These banks can be filtered using very simple calculations. For others who don’t do their homework, it is a danger zone as you wouldn’t be able to differentiate the good from the bad, from all the news out there and analysts’ random recommendations.

I encourage all investors to take time and do their homework. You work so hard at your 9-5 job, why not for your investments? The book Intelligent Investor by Benjamin Graham is a perfect starting point that every investor should read. If you haven’t read it yet, buy it. There are a few editions out there. The exact edition I recommend is listed below.

Thanks & Happy Investing!

The Investment Blogger

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Chapters.ca (CD audiobook)

Amazon.com
The Intelligent Investor: A Book of Practical Counsel

Amazon.ca
The Intelligent Investor: A Book of Practical Counsel

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One thought on “Bank Stocks & The Herd Mentality

  1. The record of large money center banks is horrible. These guys just think uncle sam will always bail them out when they get into trouble. Only problem is their right and the taxpayer ends up on the hook for their bad behavior. Their should be a website called Banks Behaving badly.

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