"I am not a buy-and-hold type of guy."
Charles Crammer, principal and senior analyst, Keefe ManagersTo start off, I have a confession to make. When it comes to investing, I'm a fundamentalist. And like any fundamentalist, I'm dedicated to the pursuit of traditional values. I've been a fundamentalist since the earliest days of my career when I had a vision. In it, a spirit appeared and said unto me: "Buyeth low, Charlie, and selleth high." From that day forward, I have made the quest for fundamental values my personal crusade. And, until recently, I always had an army of like-minded zealots marching with me.But lately I'm discovering that my beliefs make me something of an outcast in the investment community. Fewer and fewer investors, it seems, share my convictions. More and more are being lured from the straight and narrow by sexier strategies that promise immediate gratification without any sacrifice at all.Heaven knows I've been tempted by some of those strategies. And sometimes I've strayed. But so far nothing has ever worked as well for me as that old-time religion. When I say that I'm a value-driven fundamental investor, I mean three things. First, I believe that at any point in time the price of a stock reflects the market's best effort to determine a company's true economic value. That is, the price represents the consensus view of that company's value, however off base that consensus may be. Second, I believe there is a theoretical intrinsic value for any security that is totally independent of the price at which it trades at any particular point in time. Lastly, I believe that a stock's intrinsic value cannot be described by a set of fixed coordinates. Rather, it is a moving target, subject to infinite, continually shifting variables. Uncertainty is the stock market's only constant. What we can know with certainty will always be overwhelmed by what we cannot know. Far from being a fixed target, a stock's intrinsic value looks more like a probability distribution, and the prime directive of fundamental investing is to minimize the dispersion around the mean of that distribution. As a fundamentalist, I firmly believe that the harder I work, the deeper I dig, the more people I talk to, and the more numbers I crunch, the better able I will be to shrink the frontier of uncertainty that surrounds a stock's true value.Specialists Can Beat Market
It follows that, to me, the only way to establish a sustainable competitive advantage in the investment business is to know more about what you're investing in than most other investors do. That's why I'm convinced that sector specialists like us can beat the market, if not every year, then certainly over the long haul. We are on the receiving end of every piece of information that pertains to the banking industry and we know just where each piece fits into the puzzle. We get first dibs on every block of stock that shakes loose for every bank, no matter how obscure. We meet hundreds of managements every year, and have known many of them personally for decades. We comb this familiar territory every day, prospecting for anomalies and subtle changes. To be sure, expertise and access to information do not guarantee great performance; we can still make bad decisions. But we are better equipped than most to unearth those extra nuggets that tip the scales in our favor.Plenty of people say our financial services focus is risky because our portfolio is not sufficiently diversified. But I say that diversification is a false god. All it does is lure investors into areas they know nothing about. We see firsthand the effects of other investors diversifying into and out of our sector. That's what creates our best opportunities. We don't want to diversify into other industries and create opportunities for everyone else.If all this sounds a little Graham and Doddish, it is. With one big difference: I am not a buy-and-hold kind of guy. Over the long term stocks kind of vector in towards their economic value. Plus, the tax codes favor long-term investors. But in today's market there are a couple of problems with fixing on a long-term horizon. First, you need to find those precious clients willing to stick with you through periods of weak performance. Second, in sticking stubbornly with a buy-and-hold strategy you will miss a multitude of profitable short-term opportunities.Just as I believe that value plays out in the long haul, I am convinced that the market is hopelessly inefficient in the short term. In the short term, stocks are driven only by demand and supply-euphemisms for greed and fear, what Keynes called animal spirits. In the short term, stocks are nothing more than commodities. After all, we are buying and selling securities, not companies. What's more, prices are set at the margin. A company may have a million shares outstanding, but only a few thousand of those shares can move the stock enough to create a buying or selling opportunity. No matter how good or bad a company's management may be, there is a price at which you want to buy its stock and a price at which you want to sell it. So in the short term it is the rule, not the exception, for stocks to be priced out of line with their intrinsic values. "Now hold on," you might object. "How can you claim that stocks can be chronically mispriced when they are constantly being monitored by so many smart market players?"I think the answer is that the people who determine stock prices on the margin are often people with little fundamental understanding of the companies whose stocks they are buying. That's not because most investors are dumb. It's just that most investors don't much care; fundamental investing is not trendy these days. Partly that's because it's expensive for money managers to support a stable of experienced analysts. But also I think it's gotten to be self-fulfilling; value investing has not worked well for so long that no one really believes that fundamental research can make much of a contribution.Fundamentals are irrelevant to index funds and momentum investors, not to mention day traders and their ilk. Index funds don't care what stocks they buy as long as they mirror the weightings in their relevant index. Momentum investors in turn, try to keep pace with the S&P. Momentum investors don't believe in buying low and selling high. They believe in buying high and selling higher.As far as I can tell, it's a strategy predicated on abundant liquidity and the greater fool theory; for any stock I own there will always be some damn fool with the cash to take it off my hands when I want to sell it.Sell-Side Changed for Worse
Partly, too, the sell side isn't what it used to be. There are a few terrific sell-side analysts but they are a vanishing breed. Too often, analysts are more or less reliable reporters, parroting what company managements tell them. At worst, many seem to believe that their first priority is to say nice things about corporate finance clients. And many buy side people, being generalists, are not always well equipped to differentiate the good sell side analysts from the bad ones anyway.Fundamentalists and Old-Time Values
Since I've argued that nobody cares about value, I should probably be more specific about how one determines a stock's fundamental value. I use a host of models ranging from dividend discount models to balance sheet mark-to-market models. (See sidebar, below.) But in practice, all the market knows about valuing a stock is the price/earnings ratio. And the P/E ratio is a blunt instrument, to say the least.Consider the P/E ratio's denominator-typically next year's earnings per share estimate. Earnings estimates are full of moving pieces, plus the biases of analysts, plus all kinds of weird and arcane accounting conventions that may not accurately reflect a company's true business trends. It's probably best for you to think of it the way I do: Every earnings estimate is always wrong. The question is, is it too high or too low and by how much? These days much of your time as an analyst must be devoted to determining that. This is especially true of quarterly earnings estimates. In a way, the whole investment process has devolved into a process of second-guessing quarterly earnings estimates. This fixation might be myopic, but it's probably not irrational; it's the best the market can do with the limited fundamental understanding it's got. With no context within which to interpret fundamental data, the market almost always overreacts to quarterly earnings. Thus, if a company reports $1.08 per share versus $1.00 last year, when $1.12 was expected, not only are this year's earnings reduced by a few cents-the company's implicit growth rate ratchets down a third to 8% from 12%, and the stock will drop commensurately. This effect will be compounded if expectations are already unreasonably high. I can't emphasize strongly enough the importance of expectations in the investment process. The price of every stock and every market always has expectations built into it. It's a big part of an investor's job to study the market and try to divine what those expectations are. The market is not clairvoyant. It does not "know" what's going to happen before you do. But unlike most of us, the market is not burdened by what happened yesterday or earlier today. The market only cares about what happens next. It's been my experience that when something big does happen, the market almost always begins to react in advance of the news.Often, if investors expect a company to report strong earnings, they will buy the stock ahead of the announcement. This will drive up the stock's price, attracting more investors. The stock goes higher still. Then, when the company does report a record quarter, some of these holders will try to take gains, but there will be no one left to buy the stock and the price will drop. Analysts inevitably raise their estimates and scratch their heads. Many fundamental analysts sneer at technical analysis. That's their loss. To me, charts are indispensable tools, indeed, just about the only tools available for gauging expectations. Plus, charts can be self-fulfilling. Ignore them at your peril. An Ugly Chart
Now on this page is an ugly chart. It's the chart of the Keefe Bank Index, a proxy for large cap bank stocks, as it looked last August 9. Not only is this chart ugly, it is classically ugly. Just about everything that could be wrong with a chart is wrong with this one. A triple top extends back to 1998. A head and shoulders is forming with the neckline in serious jeopardy. The 200-day moving average has been breached. You must always look at charts in the context of the fundamentals; if the Fed had cut rates on August 10, this chart would have started looking better pretty quickly. But last August, as I emphasized then, this chart was screaming caution. Now let's look at how the market has actually valued bank stocks historically.Here's a fact that may surprise you: Bank earnings have historically grown faster than those of the S&P 500. Here's another: Bank earnings growth has historically been less volatile than that of the S&P 500. Capital markets theory suggests that a company with those earnings characteristics should have a relatively low cost of capital. To put it another way, such a company should sell at a P/E multiple premium to the market. Now look at the next chart. It shows that for the last 25 years bank stock P/E's have always sold at a discount to the overall market. That discount has ranged from 10% to 60%. In my opinion, two things explain this discount, and they are very much related. But to appreciate them you've got to look at the group the way the outside world views it. First, even at their best, banks seem boring. In a good year a banks' earnings will be up maybe 12%. In a great year, earnings will be up 14%. That's about it. Remember that most investors can choose from dozens of industries in hundreds of countries worldwide. U.S. bank stocks are seldom the most compelling choice. Investors don't care much about earnings stability. Not really. What they love are stories. And only rarely are bank stocks story stocks And that is as it should be. Because the fact is that banking is not a glamorous business, despite the best efforts of analysts and investors to make it so. It's not about space age technology or new patents or miracle drugs or anything else that really captures the imagination. Banking is a day-to-day, grind-it-out business that depends far more on execution than on vision. It's a challenge for any bank to establish any sort of enduring competitive advantage over a competitor, and that advantage usually results from the competitor screwing up.Not Just Dull
It wouldn't be so bad-and my job wouldn't be nearly as interesting-if bank stocks were just dull. But bank stocks have a dark side. That dark side is credit. Simply put, when the market becomes fixated on credit quality, nothing else matters. Today, after a decade of economic expansion, it's hard to imagine how scarred investors like myself are by the credit wipeouts of the 1980s.In 1983, Texas banks were considered the best managed banks in the country. Names like Texas Commerce, Interfirst, Mercantile, Allied. These weren't banks; they were houses of worship. In the four years prior to 1984 Allied sported an average ROE of 24%, twice that of its peers. But by 1988, all of these banks had failed or would have failed had they not been acquired. First City had the distinction of failing twice. Then came the Continental Illinois collapse and the LDC fiasco. Continental was widely regarded as the country's best big bank. At least everyone recognized that the Feds would find some way to bail out the money centers.Next, the entire thrift industry imploded. It is hard now to appreciate how big and powerful some of these thrifts were-long-forgotten companies like Financial Corp. of America or Goldome or Centrust.After that came Bank of New England and the real estate conflagration of 1989-90, which was ignited by fanatic examiners but quickly spread into something much worse. Today that episode is remembered only as a great buying opportunity. I wish I had just a penny for every investor who bought Citi at $9 or Bank of Boston at $3. Funny, but I've never been able to find anyone who actually sold stock at those prices. But I still believe that if the Gulf War had not gone our way and the Fed had been unable to slash rates, many of the major banks would have needed bailouts. Burned so often in the past, investors are rightly skeptical of anyone's ability to really analyze banks. When things turn bad, they view banks as blind pools of risk-leveraged pools, in fact. And every bank looks pretty much the same. The lynchpin-the loan portfolio-cannot be valued with any degree of confidence.Always bear in mind the essential bank stock arithmetic: If a company is leveraged 20 to 1, and the market becomes just 1% less confident in that company's asset base, then that company's stock will drop 20%. With those dynamics at work, any bullish story will always be swamped by a rising tide of credit fears.Engine of Value
Credit concerns, then, are the engine that drives bank stocks over the course of the economic cycle. This is not the conventional wisdom. Ask 100 investors, and 99 will tell you that banks are "interest-rate sensitive" stocks. Thus, they are supposed to outperform the market when interest rates are falling, and underperform when rates are rising.But this conventional wisdom does not conform to experience. Think back to the summer of 1998, when the Keefe Bank Index plummeted 43% in three months, even as the yield on the long bond rallied from 5.9% to 4.7%. That's not interest-sensitive behavior. The real culprit was credit quality, or, more properly, perceptions of credit quality.Having said this, I should emphasize that rising interest rates are fundamentally bad for banks. This is not because higher rates have an immediate negative impact on net interest margins. But higher rates do have an immediate, negative impact on the cash flows of bank borrowers. As rates rise and, ultimately, the economy slows, corporate cash flows are squeezed and credit quality suffers. Bank stocks suffer accordingly. Bank stocks perform well relative to the market at or near the trough of a recession, or when prospects are good for Fed easing and non-inflationary economic growth. Bank stocks perform poorly at the extremes-when the economy is overheated or in the early stages of a recession. Interest rates are highly correlated with, but do not determine, bank stock performance. Credit quality perceptions are the key.There are still those who hold out hope that bank stocks someday will achieve the higher P/E valuations they appear to deserve. While I think there is a valid case to be made that bank stock ought to sell at market P/E's, I am skeptical that they ever will, as long as they continue to lend money and use leverage. Anyway, I think that the prophets who trumpet higher multiples are mostly missing the point. Because the real beauty of bank stocks has always been that they are chronically undervalued. A portfolio of bank stocks will almost always sell at a discount to the present value of its future cash flows. Until that changes, bank stock investors will always have the wind at their backs. When people ask me how long they'll have to wait for banks to get the P/Es they deserve, I'm reminded of what Mae West said when two suitors demanded to know when she would finally decide which one to marry: "Maybe tomorrow, maybe never. But don't let that keep you from coming around." many banks today rely on a stitched-together patchwork of more or less antiquated legacy systems. That's adequate in today's environment, but it may not offer the flexibility banks will need to adapt to change in the 21st century.Beyond that, I'm concerned that even though the Internet is unlikely to endow any single bank with a big edge, it could engender price-cutting that sucks profitability out of the entire industry. But the biggest, scariest imponderable is non-bank competition. As long as the competitive landscape looks pretty much like it does today, I think that the Internet's earnings impact is likely to be muted. But what if someday Microsoft or America Online or AT&T, either through regulatory change or an alliance, gets access to the payments system and insured deposits, and figures out a truly convenient, secure way to deliver financial services online?With their millions of customers and hundreds of billions of market cap, these giants could spread their technology costs over a huge base and offer prices that banks can't touch. I don't see this as an immediate threat, but it's something I think about every day and could drastically alter the competitive balance of the industry.
