Finding Value in Negativity
How has the fund coped with the recent volatility in the financial sector?
The fund has kept pace with its benchmark. Given the attractive valuations that are found in the financial sector, we're looking to assume a small measure of risk in the portfolio. On average, every dollar that one invests in the broad market provides $1.44 in intrinsic value. But in the financial sector, a one-dollar investment provides about $1.53 in value. By our measurements, this is the greatest value found in any market sector.
This value is a direct result of the fear that has gripped the market. Recent downgrades to economic growth forecasts and the European sovereign debt crisis have created these high valuations for financial names. There's been an increased perception of risk in the financial sector compared to other sectors since 2009. When a financial crisis exacerbates a recessionary environment, investors associate financial distress with recessionary fears. That's the environment we face today and consequently many investors have avoided financial names. We believe that the sector will perform strongly in the future and that investors should begin to add risk to their portfolios.
Why is this a good time to invest in financials?
Our valuation model has a forward-looking component that accounts for long-term growth rates. We measure whether the market has reacted appropriately to negative news and believe the market has overreacted significantly to the downturn. The last time we saw this much value in the market overall was March 2009, when we calculated a value-to-price ratio of $1.42 for every dollar invested. We find ourselves in a similar situation today. From March 9, 2009, to April 9, 2009, the S&P 1500 Financial Index gained just more than 66 percent. But the financial sector hasn't been popular for a long time.
When I joined ICON in 2000, the technology bubble was in place and no one wanted to talk about the base materials fund that I managed at the time. During the last six years, base materials have become a popular topic. We're in that same situation now with financials. The sector has become a political target and few investors want to speak about financials. But the sector can receive a boost from any small vote of confidence. Recently, Meredith Whitney said that Bank of America ( BAC ) wouldn't need to raise additional capital. Afterward, the lender's shares gained 10 percent. Ironically, the next day Warren Buffet invested $5 billion in Bank of America. The lender's shares initially rose 18 percent the day before Federal Reserve Chairman Ben Bernanke revealed his outlook for the US economy at Jackson Hole, Wyo. It's remarkable how strongly financial shares react to just a bit of good news.
What financial subsectors do you believe are the most attractive?
Diversified financials have taken the brunt of the downturn. There's significant value in this subsector. We've been underweight the group this year, but have started bringing our exposure up to the same level as the benchmark. Life and health insurance, investment banking and brokerages and diversified banks are the subsectors that provide the most value.
We're underweight real estate investment trusts (REIT). When the yields in the marketplace are as low as they are now, many investors become excited about REITs and the dividends they provide. However we feel that the enthusiasm has been overdone.
Consumer finance has been one of the leading industries in the space and we've had a significant weighting to this subsector since the first half of the year, including names such as Capital One ( COF ) and EZCorp ( EZPW ), a publicly traded pawn shop chain. Those investments have helped our fund keep up with the benchmark, but the valuations have changed. Consequently, we've reduced our exposure to the sector and spread it among diversified financial services and investment banking and brokerage operations.
How are the banks and insurance companies coping with this low interest rate environment?
The banks make their money off the steepness of the yield curve. If they can borrow money for almost nothing and then loan it out for something, profit margins shouldn't be badly hurt by low interest rates. Most of the downward pressure on financial institutions is based on the value of their assets, not profit margins. Earnings flattened the first half of this year but analysts still predict they'll rebound.
Analysts still predict reasonably strong earnings-per-share (EPS) growth for the industry. Analysts expect that by third-quarter of the year, the 12-month trailing EPS will have risen 23 percent. Analysts see the environment as favorable, but the market must clear the mental hurdle posed by the struggling housing market.
Recently Bank of America donated a number of houses in depressed markets to local governments. These properties will be razed and turned into playgrounds. The carrying costs of the homes were higher than the value of the homes themselves, so the tax write-off from the donation made sense for Bank of America. But it's difficult for investors to view this move as a positive sign for the banking industry.
What risk do mortgages pose to the financial sector given that loan-loss provisions are being stepped back?
That data will be reflected in forward-looking EPS estimates. The bottom line is that analysts haven't forecast a negative forward-looking EPS. The fear over mortgages is more psychological than an economic reality.
Because forward-looking earnings numbers haven't changed by much, regulatory changes from Dodd-Frank or Basel III also don't pose a great risk to the sector?
That's correct. I also believe that the effects of European sovereign debt crisis will not be as dire as many predict. Remember that the 1998 Asian Financial Crisis was supposed to lead to a contagion that would cause the rapid devaluation of a number of Asian currencies. Many predicted that the Asian Financial Crisis would have a significant impact on the global economy, but this never came to pass. From the perspective of valuation, the market's overreaction to potential risks in the financial sector has created an excellent entry point for long-term investors.
Can you name some of your favorite plays in the financial sector?
NASDAQ OMX Group ( NDAQ ) makes money every time shares of stocks change hands, and benefits from increased trading volume during volatile periods. Exchanges such as NASDAQ OMX Group have witnessed an interesting new investment trend. In 2000, many believed that a retirement portfolio should have at least a 10 percent allocation to gold. Commodities such as gold weren't seen as suitable investments for a retirement portfolio. Since then, an astounding amount of assets have shifted to commodities and volumes in the stock markets have reached a plateau.
It's arguable that much of that shift has been a result of a six-year decline in the US dollar, which has made commodities more attractive as investments. But what happens when that trend reverses? We see significant value in exchanges. Five years ago, no investor wanted to talk to about natural resources. Today, they're at the forefront of the conversation. That generally signals that a chance in sentiment may be coming soon.
Wells Fargo ( WFC ) is one of the country's largest diversified banks and one of our portfolio's largest positions. It's not well-loved by the market. Investors have been concerned that Wells Fargo may have to dilute existing shares by raising capital to meet the more stringent reserve requirement regulations. But analysts estimate that Wells Fargo will post long-term earnings growth of about 14 percent. We've conservatively estimated 8 percent growth. Even with this conservative estimate, investors still receive almost $2 of value for every dollar they invest in Wells Fargo. Even if one assumes zero growth, investors would receive $1.20 of value for every dollar. That's a compelling valuation.
How do you avoid value traps?
We look for stability. If you employ a valuation process that relies in part on future data such as forward-looking earnings, predictability becomes important. The stability of a company's EPS, profit margins and growth rates becomes critical. If you have volatility and unpredictability in your financial ratios, you will have less confidence that your investment will achieve that valuation.