Investing in Financials

On my watchlist I highlighted how many financial sector companies represent what appears to be ‘good value’ right now. Financials are a slightly odd bunch of companies in that you can measure them on ‘net assets’ (which in effect area usually loans and claims on assets such as buildings or companies) or on free cashflow (repayments over time minus expenses), but in reality, neither of these are really effective measures of value.

2008 was a huge wakeup call for the majority of investors in financial institutions that in none of us really have much idea just what is going on in these vast, corporate behemoths. RBS lost tens of billions of pounds over the course of 18 months in write-downs, but the reality was that these ‘assets’ were worthless from the moment they were bought – the company just hadn’t really acknowledged it yet.

AIG, the huge American insurer nearly went bankrupt as it had insured against so many defaults that when the system began to teeter, it didn’t have enough cash to cover all its liabilities.

Banks around the world suffered from huge spikes in customers defaulting on their mortgages. When they ‘repossessed’ the properties from their customers, they suddenly discovered that there was so much supply and so little demand that the homes were effectively worthless. More write-downs ensued. If you look at the share price of these companies today – many of them considered to be ‘market leaders’, the majority haven’t even come close to recovering over ten years later and are trading at significant discounts to book value, indicating that the market is pricing in expected write-downs over time ‘as standard’.

Company

Pre-2008 crash peak

Current Price (March 2020)

Price to Book Value

Barclays

686p

168p

0.4

HSBC

875p

483p

0.8

Llloyds

272p

45p

0.7

RBS

5260p

146p

0.4

How do financial companies make money

My early statement about measuring a financial’s value on ‘free cashflow’ isn’t strictly comparable to other types of company in that whilst most companies produce a product and sell it, financials do not. A bank will raise capital and lend it to customers with a premium built in (interest) and be repaid over time. An insurer will offer to cover a future liability in return for either a one-off payment or a series of premiums – if the event doesn’t happen, they keep the money, if not, they usually incur a huge loss on the account.

As such, the ‘book value’ represents the expected future value of these loans providing everything is repaid or the event doesn’t happen. The companies will make certain allowances for bad debt and after that it’s basically a case of hoping too many defaults don’t occur at once. If the company can consistently grow it’s book value, then over time it should become more valuable – providing that it doesn’t sacrifice the quality of its customers to do so.

Banks also make money from the ‘spread’ between the cost of raising money and what rate they can lend it to customers. Since 2008, interest rates around the world have been pretty much non-existent (if not negative) and so this spread has collapsed. I see absolutely no reason that this is likely to change in the mid-term; I remember telling my Grandmother in 2015 that we were unlikely to see interest rate rises until 2020 and now even that looks optimistic.

How to value a financial company

In a nutshell, this is the crux of the problem – how confident are you that the company’s ‘assets’ are actually worth what they’re telling you? If a bank lends a customer £100m for a retail development that can’t be rented out, what is it actually worth? If the company defaults and the bank assumes ownership of the development, how much could it really get? A 20% discount would still be £80m – and this is for a development that has no income – what about £50m, £20m? What price would someone be willing to take on the risk of never finding tenants?

How about an insurer? Let’s say they sell a £1,500 a year home insurance policy to a customer called Mr. Liability. One day, Mr Liability’s house is flooded and then collapses. He calls up the insurer and makes a claim for full compensation included reconstruction of his home. The insurer originally estimated that this would cost £1.5m but due to the flooding, specialist groundworks are required and the eventual cost runs to more than £2m. Now imagine that the same insurer has insured everyone in Mr. Liability’s town – they all claim, and so the insurer is suddenly hit for an enormous payout which is more than they had prepared for. As a result, they have insufficient cash to make the payments and need to raise more from shareholders, take out a loan – or if they can’t, then collapse.

How can you go about valuing such a company? In my opinion, unless you’re an industry expert (and there aren’t actually that many around), then you have very, very little chance of doing it and are completely reliant on the company’s analysts, brokers, and risk managers to ensure that such an event doesn’t occur.

Likewise, if interest rates continue to stay low and debt continues to balloon, what are the odds of financiers being ‘cautious’ and only lending to the most credit-worthy? How else can they grow their earnings other than to reduce their lending criteria. Of course, they’ll mask this behind lovely annual reports talking about how conservative and careful they are, but the reality could well be a lot nastier and totally invisible. As has been said before “it’s all fine…until it isn’t”.

Conclusion

Having said all that, I do actually invest in financial companies myself including insurers and banks – I’m just careful about the ones I pick and generally avoid ‘leaping’ at what initially appear to be ludicrously low valuations. I’m keen to see growth in the book value – but not too much, and I’m very cautious about dividend cover and capital structure.

I won’t invest in any financial that which is issuing new shares regularly, which has a declining book value per share, negative revenues or earnings per share, rapidly growing debt, or a weak return on equity. This immediately eliminates a lot of the weaker companies in the sector but even those that remain on my watch list are carefully reviewed before I make the decision to invest.