Banks have had a rough time lately and the market performance of their stocks reflect that. Now that Secretary Paulson and some others are calling a bottom for the financial crisis, it is timely to look at the Keefe Bruyette & Woods Large Bank Index and the ETF that tracks it (KBE).

Technicals:

The five-year chart shows the KBW index (BKX in black) versus the S&P 500 (proxy SPY in gold). The BKX 200-day average is shown in blue and the 50-day average is shown in violet.

The YTD chart shows the KBW large bank ETF (proxy KBE in blue) versus the S&P 500 (proxy SPY in red).

The KBE candlestick chart provides alternative detail of the YTD performance of KBE alone, along with its 200-day and 50-day day moving averages.

KBE has massively underperformed the S&P 500. As of May 8, 2008, KBE is down 33% from its high on February 15, 2007, whereas SPY is down only 4%. Year-to-date, KBE is down 8% and SPY is down 5%.

On a year-to-date basis, KBE is not diverging so much from SPY and is showing some signs of a flattening pattern, and possibly some support. Technical support, however, is not the same as a bottom. The YTD KBE candlestick chart more clearly shows the support and possible bottom forming pattern.

Some Risk Issues:

Clearly, more bad news is possible, even likely, but markets may have already anticipated that news — such as construction mortgage write-downs and credit card write-downs.

Banks are also subject to spread risk when interest rates reverse and begin to combat the inflation that is popping up all around us. When that will happen is uncertain, and it may not happen until banks have financially recovered from the credit problem they face now.

The residential real estate market and its impact on banks and on the economy in general is a continuing wild card.

Share earnings dilution is a potential serious investment return risk depending on how many banks raise private capital, and how they structure and price it.

As is the case with any sector fund, it is narrowly focused and concentrated. It is diversified enough for issue specific risks to be diluted, but because all the holdings are in a similar business, they are all essentially subject to the same catalysts and drivers to decline, as well as to rise.

Some Positive Fundamentals:

The fund itself has a low expense ratio (35 basis points).

The holdings are generally high quality banking institutions (some exceptions to quality noted), but overall a high quality large-cap portfolio.

The aggregate price-to-book of the portfolio is about 1.2 compared to a 5-year average of just under 2 (a 40% discount to the norm).

The trailing dividend yield is over 6%. That’s way above normal.

Most of those that need to cut dividends may have already done so, with the exception of Citigroup.

Assuming the aggregate Dollar amount of the dividends does not deteriorate substantially, the yield will normalize perhaps in the 4% range. That would generate a 50% price increase — putting the banks back at approximately the prices they sported before they cracked.

Our Portfolio:

This year, we added KBE to our portfolio and to some aggressive client portfolios. We did that because we believe that large US banks will survive, will recover and are paying substantial dividend yields to compensate us to wait for recovery.

With KBE paying a trailing twelve-month yield over 6%, taxed favorably (at least for now), we can afford to wait a long-time for conditions to be restored to normal. We also believe that a material portion of the write-downs that have been made, will become write-ups later. That will happen when liquidity is better and bids on marketable securities rise as investor confidence causes them to require less risk premium.

If more bad news pushes prices down further, we will probably increase our holdings somewhat more. Our current portfolio is about 20% overweight in financials, principally banks — mostly through KBE.

Our approach is on the edge of opportunity or loss. The May letter from Bill Gross of PIMCO describes them as seeking to implement the current stage of their plan to “Reinvest in high-quality financial institutions which suffer capital impairment during the anticipated recession.” He points out that if the house prices are ready to stabilize due to all that has been done, the “reinvestment” will produce gains. He also states that if the house prices continue to fall, the resulting generalized asset deflation that could result would make reinvestment in financial institutions unprofitable.

Consistent with his equivocation, we have split the baby and have reinvested about 1/2 of our funds allocated to banks, and hold about 1/2 of that allocation in cash for now.

Volatility:

The volatility of investment in banks is substantial, as the RiskGrades (Risk Metrics trademark) shows:

KBE is about twice as volatile as SPY and six times as volatile as AGG (tracks Lehman US Aggregate Bond index).

It is not for the faint of heart, and shouldn’t be a large part of the portfolio of any but the few who make large concentrated bets with both intention and conviction — and who are ready for the financial consequences if they are wrong.

From a risk management perspective in a dynamic asset allocation portfolio, sectors such as financials, should only be over-weighted or under-weighted in some reasonable relationship to the weight they have in the larger multi-sector index of which they are a part; and within the overall asset class target weights for the portfolio.

Earnings and Dividends:

Earnings of banks have been cut and some have reduced their dividends.

An indication of how secure the current dividend rates are can be glimpsed by comparing current year (2008) and next year (2009) earnings estimates to see if recovery is expected. Also useful, is a calculation of the payout ratio (dividend to earnings) for the current year and next year, based on the current dividend rate.

The KBE holdings table shows the Standard & Poor’s earnings estimates, and our calculation of current and pro forma payout ratios, for the 24 banks in the KBW Large Bank index.

We have highlighted those banks with payout ratios above 70% (no magic there, just an arbitrary threshold) to see which banks might feel squeezed, or that might not have adequate earnings to maintain their dividend.

Based on S&P estimates, the future doesn’t look that bad. Most of the banks (16 of 24) are projected to have rising earnings in 2009, not declines. Most of the banks (16 of 24) are projected to have payout ratios of 70% or less. And, at least two stinkers (about 10% of the banks) have already cut their dividends to near zero and several have already raised additional capital. There may be more pain ahead, but certainly a lot of the pain is also behind us.

Bottoms versus Good Enough:

We wish we knew how to reliably call bottoms. We don’t know how to do that. However, we do have the ability to know when a fundamental situation is good enough for us to take a long-term position.

A 6+% yield to hold the largest US banks, which we expect to produce at least a 50% capital over the next several years, is good enough.

We would rather take this good enough opportunity and then find that we could have gotten an even better opportunity by waiting, than to wait and miss the opportunity altogether.

With a long-term stock market average return in the 8% to 10% range, we are happy to get 6% in cash and the rest in capital gains later.

We are not traders, we are value investors, with a bias in favor of yield. Calling reversals is not essential. Finding value that is good enough is essential.

Richard Shaw
QVM Group LLC

[securities mentioned in the article:
KBE SPY AGG BAC BBT BK C CMA COF FITB HBAN JPM KEY MI MTB NCC NTRS PBCT PNC RF STI STT USB WB WFC WM ZION ]

We believe that executives at Washington Mutual don’t do right by their shareholders.

They made bad business decisions by loading up on subprime loans.

When the losses flooded in and the stock plummeted about 75%, they changed the terms of the deferred compensation plan to allow employees (read most of the money was for executives) to take a one-time cash out of the money before 12/31/2007 (note that deferred comp is subject to general creditors of a company). [see our Nov. 25, 2007 article on that -- stock price $18.21]

Then they modified executive bonus plans to reduce consideration of losses due to the bad loans from the ill-conceived subprime strategy that caused the stock to plummet [see our Mar. 5, 2008 article on that -- stock price $12.80]

Then they cut the dividend to shareholders from $0.56 to $0.15. Again no direct pain for executive compensation.

Now they have sold $2 billion of new issue shares to an investor group at $8.75 per share when the market closed the prior day at $13.15; and sold $5 billion of convertible debt that surely has a conversion price that will create a strong resistance price level until the bonds are all converted. And they virtually eliminated the dividend, dropping it to $0.01 per share.

So — capital losses for regular shareholders and a virtual total loss of dividend income from regular shareholders, but no rights offering of shares and convertible bonds to regular shareholders to recapitalize the company at the huge discount offered to an investor group.

Yes, the new investors are shareholders now too. They are taking big chances; but what about the pre-existing shareholders? Shouldn’t they have been given the same opportunity in a rights offering? That would have taken some time, but they have had the last several months to ponder their capital needs.

Yes, this cash infusion is important to survive the company, and we expect the new shareholders will exert strong influence and cause more economically rational management decisions.

However, was it really necessary to leave the ordinary shareholder so completely in the cold? Was it “fair” to enrich executives to implement terribly flawed lending plans, and then protect their deferred comp and bonuses after the crisis nearly killed the company? Was it “fair” to recapitalize the company without any offer to existing shareholders to participate? Was if “fair” to eliminate the dividend for pre-existing shareholders, while issuing interest paying convertible debt to the new investors who have the equity upside too?

What a horrible situation. What an unfortunate example of how companies shouldn’t treat their shareholders.

The shares are trading at about $11.60 to $11.85 right now a few hours after the announcement. Will the new capital cause shareholders to see new value and stabilize or increase the price — or will shareholders react to being $3.00 above the new issue shares and being capped by the conversion price of the bond by trading down?

Institutions are probably mostly out if they plan to be out. Speculators are probably a bigger portion of the shareholder base than normal. The news will be digested by a wider audience tonight and tomorrow will probably tell much of the story — thumbs up or thumbs down. It is not at all clear which way this move will push the chart.

New capital for a bank is good news for the market. A deal like this may be frustrating to investors who may see a major flat spot in the price future, or they may see a bright new future from a low point.

We’re short WM. Time will tell. It could go either way.

The 10-day, hourly chart below tells some of the story.

The stock was anticipating something yesterday, but was somewhat disappointed today — not to the extent that it was unhappy the day before yesterday.

This is the news as reported today by Bloomberg:

“April 8 (Bloomberg) — Washington Mutual Inc., the largest U.S. savings and loan, got $7 billion from a group of investors led by David Bonderman’s TPG Inc. after losses on subprime loans ate up capital and erased 74 percent of its market value.

Washington Mutual sold 176 million shares at $8.75 a piece, 33 percent below yesterday’s closing price on the New York Stock Exchange, and $5.5 billion in convertible preferred shares, the company said in a statement today. TPG will buy $2 billion of the shares. The lender also slashed its dividend and announced 3,000 job cuts. The stock fell as much as 13 percent.

Chief Executive Officer Kerry Killinger, struggling to reassure investors the bank has enough capital to stay afloat, said the dividend cut will preserve $490 million annually.

“When a firm has to double its shares outstanding and yet still be under credit-quality pressure, it’s not a particularly comforting move,” said Sean Egan, managing director of Egan- Jones Rating Co. in Haverford, Pennsylvania.

Washington Mutual will stop making loans through mortgage brokers and close its home loan offices, while focusing on its 2,500 bank and small business lending offices. The unit that’s being closed, known in the trade as wholesale mortgage lending, contributed 40 percent of fourth-quarter originations, according to a slide presentation. …

The quarterly dividend was cut to 1 cent a share from 15 cents, the second time it’s been reduced since November 2007 when it was 56 cents.

The infusion, originally planned for $5 billion, was increased because of strong investor demand, according to Washington Mutual spokesman Derek Aney. …

“It’s dilutive for shareholders on a massive basis, so it’s not great for the company, but it’s great for the system that capital can be raised during these stressful times,” Vincent Farrell, a principal at New York-based Scotsman Capital Management LLC, said on Bloomberg Radio.”

Richard Shaw
QVM Group LLC