Investors must focus on different attributes of companies at different times in the market. In normal times, capital adequacy is not at the forefront of bank analysis for most stock investors. Profits and profits growth are more often the focus. However, in these troubled credit market times, solvency measures are or should be the first line of review.

It’s not that we expect banks to go out of business, although some might have to be absorbed by others. The concern is that as bank capital withers and risky assets remain the same or grow, the ability of a bank to operate becomes more and more limited. That in turn impacts future profits and can cause some troublesome situations — such as dilutive new equity issues, dividend cuts, selling off of strategic operations, and nasty stock price declines.

We don’t think the worst is yet behind us. The fourth quarter will probably be worse than the prior quarters this year. We don’t have the statistics on how much more loss reserves will be required, but we do know something about human nature.

CEO’s will want to start 2008 with as clean a balance sheet as possible. That means they will probably be quite aggressive in reserving for losses in the fourth quarter. With that in mind, we reviewed the most recent 10-Q filing of the 24 banks in the Keefe Bruyette & Woods large bank index to see what capital adequacy ratios they have.

On the belief that those that were in the best shape as of September 30 will probably be in the best shape as of December 31, and that those in the worst shape will probably remain in the worst shape, we made the following selection of Best and Worst Banks.

The Best are Bank of America (BAC), US Bancorp (USB) and BB&T (BBT). The Worst are Washington Mutual (WM), National City (NCC) and Citigroup (C).

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Of course, if some banks have been holding back on reserving, the lineup could change.

We made our choice by recording the two key capital adequacy ratios reported by all the banks (Tier 1 and Total) and identified the three Worst and three Best of the 24 banks from that data, plus yield data. The Worst were identified purely on below average capital adequacy. The Best were those with above average capital adequacy and with the highest dividend yields.

Yield is helpful to pay you while you wait for down and out value stocks to be recognized and revalued by the market.

We recommend selling any of the Worst you own; however we do not recommend buying any of the Best at this time. We think a better time to buy the Best would be sometime after the fourth quarter results. We will make a decision then about whether enough of the damage is behind us to take bank positions.

If you don’t want to concern yourself with selection and want diversification, we would recommend the State Street KBW Large Bank index ETF (KBE) which has 24 large banks (including the Best and Worst). That too should be considered for investment after the fourth quarter.

Be patient and banks will present a nice opportunity.

Richard Shaw
QVM Group LLC

Disclosure: Author does not have a position in any of the named securities.

Whatever happened to women and children first?  The Directors and Executives of Washington Mutual (WM) recently exhibited a level of self-interest and insensitivity to the interests of their shareholders that reflects quite badly on them.

WaMu is in the worst shape of the large banks.  Their capital adequacy ratios (Tier 1 and Total) are both below average.  Their Tier 1 ratio is at the bottom of the 24 large banks in the Keefe Bruyette Woods large bank index.

Their stock is down about 55% for the year.  Their dividend (currently yielding over 12%) is in question due the possibility of having to raise money to restore capital adequacy.

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The fourth quarter is likely to bring more unpleasant mortgage write-off news for them and other banks due to pending variable rate mortgage resets and the desire of managements to get as much of the bad news out before beginning the new year of 2008.

Why then don’t the Directors and Executives of WaMu put their compensation at risk as they have risked shareholder wealth?  Instead of standing up take their medicine for the lending decisions they made with our investor money, they have changed the deferred compensation plan to allow executives to withdraw lump sum assets in July of 2008.

Oh, sure they have some risk for the next 7 months, but the full consequences of the mortgage crisis may not mature that rapidly.  Instead of the captain and crew helping the passengers to their life boats, the captain and crew are pushing to the front of the line to get to the life boats first.  Shame on them.

Here is the text of their November 15 SEC 8-K filing.  Judge for yourself if there is any reason to continue to have faith in management at WaMu.  If we were you, we’d fight our way past the captain and crew and get off this boat now.

“Item 5.02 Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers.
As provided for in transition rules under Section 409A of the Internal Revenue Code, the Human Resources Committee of the Board of Directors of Washington Mutual, Inc. (the “Company”) approved the amendment of the Company’s Deferred Compensation Plan (the “Plan”) to allow Plan participants, including the Company’s executive officers, to make a one-time election before December 31, 2007 to receive distributions of their Plan balances commencing in July 2008. Under the amendment, a participant may elect that all or a portion of his or her account be distributed in a lump sum in July 2008, or in annual installment payments for a payment period of up to ten years.”

What an incredibly bold, audacious and anti-stakeholder act on the part of the WaMu Directors and Executives. WaMu is in need of capital and should not be increasing outflows to management. 

It is quite alarming that management feels the need to protect their deferred compensation by taking it now instead of later as was the original plan design.   Why do you think management is in such a hurry to take out their cash in the midst of a credit crisis and a plummeting company stock price?

What’s next, stay bonuses and stock option strike price resets? 

Of course don’t forget the bonuses paid for the production in the past that is the cause of the problem today, to be followed most likely by future bonuses for curing the problem caused by the production.

There is something terribly wrong with the misalignment of shareholder (owner) interests and management (employee) interests these days.  This example at WaMu is just that, an example – one of far too many examples.  We hope institutional investors (or class action attorneys) who have the muscle would figure out a way to force realignment of the interests of those who own and those who manage public companies.

WaMu could be a real home run for investors who go in now with the possibility of price recovery and a handsome dividend, even if it is cut in half, but the risk is quite high.

Even for a high risk betting person, it would be better to wait until after the fourth quarter to see how much worse mortgage losses may become for WaMu (and other banks as well) before committing funds.

If you own it, sell it now!

Richard Shaw
QVM Group LLC

Disclosure:  Author is a former WM shareholder

Fundamental investors seek stocks at or below “Fair Value”. That is the sensible thing to do. Buying companies at or below their worth is one of the best ways to limit risk, which is key to investment survival and prosperity.

Once you get past the conceptual agreement about fair value driven investing, you hit a wall. There is no fixed definition of fair value. People have different views on the matter.

In the short-term, the market will price stocks any way it pleases, seemingly without regard to value. In the long-term, however, the market will tend to find value price points.

Some stocks start overvalued and seem to stay there forever, until they decide to crash back to earth. Some stocks seem to be wonderful values, but have been in the basement forever with seemingly unrecognized value.

Nonetheless, we prefer to risk being wrong or early seeking fundamentally undervalued stocks than being wrong or late on momentum stocks.

By adding dividend yield to the value selection process, you can also get paid to wait for the market to come around to seeing fundamental value.

To a certain degree changes in market prices are driven by changes in expectations about future results. In terms of risk management, we think it is a safer place to be with fundamentally sound stocks for which the market has low expectations than with high expectation stocks. Disappointments cause stock prices to be punished. High expectation (momentum) stocks may have more risk of disappointment than low expectation (value) stocks.

Three popular independent services that provide opinions on value are Standard & Poor’s, Value Line and Morningstar.

To illustrate the problem associated with relying on one service or the other for fair value, consider this experiment comparing fair value calculations by Standard & Poor’s and Morningstar on the 30 stocks in the Dow Jones Industrial average (ETF symbol: DIA) as of November 19.

Morningstar assigned significantly higher fair value to Proctor and Gamble (PG), American Express (AXP) and Verizon (VZ) than did Standard and Poor’s. Standard and Poor’s assigned significantly higher fair value to Merck (MRK), Hewlett Packard (HPQ) and AT&T (T) than did Morningstar.

In 12 of the 30 stocks, Morningstar and Standard & Poor’s were in disagreement as to whether the fair value was higher of lower than the market price.

In only 8 of the 30 stocks did Standard and Poor’s come within 10% of each other on the fair value they assigned.

Clearly, fair value is not science. Value like beauty may be in the eyes of the beholder. At best, it is an art.

When you read a financial article where an expert says that some stock is worth this or that, keep this experiment in mind. Opinions on value can be are all over the lot.

In spite of the problems finding consistency in value opinions, we believe that finding out what others think about fair value is useful, however it should not be relied upon blindly. Treat fair value opinions from others as a tool to help narrow your own research. Look into the fundamental investment prospects of each stock on your own before committing funds.

To do your own fundamental screening, a good place to obtain a comprehensive and reasonably priced data set for fundamental information is the American Association of Individual Investors. With lesser detail or customization potential, your broker-dealer may provide effective value screening tools.

In the end, nothing beats careful study of the 10-K and 10-Q SEC filings for companies that make your short list — and don’t forget to read the footnotes which can shed important light on the financial statements.

Good hunting!

Richard Shaw
QVM Group LLC