Protection Against a Dangerous Enemy

By Vitaliy Katsenelson, CFA

February 15, 2005 – Motley Fool

A few nights ago I was awakened by my two and a half year old son Jonah at two o'clock in the morning. He was whimpering and crying out for us to pick him up and bring him into our bed. We succumbed.

For the next couple of hours my dear wife and I would receive the occasional kick in the stomach, or elbow to our eyes, ears, and other vital body parts. Oddly enough, this experience made me realize that investing is often not very different from parenting.

Let me explain. As tired, sleep-deprived parents, my wife and I made an emotional decision about a year and a half ago. We gave into Jonah's cries and acted on our emotions by bringing him into our bed in the middle of the night. The harder, more logical route would have been to calm him down and let him fall asleep on his own, in his own bed. If we had done that, we would have been enjoying eight hours of uninterrupted sleep for the last 18 months, and Jonah would've gained the security to sleep on his own.

Clearly, emotions are a large part of both parenting and investing. Unfortunately, emotions often cloud our judgment and steer us toward making erroneous and irrational decisions. Emotions are a far more dangerous enemy to investors than anything Elliot Spitzer has unearthed. Emotional decisions are worrisome because they are usually made to satisfy an emotion that is short-term in nature. In the absence of emotions, the decision often would have taken into account the long-term consequences and therefore, would have been different.

For example, emotions were responsible for investors suddenly waking up after the tech meltdown, and finding that "boring" blue-chip stocks like Wal-Mart(NYSE: WMT) and Coca-Cola(NYSE: KO) had been replaced by exciting, but now considerably less valuable stocks like Sun Microsystems(Nasdaq: SUNW) and JDS Uniphase(Nasdaq: JDSU). As recent history instructs, emotions lead us to buy stocks like there is no tomorrow during a bull market and dump them during a market decline; these are not the actions of a rational investor.

A very effective way to maintain rationality and fight off the desire to act on emotions is to create rules of engagement for your portfolio: an investment policy. An investment policy doesn't need to be very formal, but it helps to have it written down, since it is easy to forget your plans from even a week ago, let alone a year or two ago. An investment policy should be created at a time of emotional tranquility. It should spell out your investment goals and specifically define the strategy for achieving them. Asking the following questions can help you create a simple investment policy:

• What is the purpose of investing (retirement, college, larger boat)?
• How much money is needed to achieve these desired goals?
• What rate return will be required to achieve these desired goals?
• What is a tolerable level of risk?
• What asset allocation will produce a required rate of return and still fall into the comfort zone of risk tolerance?
• How often will the portfolio be reviewed and rebalanced? (It should not be more than twice a year.)

Once an investment policy is created, it should be looked at as an investment constitution. Not unlike the Constitution of the United States, amendments should not be made on a whim and should require considerable deliberation and the input of trusted and involved advisors, friends, or relatives.

An investment policy is the unemotional "you," made at a time when you were thinking clearly and rationally. An investment policy will provide you peace of mind. No matter how volatile markets become, you will have a lucid strategy for rational decision-making.

Being emotional is part of being human. Finding a way to make rational decisions under emotional pressure is what makes us good parents and successful investors.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He owns no shares of any stocks mentioned above. The Motley Fool has a disclosure policy.Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

The Future of Corporate Profits

 

Why Are Bank P/Es So Low?

February 10, 2006 - Motley Fool

By Vitaliy Katsenelson, CFA

Investing in the stock market is a never-ending learning experience. That's what makes it so appealing and intellectually stimulating. And I inadvertently had one of those live-and-learn experiences just the other day.

In my piece on Lloyds TSB(NYSE: LYG), I wrote that banks usually trade at lower price-to-earnings ratios to the market because they are considered riskier investments as a result of their high use of debt. That line caught the eye of Foolish financial editor Joey Khattab, who asked writers Stephen Simpson and Nate Parmelee whether they agreed with my logic. Both disagreed. They argued that larger banks have lower P/Es generally because they are perceived to have a slower or more limited growth potential.

At first, I thought there might be a conspiracy of Fools at work against me! So I asked several investment professionals for their opinion. And to my amazement, they all agreed with the Fools.

So I looked at some larger banks to see whether they had been slozw growers in the past, and I couldn't reach that conclusion. Many of these banks, in fact, had achieved very respectable earnings growth and paid above-average dividends in the process. I then looked at expectations for future earnings growth, and they appeared not to be below average, either. With the exception of Fifth Third(Nasdaq: FITB), which Wall Street once loved to love and now loves to hate, the rest of the pack was trading at a substantial discount to the market and still are.

(to see table please click here)

The answer must be more complex than just the growth rates. I believe the answer to banks' lower P/Es lies in the following four factors.

1. Cyclicality The banking business is closely tied to the health of the economy. As the economy expands, demand for loans increases and bad debt declines -- a combination that improves banks' profitability. In a contracting economy, of course, the reverse takes place.

Because investors pay up for predictability, they rarely pay a full market multiple for the volatility that comes with cyclical companies. Cyclical heavy-industrial companies like Caterpillar and Ingersoll Rand, for example, usually trade below the market P/E just as a many banks do.

2. Financial leverage We have not had a bank crisis in the U.S. for a while, so most investors have forgotten just how risky banks can be. But as Warren Buffett has said, by the time you find out a bank has a problem, it will be too late. The equity at most banks stands at meager 6%-10% of total assets, so when a bank does make a mistake, its high leverage amplifies the problem.

3. Interest rate volatility Banks are subject to the risks that come with changing interest rates. They prosper when the difference between long-term and short-term rates -- in other words, the interest rate spread -- is high. However, when that spread narrows, it becomes increasingly difficult for banks to make any money. Many banks have addressed the problem by boosting their fee businesses. For example, fees account for a full 46% of U.S. Bancorp's income, thereby making the company less susceptible to swings in interest rates.

4. Complexity of financials I could teach my 4-year-old son to analyze retailers' financials in about 20 minutes, if I could get him to sit and concentrate for that long. OK, maybe I'll have to wait a couple of years. But the point is, retailers' financials are very easy to understand. A quick look at the income statement and a glance at the balance sheet (especially the part that focuses on inventories) will very quickly tell you what happened during a retailer's quarter.

Banks and insurance companies, on the other hand, are very different animals. Where analyzing a retailer is like playing checkers, analyzing a bank is akin playing two-dimensional chess. (I'll save the 3-D chess analogy for insurance companies; their financials are even more complex than banks' are.) Investors need to look at financial statements and at dozens of other sources to assess a bank's true performance. And that's a problem, since investors tend to embrace simplicity and shy away from complexity.

To make things even worse, banks' financials are riddled with assumptions. Although all companies have to make some amount of assumptions in their financials, the complexity and magnitude of those assumptions increase exponentially with banks. Consider, for example, that it's not uncommon for a high-growth bank to have its expected credit losses understated because of the immaturity of its portfolio (in other words, new loans have not matured yet). However, as growth decelerates and large portion of the loans matures, credit losses may skyrocket beyond the estimated provisions.

The quality of growth The very size of large banks often gets in the way of their ability to continue producing high-percentage growth. Instead, the bulk of growth for large banks comes from acquisitions. An acquirer is able to fold most of the acquired bank's operations into its existing infrastructure, which, in turn, results in huge cost savings and, of course, higher earnings.

That sounds great on paper. However, acquisitions come with risks, including integration challenges. Bank One (now part of JP Morgan Chase) learned about that problem firsthand when it acquired First USA. Soon after the acquisition, Bank One ran into huge problems with the incompatibility of the combined companies' computer systems, and the stock tumbled as a result. Regions Financial had similar integration problems after making successful acquisitions for a long time. To sustain its growth, it eventually had to start marking larger and larger acquisitions, and that's when the problems began.

In addition to the integration risks, bank executives' egos and their attendant desires to manage bigger and bigger (though not necessarily better) empires often get in the way of common sense. Ultimately, the acquirer overpays for the acquired.

Still, despite all of the potential pitfalls, acquisitions have been the main source of EPS growth for most large banks. In fact, I can't think of a large bank that became large by way of organic growth. Not one!

Bottom line Growth by acquisition is much riskier and usually more expensive than organic growth is. Investors recognize that risk, and thus they put a lot less value on large banks' growth. So, to a large degree, Joey, Stephen, and Nate were right: Slow organic growth is, in part, responsible for banks' below-market valuations. However, I believe that higher risk caused by cyclicality, high financial leverage, and the complexity of financials contributes to the lower P/E as well.

Motley Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He owns shares of Lloyds TSB, and his company has positions in U.S. Bancorp, Lloyds TSB, Wells Fargo, Citigroup, Bank of America, Amsouth, Regions, and JPMorgan. The Motley Fool has a disclosure policy.

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

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