Upside Down Financials
Value investors like strong companies that are selling at a discount to intrinsic value. Increasingly, financials have been looked at as a potential value play because they have been sold so heavily in the aftermath of the financial crisis. Shares of Citigroup Inc. (NYSE:C), for example, are down over 93% since October 2007. Following a relatively stable 2010, big bank stocks have been hammered again this year. The SPDR KBW Bank (ARCA:KBE) is off about 25% year to date. There's been a whole laundry list of reasons for the recent downtrend, including slowing global growth expectations, European banking contagion and damaging litigation relating to housing securities.
As a result of the selling pressure on banks, stock prices are no longer aligned with asset value. Look at Bank of America Corp (NYSE:BAC), which has been one of the most heavily sold financials this year. At the same time, regulators have forced banks to aggressively recapitalize through new standards like Basel III. While restructuring its business lines, Bank of America has accumulated roughly $140 billion in cash. Tangible common equity (book value) stands at roughly $125 billion. Yet the market cap of this company is $67 billion. That's an upside down relationship. Normally, market cap is greater than book value, and book value is greater than cash on hand.
Logically speaking, Bank of America's stock price should rise to reflect the capital position, or the cash on the balance sheet at the very least. The fact that the market is not bidding up Bank of America, to reflect the capital on hand, suggests the cash does not cover all of the looming liabilities. Clearly, the market is stating that legal claims, particularly those related to the disastrous Countrywide Financial acquisition, will eat up all of the cash on the balance sheet. (For more on Contrywide and Bank of America, check out Can Bank Of America Dispose Of Countrywide?)
Citigroup is in the same position. Citigroup has about $186 billion in cash on the balance sheet, and another $170 billion in government backed securities. Yet, the market capitalization of the company is roughly $92 billion. The stock is selling at a steep discount to book value. Apparently, the cash that these banks hold is not worth the paper it is printed on.
The Bottom Line
The banking sector is an extremely risky play for retail investors, as I noted back on August 19 in this article concerning European banks. One of those Euro bank stocks, Societe Generale (OTCBB:SCGLY), is down a staggering 14% since then.
The American banking system is in a much better condition than Europe. Capital as a percentage of assets of American banks has never been higher, and liquidity positions are terrific. But, the market is reflecting a massive risk premium for these banks in the current operating environment. Even Goldman Sachs Group, Inc. (NYSE:GS), which is widely considered the gold standard of the financial services industry, posted a loss for just the second time in their history as a public company last quarter. Goldman lost $428 million as investment banking revenues fell, and private equity investments and fixed income trading securities were marked down sharply.
Banks are still working to move a ton of bad loans off their balance sheets, and litigation issues are keeping stock prices of Bank of America and Citigroup from reflecting cash or book value. These banks will continue to get a heavy risk and conglomerate discount. Retail investors should avoid these stocks for now.