Financial Follies Part Deux

July 2, 2008

The following excerpt from “The Lancz Letter” features some of our commentary from June 2007, when we were recommending taking profits while the stock market surged, as well as our updated commentary from July, 2008.

One year ago in our “Investors Wake Up to Risk” issue, we followed our initial warnings concerning real estate and the financials from four weeks prior with the following:

“The financial sector comprises over 20% of the S&P 500 and any further fall-out in the sub-prime arena will definitely have a dramatic and immediate impact in the financials as well as the overall market.”
The Lancz Letter – June 27, 2007

At the time, the overwhelming consensus opinion was that sub-prime was such a minute part of the overall economy that its overall effects would be immaterial. Last summer our research appeared on at least a dozen separate occasions in the national media warning about the ripple effects that sub-prime will create on a global basis. We have to admit that 13 months after our words of warning, these “ripple” effects have been even greater than what we feared. Part of the problem is with the management of these financial institutions. Rather than immediately acknowledge the potential negative developments and be proactive in raising necessary capital and reducing expenses, most bank executives totally underestimated the problem or worse yet, totally ignored it. Fifth Third Bank actually increased their dividend early last summer, showing a total disregard toward the financial environment unfolding around them. Last month, in an all too typical reactive move, Fifth Third raised capital after the stock had already plunged toward single digits and – oh yes, you guessed it – dramatically cut the dividend they recently raised. Last year they could have easily raised capital from a position of strength rather than the dilutive moves many banks are currently pursuing. We do not mean to single out Fifth Third, because so many financial institutions failed to act. Unfortunately this failure to act will extend and broaden the ripple effects from this credit crisis, which means that investors should continue to maintain a very selective, cautious approach. Rising energy and food costs, the negative wealth effect and plunging consumer confidence all will provide difficult headwinds for equities.

Last issue we discussed the problems within the financial sector and explained why we are still avoiding it, or are dramatically underweight in the sector. It is not just those transparency issues that bothered us from day one in trying to value their underlying assets, but similar to tech back at the start of this decade many banks and brokerage firms have lost much of their earnings leverage that was a critical component to their previous escalated valuations. Those high margined products and services that fueled the unprecedented opening of the liquidity spigots are gone for good. In addition, many areas of the country are still going to experience significantly lower real estate prices that have yet to be adjusted on bank balance sheets. In the United States alone there is over $1 trillion of outstanding home equity loans and as homeowners fall to negative equity, these loans hit the lenders by immediately turning to unsecured from secured loans. When you combine this with the disturbing trend of growing vacancies in commercial real estate and heavy exposure in unsecured construction loans, it is no wonder investors are finally taking our words of warning to heart, even though it may have been a much procrastinated response! In addition, banks do not have nearly the loan-loss reserves that they enjoyed before accounting rules changes after the Enron scandal. This leads us to believe that it will take at least 2 – 3 more quarters before the financial clouds begin to lift and a total assessment of the damage can be made.

Many investors were surprised that we were still not even a tad more favorable toward the financials after their 12 month plunge with our updated assessment last issue. At the time two of the largest banks based in Ohio, Fifth Third and Key Bank, both were trading at over $18 a share in early June only to plunge to the $10 a share level just two weeks later. National City had already plunged from over $18 a share on Feb. 1st to $5 a share by the middle of May. There will be opportunities in financials as the markets always work to extremes in both directions. It is just a matter of being selective and buy 1/3 of a typical position now and another 1/3 into further weakness the second half of 2008 (our initial recommendations were made in mid-March, with Goldman Sachs below $150 a share).

Taking advantage of these extremes, especially when it comes to profit taking and lowering (high) valuation exposure, is an excellent, low risk way to enhance performance versus the typical passive index investing. Rather than ride a 24% financial exposure all the way down for nearly 13 consecutive months, avoiding the carnage not only reduced investor’s risk when valuations were high but also was a critical component in overall out-performance. When you can reduce risk and improve long term performance, you have the best of both worlds but investors must be proactive to take advantage of such extremes and volatility. Once again, following the herd and chasing the much-loved financials one year ago proved to be a tough lesson for the average investor to learn.

One Year Ago:
“On June 1 (2007) when the U.S. markets hit another all time high in the D.J.I.A. and a seven year high in the S&P 500, we were questioned (on CNBC) why we are recommending taking profits when the U.S. market looks so resilient. We stated that at times like these (when investors are looking at the glass half full) investors have to be particularly careful.”


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