Signs of Topping in the Consumer Credit Cycle

Don’t bother counting me in the camp that thinks they can predict when the next recession will hit. The current consensus from those who try to do such things seems to be sometime in 2020, but I don’t think anybody really knows.

But that does not mean that keeping an eye out for economic signals is not worth doing. If the consumer credit cycle, for instance, is nearing a top, it very well may impact what multiple of current earnings you are willing to pay for shares of financial services companies. When you see strong return on equity metrics for full year 2018 this earnings reporting season, you might consider the notion that further expansion could be minimal.



In recent months I have come across a couple of interesting press reports that help shed some light on where we are in the current consumer credit cycle, both from the Wall Street Journal.

First, we had a piece in mid December about how credit reporting giant Experian was going to start including cell phone bills in credit reports. The goal is to boost credit scores so that lenders can widen their pool of eligible borrowers:

“Most lenders tightened standards dramatically after the 2008 financial crisis, and have been in intense competition for the most creditworthy borrowers ever since. And while most large banks have limited appetite for the subprime borrowers they lent to in the runup to the financial crisis, some have been eyeing customers with thin borrowing histories as a new revenue stream, a sign the lenders believe the good economy still has room to run.”

So rather than scare their investors and regulators by accepting lower credit scores when considering new borrowers, why don’t we ask the credit scoring bureaus to find ways to raise credit scores so that more people qualify. Yikes.

And cell phone bills are not the full extent of the changes. The article goes on:

“Fair Isaac Corp. , creator of the widely used FICO credit score, is close to launching a new credit score in partnership with Experian that will factor in consumers’ history managing their checking and savings accounts, which will give a boost to most consumers who keep at least several hundred dollars in their accounts and don’t overdraw.”

Given that the credit reporting companies get paid by the lenders, not consumers, it stands to reason that when approached by their customers to refine their scoring methodologies, they were amenable to the idea. Kind of reminds me of the scene in the movie The Big Short when the Standard and Poor’s employee explains why they rated all of those sub-prime mortgage bonds triple A; “because if we didn’t give them the ratings they wanted, they would go down the street to our competitor.”

The signs of a topping credit cycle don’t end there, unfortunately. It appears unconventional mortgage underwriting is making a comeback as well:

“Aryanna Hering didn’t have pay stubs or tax forms to document her income when she shopped around for a mortgage last year—a problem that made it tough for her to get a loan. But the nursing student who works part time providing home care for children and the elderly eventually hit pay dirt: For a roughly $610,000 home loan, a mortgage company let her verify her earnings with 12 months of bank statements and letters from clients. Ms. Hering said money she collects from roommates and from renting to Airbnb guests covers more than two-thirds of her roughly $4,300 in monthly payments, and her earnings cover the rest.”

While not a large proportion of the overall home lending pool, these types of loans are growing quickly:

“Lenders issued $34 billion of these unconventional mortgages in the first three quarters of 2018, a 24% increase from the same period a year earlier, according to Inside Mortgage Finance, an industry research group. While that makes up less than 3% of the $1.3 trillion of mortgage originations over that period, the growth is notable because it came as traditional home loans declined. Those originations fell 1.2% over the same period and were on track for a second down year in 2018.”

So what exactly were the terms of the loan Ms. Hering received? Tell me if this sounds familiar:

“Ms. Hering, who is 30 years old, received a loan at a rate of just over 6% for the first five years; it adjusts after that.”

Do these stories mean that the economy is about to collapse a la 2008? Of course not. All it means is that the business cycle is alive and well and that consumer lending has reached the point where prime borrowers have reached a level of debt they are happy with and lenders are now stretching a bit to grow. This happens every cycle, frankly. What it tells me is that delinquency rates are probably troughing out and overall credit quality and lender returns are probably peaking.

While these are important tidbits to consider when valuing financial services companies on multiples of book value or normalized return on equity, it is probably not going to help pinpoint the next recession. Leave that job to the economist community that has correctly called ten of the last five recessions, or the Federal Reserve, which has never (and will never) predicted one at all.

After Post-Election Euphoria, Big Banks Start To Look More Attractive After Sideways Action

I was underweighted bank stocks heading into the 2016 presidential election and proceeded to watch as they soared immediately following. I didn’t jump on the bandwagon because although the reasoning was solid (less regulation, higher interest rates) the stocks seemed to get way ahead of the actual fundamentals (in terms of timing). Below is a chart of the KBW bank index during that time:

 

 

 

 

 

 

As is often the case when upward moves appear a bit too steep, the stock have since leveled off and moved sideways for the last year or so. I have gotten more interested lately, not only because valuations are more attractive, but because the regulation relief is indeed occurring now and more normal levels of financial market volatility bode well for banks with exposure to the investment side of the business.

To figure out the best companies to focus on, I decided to see what the valuations today we saying about the profitability of the large banks, relative to the return on equity metrics posted for the first quarter, which is the first period where tax rates have come down to the new, lower level.

Oftentimes investors simply look at price-to-book ratios (the most common valuation metric for banks) and assume that the highest ones are fully valued and the lowest are most attractive. While this may be true sometimes, I am more interested in how the market is valuing these banks relative to their profitability outlook. To judge on that level, I prefer to see where price-to-book ratios are, versus where I think they should be based on each bank’s fundamentals. To do so, I look at return on equity and look for relative mismatches in the data.

Below are current metrics for six of the largest U.S. banks:

 

 

 

 

If we only look at price-to-book, we would want to buy Citigroup and short JP Morgan. But since JPM is a best better managed bank, and earns 50% more on its equity (15% vs 10%), those two banks should not trade at similar P/B ratios.

To balance out the data, I calculate what I call “Implied P/E” which tells us what valuation the market is pricing in, assuming current ROE’s remain constant. On this metric, we see that JPM is trading at 10.9x earnings (if they earn 15 cents for every $1 of equity, a P/E of 10 would equate to a price-to-book ratio of 1.50x). Similarly, Citi trades at 9.8x implied earnings.

All of the sudden, JPM doesn’t look as expensive relative to Citi. The price-to-book premium is 67%, but since their returns are different, the premium us really more like 11%. Framed that way, investors who might have balked before could very well decide they prefer JPM at ~11x earnings, to Citi at ~10x.

The chart above resulted in me being less interested in WFC, even though their recent troubles on the surface appeared to provide long-term investors a good entry point for the stock. Of the entire list, I would say GS and JPM are the best-run companies. To see GS at the top of the list on my preferred “implied P/E” metric really got my attention. Their long-term track record as a public company (since 1999) is quite impressive and as a result, I am quite intrigued by the stock at current prices.

Full Disclosure: Long shares of Goldman Sachs at the time of writing, but positions may change at any time without further notice.

Even After 30% Decline, Equifax Shares Not Cheap

It seems that data breaches are going to become the norm globally, if they have not already, so whenever a company is hit by hackers and the stock price declines as a result, I try to take a look and see if there are investment opportunities. The best example was Target several years ago, when hackers pierced the retailer’s in-store credit card scanners and stole customer payment data. While the media would have had you believe people were going to abandon the chain for life, after 6-12 months (and many more hacks of other companies), it was business as usual.

Equifax (EFX) might be a different animal given that they are in the business of collecting credit data, but most corporations do not seem to be much of a match for professional hackers. So while it is easy to argue that their security should have been stronger than Target’s, I am not so sure that a year from now Equifax’s business will be materially harmed. It is worth watching, however, since there are other data providers corporate clients can use.

What is interesting to me is that even after large drop (in recent weeks EFX shares have fallen from the low 140’s to today’s $103 level), the stock is not cheap. In fact, it appears it was quite overvalued leading up to the hack disclosure, making a 30% decline less enticing for value investors.

I went back and looked at Equifax’s historical valuations and found that the stock has ended the calendar year trading between 14x and 23x trailing free cash flow since 2010. I would say that 20x is a fair price for the company.  But pre-hack the shares had surged more than 20% year-to-date and fetched roughly 27x projected 2017 free cash flow. So at today’s prices they still are trading at the high end of recent historical trends at ~20x.

For investors who think this hack will come and go without permanently damaging the Equifax brand, the current price is a discount from recent levels but hardly a bargain. If you are like me and would want to see how financial results come in over the next 6-12 months (to see if customers are bailing), you would want a far better price if you were going to start building a long position now. And even when you felt comfortable with the long-term prospects of the business, the current price would hardly scream “buy” at you.

The stock seems to be acting well in recent days, which suggests many are taking the bullish view. While I don’t necessarily think that is the wrong move, recent history suggests the stock isn’t worth the $140+ it was trading at prior to the hack.

Full Disclosure: No position in EFX at the time of writing, but positions may change at any time

Even Great Investors Like Bruce Berkowitz Make Mistakes

I know, I know, the headline above is not earth-shattering news. Every quarter dozens of the world’s best investors disclose their holdings to the world via SEC filings (granted, the data is about 45 days outdated, but it still gets lots of attention). It’s easy for individual investors to follow well-known money managers into certain stocks, figuring that they can piggyback on their best ideas. I can certainly find far worse investment strategies for people to implement, but it is still important to understand that even the best investors make mistakes. And there is nothing stopping the stocks you follow certain people into from being one of the mistakes rather than one of the home runs.

I think this topic fits right in with my previous post on Sears. Not only is Eddie Lampert the company’s CEO and largest shareholder, but he is one of the best hedge fund managers of the last 25 years. It is perfectly reasonable to assume that a billionaire in his position would be primed to create tons of value for investors. And yet, since Lampert orchestrated the merger of Kmart and Sears, which formed Sears Holdings in 2005, the stock price has dropped from $101 the day the deal was announced to $40 a decade later. Adjusted for dividends and spin-offs received over that time, Sears stock has fallen by about 40%, while the S&P 500 index has risen by about 80% during the same period. Eddie Lampert’s ownership and involvement alone has meant little for investors’ portfolios. Simply put, Sears Holdings has been one of his mistakes.

Interestingly, many of the company’s steadfast bulls point to the fact that another very smart and successful investor, Bruce Berkowitz of Fairholme Capital Management, owns 23% of Sears Holdings. That’s right, Lampert and Berkowitz own or control 70% of the company. Berkowitz isn’t new to the Sears investor pool either; he started buying the stock in 2005 just months after Sears Holdings was created. How can both of these guys have been so wrong about Sears for so long? It’s not a tricky question. Neither of them is perfect and they have made (and will continue to make) mistakes. It really is that simple. Since I have written about Eddie Lampert many times since this blog was launched ten years ago, I think it would be interesting to try and figure out why Bruce Berkowitz has been on the losing end of Sears.

Berkowitz’s background is in analyzing financial services companies, which is why you will often find most of his capital allocated to banks and insurance companies. Those industries are his bread and butter. In fact, Berkowitz’s flagship Fairholme Fund had more than 80% of its assets invested in just four companies as of February 28, 2014: AIG, Bank of America, Fannie Mae, and Freddie Mac. If that doesn’t signal his preponderance for financial services companies, I don’t know what would.

Now, Berkowitz has not been shy about why he invested in Sears Holdings; he thinks there is a ton of hidden value in its vast real estate portfolio. Unfortunately, his trading record in Sears (he first bought the stock during the third quarter of 2005 at prices well over $100 per share) shows that real estate might not be one of his areas of expertise. Warren Buffett has popularized the term “circle of competence” and tries very much to only invest in companies he understands very well. That’s why up until recently (his 2011-2013 purchases of IBM shares bucked the trend) Buffett has avoided technology stocks.

I would postulate that real estate investments do not fit squarely into Bruce Berkowitz’s circle of competence. As you will see below, his trading record in Sears underscores this, but we have also seen it with his massive and long-standing investment in St Joe (JOE), a Florida real estate developer.

Below is a quarterly summary of Fairholme Capital Management’s historical trading in Sears stock (I compiled the data via SEC filings). Of the 24.5 million shares Fairholme currently owns, more than 55% (13.6 million) were purchased over a 15-month period between July 2007 and September 2008, at prices averaging about $110 per share. More troubling is that this was when real estate prices in the U.S. were quite bubbly, coming off a string of record increases (most local markets peaked in 2006 and 2007) and Berkowitz was largely investing in the company for the real estate. The timing was quite poor. All in all, if we assume that Fairholme paid the average price each quarter for Sears, the firm’s cost basis is about $85 per share (before accounting for spin-offs).

FAIR-SHLD

St Joe (JOE) has also turned out to be one of his relatively few mistakes. It could certainly be merely coincidence that both the Sears and St Joe investments were made based on perceived (but yet-to-be-realized) real estate value, but I’m not so sure. Like with Sears, Fairholme Capital Management has a very large stake in St Joe. In fact, Fairholme is the largest shareholder (owning about 27% of the company) and Bruce Berkowitz is Chairman of the Board (sound familiar?). Berkowitz started buying St Joe during the fourth quarter of 2007, around the same time he was massively increasing his investment in Sears. His largest quarterly purchase was during the first quarter of 2008 (talk about bad timing), when he purchased more than 9.2 million shares (37% of his current investment).

St Joe’s average trading price during that quarter was about $38 per share, but subsequent purchases have been at lower prices, so the losses here are not as severe as with Sears. By my calculations (see chart below), Fairholme’s average cost is around $28 per share, versus the current price of about $20 each. But again, not only has the investment lost about 30% of its value, but the S&P 500 has soared during that time, so the gap in performance is so wide that it would take a small miracle for either of these investments to outpace the S&P 500 index over the entire holding period, as the returns needed to make up for 7-10 years of severe losses during a rising stock market are significant.

FAIR-JOE

Now, the purpose of these posts is not to point out the few big mistakes two very smart investors have made over the last decade, while failing to mention their big winners. Any of my readers can look at the history of the Fairholme Fund or ESL Partners (Eddie Lampert’s hedge fund) and see that they both have posted fabulous returns over many years. The point is simply to show that sometimes these investors make mistakes, even with companies where they own and/or control a huge amount of the stock. Just because Eddie Lampert and Bruce Berkowitz are involved in a major way (either in ownership, operationally, or both), it does not ensure that the investment will work out great for those who eagerly follow them. Just because they are smart investors does not mean these are “can’t miss” situations. There are plenty of people who are sticking with Sears because of Eddie, or sticking with St Joe because of Bruce. That alone, however, is not necessarily a good reason to invest in something.

I will leave you with one more example of Bruce Berkowitz making a large bet on a stock outside of his core financial services wheelhouse. At the end of the third quarter of 2008 Fairholme Capital Management owned a stunning 93 million shares of pharmaceutical giant Pfizer (PFE). It was an enormous position for him and was featured in many investment magazines. This single $1.73 billion investment represented as much as 24% of end-of-quarter total assets under management for Fairholme, and all of those shares were purchased over a 26-week period in 2008 (more than 3.5 million shares purchased, on average, every week for six months).

FAIR-PFE

Now, given how large of a bet this was, even by Bruce Berkowitz standards, it would have been easy to assume that this investment would be a home run. But as you can see from the trading data above, Fairholme lost money on Pfizer after holding the stock for only about 18 months. During the fourth quarter of 2009 alone, the firm sold more than 73.4 million shares of Pfizer (after having purchased 73.7 million shares during the second quarter of 2008). Perhaps pharmaceuticals aren’t Bruce Berkowitz’s bread and butter either. Fortunately for him and his investors, however, his prowess picking banks and insurance companies has helped him compile an excellent track record since he founded his firm in 1997.

Full Disclosure: No position in St Joe or Pfizer at the time of writing, but positions may change at any time.

The Average Investor Can (And Should) Ignore the 60 Minutes Story About “Rigged” Markets

The piece on 60 Minutes this past Sunday has ignited a discussion about high-frequency electronic trading systems and undoubtedly has spiked sales of the new Michael Lewis book entitled “Flash Boys: A Wall Street Revolt” which digs deep into the topic. Since I have yet to read the book, I am not going to get into many details here, but the big issue is that technology has become so advanced these days that certain people are now able to get insights into what orders are coming in for a particular security, and jump in front of those orders to make a few pennies per share on the backs of smaller investors. It’s gotten so bad (read: unfair) that a company called Virtu Financial Inc, which recently filed documents to go public, disclosed that it has only lost money on one day out of the first 1,238 trading days it has been operating.

Since I work with regular retail investors, the most salient question my readers might want to ask is “Does this affect me?” I would say “No, it doesn’t.” There are definitely counter-arguments to be made, but for the typical investor (who is investing in the stock market and planning on holding a stock for months or years) the existence of high-frequency trading firms should not even be a blip on their radar. The market is not “rigged” against the types of investments they are making. If you want to invest in Company A, you have done your research, and you feel as though paying $20 per share for that stock is an attractive price, then all you have to do is enter a limit order to buy Company A at $20 per share. In that scenario, you know what you are getting, you know what price you are paying, and you feel good about your odds of success. Over time if your investment thesis proves accurate then you will make money, and vice versa. Nothing else really should matter to you.

Now, it is hard to argue that we should embrace or even accept a system where certain groups of people with more money and better technology should be in a position to game the system and earn a profit 1,237 out of every 1,238 days the market is open. Hopefully regulators will do everything they can to close these loopholes in the system. That said, the discussion around whether regular investors should change how they save and invest based on this new book or the 60 Minutes segment are focusing their coverage and attention on the wrong headlines, in my view. Carry on.

Consumer Debt Paydown Crimps GDP Growth

It’s election season so both candidates would love for you to think that the POTUS has a lot of control over economic growth, but this week we got a report that sheds light on one of the major reasons the U. S. economy is growing at around 2%, down from its long-term average of around 3% per year. The New York Federal Reserve reported that credit card debt balances last quarter dropped a $672 billion, a level not seen since 2002. It also marks a 22.4% decline from the peak we saw in the fourth quarter of 2008.

So how exactly has this de-leveraging trend negatively impacted GDP growth? Well, consumer spending represents about 70% of GDP, so a drop in credit card balances of $200 billion over the last few years represents a lot of money that was sent off to pay bills, not spent on goods and services. Toss in another $100 billion of spending that would normally be incremental over that time period due to overall growth in the underlying economy, and you can see that about $300 billion of consumer spending has been absent from the system, compared to what would have been normal.

With annual U.S. GDP at around $15 trillion, this consumer credit card de-leveraging represents about 2% of GDP growth lost. Over 3-4 years, that comes out to about 0.5% GDP impact per year. In a world where GDP growth has dropped a full percentage point from its long-term normalized level, consumer debt repayments account for a major portion of that slowdown. You aren’t likely to hear much about that on the campaign trail, but politicians rarely deal with facts and truths when it comes to hot-button issues like the economy.

JPMorgan Sell-Off Excellent Example of Contrarian Opportunity

News of a $2 billion trading loss at JPMorgan Chase (JPM) last week prompted a 15% sell-off in the stock, which now sits more than 20% below its 52-week high, at a trailing P/E ratio of 8, at only a slight premium to tangible book value, and with a dividend yield above 3%. One of the best ways to be a successful investor is to buy quality companies at times when their share prices are temporarily depressed due to short term news headlines that likely will not impact the long term profit generation of the company. Warren Buffett has perfected this investment strategy over many decades. While JPM was not really on my radar before last week, the recent events at the company have changed that. At around $36 per share I think JPM makes for a very attractive long term investment. As a result, I have initiated a position in the company.

Full Disclosure: Long shares of JPM at the time of writing, but positions may change at any time

Despite Cyclical Headwinds, Goldman Sachs Stock Is Still Too Cheap

Shares of Goldman Sachs (GS) are rising modestly this morning, to about $98 each, after the investment banking giant beat earnings estimates for the fourth quarter. Earnings for 2011 came in at $7.46 per share, down about 50% versus last year, as the business has been struggling through a cyclical industry downturn. Still, the company made a $4 billion profit, bought back about 8% of its shares outstanding, and grew book value by 1% in 2011. And yet, the stock is trading about 20% below tangible book value of $120 per share.

I have been making this argument for a while, and holding the stock has not been fun while it has been treading water far below tangible book, but even with a cyclical industry like investment banking, GS stock should not be at these levels. It is really hard to see how the company would face a scenario where book value dropped 20% from here (which is essentially what investors are fearing when the stock trades at $98). If the sub-prime mortgage meltdown barely hit book value at Goldman, I don’t see the European debt crisis doing far more damage. And even if the industry does not turn around as quickly as it has in past cycles, book value will likely go sideways or slightly higher, as we saw in 2011.

For investors to justify the idea that large, well-positioned, and profitable financial institutions should be trading far below tangible book value per share (and GS is far from the only one), one of two scenarios would need to play out. First, the companies would have to have huge unrealized losses already sitting on their books, which when realized would crush book value and wipe out the discount on the shares. Unlikely. Second, the business model would have to break down long term, rendering the firms unprofitable, which would result in a slow degradation of book value (again, narrowing the valuation gap to the downside). Again, unlikely.

Profit margins will likely drop permanently due to the Volcker Rule (no prop trading), but they should stay in positive territory (Goldman’s ROE in 2011 was 6%). That should result in lower price-to-book valuations for these banks versus prior cycles, but not below one. As a result, I think GS and their strong peers should trade for at least tangible book value, which means about 25% upside from here.

Full Disclosure: Long Goldman Sachs at the time of writing, but positions may change at any time

Europe’s Woes Crushing U.S. Stocks, Creating Longer Term Opportunities

You can certainly argue whether the TARP program was a good idea or not, but you cannot accuse the U.S. government of dragging their feet. They took decisive action, injected much-needed capital into the banking sector, brought confidence back into the system, and the end result was a well capitalized banking industry and a profit on the U.S. taxpayer’s $700 billion investment. Unfortunately, the powers that be in Europe are taking their good ol’ time to take meaningful action. Greece may be the size of Ohio, as I have repeatedly reminded investors, but as long as the markets freak out about it anyway, strong action must be taken to settle the financial markets down. We have yet to see that (hence the market’s continued concern this morning), but let’s keep our fingers crossed that we are getting closer.

In the meantime, there are plenty of strong companies that are being dragged down by this prolonged bailout process. Not surprisingly, most of these opportunities are in the financial sector, but in many ways are not directly in the middle of the European crisis but rather only marginally impacted. In my view, a perfect example is Aflac (AFL), the supplemental health and life insurance company whose two largest markets are Japan and the United States. As you can see from the chart below, shares of Aflac have been crushed from $59 to $33, a 44% drop from earlier in the year.

Now Aflac is not exactly the first company that comes to mind when you think about the European debt crisis. So why the huge sell-off in the stock? As a large insurance company, Aflac collects premiums from its customers and invests that capital to earn income until it needs to pay out claims. Aflac’s investment portfolio amounts to a relatively large $90 billion. When investing that much money, and doing so in mostly shorter term fixed income securities, an insurance company will own a little bit of everything, and that includes debt of European countries. And therein lies the problem for the stock in 2011.

Aflac has already sold all of its Greece exposure and over the next year or so will de-risk its holdings in the other smaller European countries that people are worried about (Italy, Portugal, etc). Of course, most of Aflac’s investments are outside of the troubled European countries and their underlying business is very strong. But in times of stress investors focus only on the negatives, and if any losses at all are possible from Europe, that will drive the stock down quickly.

Given the health of Aflac’s business, any losses should be more than manageable. The company right now is earning more than $6 per share. At $33 per share, that puts the stock’s P/E at 5.5. Such territory is nothing new for Aflac stock. During the U.S. sub-prime crisis Aflac stock also got killed, dropping from $68 in early 2008 to $10 in early 2009. The company’s sub-prime exposure back then also proved to be very manageable (most of the losses were marked-to-market and never actually realized) and the stock soared nearly 500% over the following two years. I have little reason to think this time around will be much different in terms of how the company can weather the storm in the financial markets and the European debt crisis.

Full Disclosure: No position in AFL at the time of writing, but clients of Peridot Capital have owned the stock in recent years and may again in the near future