Sunday, June 26

Week 260 - Barron’s 500 Global “Systemically Important Financial Institutions”

Situation: Unless you just returned from 10 yrs on another planet, you know that financial innovation almost crashed this planet’s largest economies in 2008. The financial services industry in the US had earlier been given free reign to “innovate” by the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999. Prior to that Act, any one financial services institution had been prohibited “from acting as any combination of an investment bank, a commercial bank, and an insurance company.” Not only did such combinations become legal but the Securities and Exchange Commission was denied authority to regulate the “large investment bank holding companies” enabled by the Act: The fox would be running the henhouse. 

Once the consequences of that became clear in 2008, the US Congress was moved to pass the Dodd-Frank Wall Street Reform and Consumer Protection Act; President Obama signed it into law on July 21, 2010. Most of the reforms enabled by that Act will be extended worldwide when the Third Basel Accord (Basel III) takes effect on March 31, 2019. However, we note that Mervyn King, the former Bank of England Governor, doubts whether Basel III will prevent another financial calamity

Now that the status quo ante has largely been restored, we can take a fresh look at financial services institutions, beginning with the remaining Bank Holding Companies. Those 33 money center banks are now called Global SIFIs (Systemically Important Financial Institutions) or G-SIBs. To remain Bank Holding Companies, each is required to carry large amounts of reserve capital and publish a “living will” that has been approved by its central bank. So, if a financial calamity were to consume all of a holding company’s reserve capital, there is a plan in place to resolve the difficulty in an orderly manner. To prepare for that day, each G-SIB has to lock away tens of billion dollars. Those funds are unavailable for making loans or serving as collateral. The idea is to have G-SIBs gradually go away, since restrictions on their ability to provide loans or collateral make it difficult for them to sustain competition against investment banks, commercial banks and insurance companies. Three of the original 33 G-SIBs have already been broken up.

Mission: Given that G-SIB CEOs believe there is a competitive advantage to providing a complete range of financial services for their customers, we’ll look at a variety of metrics and decide whether or not they’re on a quixotic mission. Why should we care? Because the severity of regulation being applied by central bankers almost guarantees that G-SIBs won’t collapse. If you own stock in one, you’ll almost certainly make money. We’ll limit our attention to the 8 G-SIBs in North America, i.e., those that appear in the recently published 2016 Barron’s 500 List.

Execution: We’ll deploy our recently expanded spreadsheet (see Table). There you’ll find performance data and new metrics designed to scope out future prospects for success. Column L in the Table shows the consensus of analyst’s estimates for the trend in each company’s earnings over the next 5 yrs. The green highlights in Columns P and Q indicate that cash-flow based ROIC and sales have been improving at each of the 8 companies for the past 3 yrs. Column T gives the Graham Number and Column U gives the stock price. The Graham Number is where the stock price would be if it were to reflect 15 times earnings per share and 1.5 times book value per share. Benjamin Graham is the “father of value investing” and was the Professor of Economics at Columbia Business School who had such a large effect on Warren Buffett (MSc Economics, 1951).

Bottom Line: Wall Street banks have become a thicket of thorns. Financial engineering has not paid off for them, and the various routes they have discovered for creative finance are now blocked. Workarounds have been forged, and may yet pay off. For the retail investor, these are not promising stocks. The only exception is Wells Fargo (WFC), which has long avoided the kind of creative finance that brought us the Lehman Panic.

Risk Rating = 9 (Treasuries = 1 and gold = 10).

Full Disclosure: I dollar-average into JPM.

NOTE: Metrics are current for the Sunday of publication. Metrics highlighted in red in the Table indicate underperformance vs. our key benchmark, the Vanguard Balanced Index Fund (VBINX, at Line 14 in the Table). Metrics highlighted in green at Columns P and Q in the Table indicate improving performance trends for fundamental metrics (per analysis by Barron’s 500 editors). Metrics highlighted in purple at Columns Z and AA in the Table indicate a company in current difficulty, ROIC being lower than WACC.

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