Sunday, January 7

Week 340 - Financial Services Companies in “The 2 and 8 Club”

Situation: Ten years ago, you were probably burned in the recession by owning stocks (or bonds) served up by the Financial Services industry. OK, I’ll give you that. But now the industry is back on its feet and paying good dividends, and your job is to invest. “Once bitten, twice shy” can’t be your approach. Instead, you need to know a little about when to get in and when to get out. Why? Because it’s one of the two industries where you stand to make a lot of money--the other being Information Technology. You can’t be a stockpicker and keep up with the S&P 500 Index unless you invest ~15% of your stock portfolio in each of those.

The leading company in this space is Berkshire Hathaway, which is an insurance company that makes side bets by using income from premiums (while waiting for claims to be filed). This sounds easy but it all depends on the quality of those side bets and the amount of cash set aside to pay claims. Greed will doom that project, which is why Berkshire’s CEO (Warren Buffett) says “be fearful when others are greedy and greedy when others are fearful.” These days, he must think that others are being very greedy because he has set aside over $100 Billion in cash. But, with Berkshire Hathaway being an insurance company, recent hurricanes have already shrunk that pile of cash by $3 Billion.

Mission: Run our standard spreadsheet for Financial Services companies in “The 2 and 8 Club” (see Week 329). 

Execution: see Table

Administration: Let me use an example to explain why banks can be so profitable. Banks set a price on your use of their money. That interest rate has to appear attractive or you won’t sign up for a repayment plan. If the counterparty (loan officer) thinks the project is too risky, she can still make the loan at an attractive rate, provided that the collateral (e.g. your home) becomes bank property if you default on the loan and is worth enough to cover the bank’s risk. 

Let’s say you need money to dig a gold mine. Chances are, that won’t “pan out” and the bank will have to claim collateral, i.e., all or part of the tangible assets (land, equipment, and structures that you purchased with their money). But sometimes the mine “proves up” and you’ll want to expand it. The loan officer is happy to extend credit because now there is new collateral (gold). The bank will accept a royalty in lieu of repayment. If you are a stockholder in a bank that specializes in loaning money to gold (or silver) mining companies (see Week 307), your payoff is much greater than it would be from owning a mutual fund of gold mines, e.g. VanEck Vectors Gold Miners ETF (GDX). Go to Lines 19-21 in the Table and compare Royal Gold (RGLD, a company that finances gold mines through royalty agreements) with the total returns from owning a gold bullion ETF (GLD) or stock in GDX. You’ll see that RGLD is a reasonably good investment (indeed, it’s a Dividend Achiever), whereas, GLD and GDX are anything but.  

Bottom Line: The reality is that the hopes and dreams of people who are “cash short” can be fulfilled by borrowing money, and their risk of a crippling loss from various enterprises can be reduced by taking out insurance. The bank (or insurance company) wins, even if the borrower defaults on the loan (or is wiped out by a natural disaster). In fact, it often prefers that outcome. Over time, the bank’s Return on Equity (ROE) can be amazing, say 15-20%. But the bank may be funding those loans with too much borrowed money (e.g. more than 20-25 times the amount of cash equivalents and stock that is backing those loans). On the other hand, when ROE grows because the bank is able to sell the assets it acquires at a nice profit (or the insurance company is able to double its premiums on new contracts because recent disasters proved that premiums had been too low), the risk-adjusted returns for stockholders are very good.

Risk Rating: 7 (where US 10-Yr Treasury Notes = 1, S&P 500 Index = 5, gold bullion = 10)

Full Disclosure: I dollar-cost average into J. P. Morgan Chase (JPM), and also own shares of The Travelers Companies (TRV) and Berkshire Hathaway (BRK-B).

"The 2 and 8 Club" (CR) 2017 Invest Tune

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