The Market Now Believes All Banks Are The Same

For months I have been in the camp of investors arguing that there are distinctions between U.S. banks. The comparisons have been made for a long time. JPMorgan Chase (JPM) is better than Citigroup (C). Wells Fargo (WFC) is better than Wachovia. The market seemed to agree with this premise until recently, and Tuesday's market action in the banking sector was startling. Once again we have fierce and indiscriminate selling of all banks.

The drops in these stocks in recent days signals than many market players believe that all of these banks are in serious trouble, regardless of whether they have or have not done things such as loaned to sub-prime borrowers, accumulated lots of structured products on their balance sheets, maintained strong underwriting standards, or focused more on businesses rather than consumers.

The fear now is that the stronger banks who bought up the troubled institutions for pennies on the dollar actually did not get a good deal. Instead, the bad assets they took on will cripple them. The government will be forced to bail them out, common stock dividends will be eliminated, equity holders diluted, share price values decimated, and the companies eventually nationalized.

While this may be true in certain instances, I still do not believe that every large U.S. bank is on the brink. The market though, disagrees right now. After all, people thought State Street (STT) was safe because its main business was not lending, but rather back office and custodian services. And yet somehow they have managed to amass an $80 billion investment portfolio with $6 billion of unrealized mark-to-market losses so far. Maybe it isn't safer.

Fourth quarter earnings reports released in coming days and weeks will shed more light on whether banks that have been able to post relatively better financial results this far in the cycle can continue that trend. Maybe all of the number-crunching people like me have done in recent quarters, trying to identify the better banks, was a worthless endeavor. I sure hope not.

If last quarter marks the end of that relative out-performance, there might not be a single bank stock that qualifies as quality. That would be a sad day, but the market is losing patience and is spooked by that possibility, as Tuesday's trading brought with it 20, 30, even 40 percent losses for some banks on relatively little or no news.

One of the better banks in the eyes of many, U.S. Bancorp (USB), released earnings today and recorded a fourth quarter profit of $330 million. The market has greeted the news by sending the stock down 12% today, bringing the year-to-date loss to -46 percent. The culprits appear to be worries over increasing credit losses and the possibility of a dividend cut.

These two issues are interesting because many of us believe that increasing credit losses and dividend cuts are to be expected. As the economy worsens, credit losses rise and in order to cover those losses and reserve for future ones, earnings will drop below dividend rates and dividends will be cut. These things should be obvious by now.

For a company like U.S. Bancorp though, it appears manageable and investors should not own the stock just for the dividend. USB is an excellent franchise and the long-term earnings power of the company is what should drive the share price. As a shareholder, I don't mind if USB has to cut or eliminate their dividend for a year or two in order to cover credit losses from loans made during the boom.

Looking at USB's losses and reserves, I don't see a reason to be panicky. Charged off loans in Q4 were $632 million. The company covered those, set aside another $635 million for future losses, and still earned a profit of $330 million for the quarter. Total allowance set aside for future credit losses sits at more than $3.6 billion. USB's gross earnings (before credit losses) was $1.66 billion for Q4, so between that and the $3.6 billion already set aside, the bank has plenty of capital to cover increased losses throughout 2009.

While there are no banks, strong or weak, that are going to be able to avoid increased credit losses over the course of 2009, there are certainly banks that are better positioned to withstand the losses than others. Although the market is no longer giving them credit for being one of the stronger institutions, companies like U.S. Bancorp are the favorites to survive the current economic downturn and be stronger on the other side of it with fewer competitors. Investors looking at bank stocks need to take that kind of longer term view. If you are looking to make a killing over the next three or six months, bank stocks are not the place to look.

Full Disclosure: Peridot was long USB at the time of writing, but positions may change at any time.

The Idea That Banks Aren't Lending Anymore Is Ridiculous

One of the worst parts of being a money manager is that in order to stay on top of financial news one should really have CNBC on in the office constantly. There are many people on CNBC that I thoroughly enjoy (David Faber and Erin Burnett, to name a couple), but I say this because you also have to hear a bunch of garbage that people continually spew out of their mouths.

One of the things you constantly here nowadays is that "banks aren't lending anymore." Whether it is a politician who is upset about how the government's money is being spent, or an economic doomsayer, this statement is simply untrue based on actual reported data (sorry, I'm a stickler for actual data). Depending on how strong a bank is right now, lending for the most part has either been increasing modestly, staying flat, or dropping modestly. Claiming that banks aren't lending anymore implies that loan volumes have simply fallen off a cliff, but nobody making these accusations ever can back it up with any facts when pressed.

Take the fourth quarter earnings report from JPMorgan Chase (JPM) released today. Despite an economy that shrunk during the quarter, JPM's total consumer loans rose by 2% or $10 billion, to $483 billion, between September 30th and December 31st. This is not an aberration. As we will see (and I will add more data to this post as it comes in) most banks will show similar numbers for the latest quarter.

Given that economic growth is negative and unemployment is rising, one could easily understand if lending dropped during a recession. After all, if the core problem was lax lending standards and those standards are being revised upward, lending should be going down, not up. Evidence of increases or simply a stagnation in loan levels goes against exactly what many are claiming (that the banks are hoarding capital).

It is certainly true that someone with a FICO score of 500 or 600 (sub-prime) might not get a loan in today's environment, but that does not mean that banks aren't lending. Instead, it means that banks are not giving money to people who likely won't be able to pay it back. Isn't that exactly what we want, given that the sub-prime mortgage crisis is what got us here in the first place?

Remember, numbers don't lie but people do. For some reason too many people seem to want to blame the banks for more than their fair share, and that is saying a lot given that these institutions don't exactly have impressive operating track records recently.

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

Update (1/16/09):

Consumer Loans Q4 2008 vs Q3 2008

Bank of America -2%, Citigroup -4% vs JPMorgan +2%

Makes sense given the relative strengths of each bank. In all three cases, loan growth is rising faster than GDP. Banks are lending, you just need to be a prime borrower to qualify (and the majority of U.S. consumers are in prime territory).

Despite Capital Infusions, U.S. Government Should Not Dictate Bank Behavior

With at least a mini Citigroup (C) break-up plan coming to fruition, there is chatter that the U.S. government has a hand in some of these decisions. The justification is that the TARP program has resulted in the government directly injecting capital into banks like Citigroup, and as a result they are shareholders and have a large influence on guiding future operational decisions.

This is an interesting assumption because the government does not own common shares in Citigroup or any other U.S. bank, and therefore has no controlling rights like other shareholders do. The preferred shares the government bought carry no voting rights, as that is a core characteristic of preferred stock. The government does have warrants to buy common stock in the future, but those warrants are under water and as long as they are not exercised, they don't bring with them any rights of control.

If the government really is behind much of Citigroup's decision making, it may signal that the bank knows it will need more financial assistance down the road and therefore feels it must comply with government requests. If not, I would tell them to buzz off.

As for the break-up plan itself, does it make me bullish on Citigroup stock? Not really. While it is a step in the right direction, Citi still has one of the weakest balance sheets in the industry. It is practically impossible to know what their assets are worth and how high future losses will be. As a result, trying to accurately value the company is extremely difficult. The stock is cheap, but that alone is not enough of a reason to buy it.

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

Brokerage Joint Venture With Morgan Stanley Is Positive Step For Citigroup

I have written previously, as have numerous other investment managers, that in order for Citigroup (C) to have the best chance of being nimble enough to grow and be managed efficiently it needed to be broken up. The vast number of businesses they have, coupled with the dozens of countries they conduct business in, would make it extremely difficult for anyone, including current CEO Vikram Pandit, to successfully manage the company.

It now appears we are a day or two away from hearing from Citigroup that they are contributing their Smith Barney retail brokerage division to form a joint venture with Morgan Stanley's retail business. The combination would have more than 21,000 brokers, making it the largest brokerage firm in the world.

Although a dramatic shift from prior assurances from Citigroup CEO Vikram Pandit that he would not break up the company, I think this joint venture makes a lot of sense from their perspective. Under the rumored terms of the deal, Morgan Stanley would own 51% and manage the joint venture. Citigroup would own 49% and receive a ~$2.5 billion equalization fee (to account for the fact that Smith Barney has more brokers than Morgan Stanley).

Initial press reports had Citigroup selling 51% for $2.5 billion, which made little sense since it would only value the unit at about $5 billion. However, it appears they are getting $2.5 billion in cash and a 49% stake, which sounds more like it. In addition to the cash, Pandit downsizes Citigroup and makes his job of managing it a whole lot easier.

While this deal does not put an exact dollar value on Smith Barney (the joint venture will not trade publicly), which would have helped Citigroup shareholders more easily justify the current $6 stock price, it does give Morgan Stanley the option to buy out Citi's 49% stake in the future. While I would not suggest Citigroup sell the entire thing (it is doing far better than their banking businesses), this deal does manage to raise capital and make the large bank more manageable.

While not a life saver, this deal does make some sense, which is more than we can say about Citigroup's business decisions in recent memory.

Full Disclosure: No position in Citigroup or Morgan Stanley at the time of writing, but positions may change at any time

Fourth Quarter Earnings Will Be Horrible, But We Already Know That

Aluminum giant Alcoa (AA) kicks off fourth quarter earnings season after the closing bell today and there is little doubt that they will be the first in a series of profit reports over the next few weeks that will be absolutely brutal. Fortunately, most investors already know that, so the market's reaction is unlikely to mirror the dramatic sell-off we saw in October and November. The fourth quarter could prove to be the weakest quarter of the entire recession in terms of GDP growth (a 5 or 6 percent decline is both possible and probable), which would imply that corporate profits have no chance of exceeding expectations this quarter.

The key, however, is not what the numbers are but rather how the market reacts to them. With sentiment so negative on the earnings front, there will be instances where stocks actually do not drop, or even rise slightly after poor profit reports are announced. Since the stock market is forward looking, a company reporting a lousy number, if no worse than expected, will actually bring smiles to investors' eyes because it alleviates the concern that things could be even worse than many believe they are.

How the market reacts during this earnings season will be very telling for the near-term dynamics of Wall Street. If numbers come in weak as expected, but not a lot worse than the already low expectations, technical analysts will be quick to point that out as a positive sign. This would be a key signal that the market has reached a short term bottom. Such action would tell me that the market is truly looking ahead to possible economic stimulus and other actions that could help make the fourth quarter the worst quarterly GDP reading we ultimately see.

Conversely, a poor market reaction to these profit reports could mean a retest of the November lows. The market has done pretty well in recent weeks as it looks ahead to an Obama administration, but its patience will certainly be tested over the next couple of weeks. Personally, I think we will see a modestly negative reaction over the short-term, only because we have already seen a decent level of bargain hunting prior to earnings season.

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

Action in Palm Stock Highlights Why Analyst Recommendations Continually Fail Investors

In recent months it would have been difficult to find a stock that Wall Street analysts were more pessimistic about than struggling smart-phone maker Palm (PALM). According to Thomson/First Call, 23 analysts follow the stock, 10 have sell ratings, and only 2 have buy ratings (the rest were neutral). In a world where brokerage firms make money by getting people to buy stocks, such negative sentiment is rare.

As a contrarian, I had actually been accumulating shares of Palm throughout 2008 in some client accounts, as hints of a possible recovery in the company's business began to appear. Most notably, the combination of a sizable equity investment from private equity firm Elevation Partners (run by Roger McNamee, a man I have great respect for) and the hiring a former research and development star from Apple (Jon Rubenstein).

In recent months Palm had explained to investors that they were revamping their software platform and with the help of Rubenstein and McNamee were set to launch a new set of innovative products in 2009. Given how short-sighted Wall Street is, Palm shares struggled as the iPhone and new Blackberry products came to market. Wall Street analysts were negative on Palm because they claimed Apple and Research in Motion were way ahead of them in terms of products and market share. The stock actually reached a low of $1.14 per share in December, down from $4.00 just a month earlier.

The reason I was interested in the stock was not because I disagreed with the analysts' assumptions (I too expect Apple and RIM to have higher market share than Palm), but rather because they were ignoring the fact that the global cell phone market is over 1.2 billion units. Palm could lag Apple and RIM and still collect 5% or 10% of the worldwide market, which would translate into tens of millions of units and perhaps several billion dollars of revenue. The idea that Palm had to beat out Apple and RIM to stay in business (some analysts are projecting Palm will file bankruptcy) seemed off the mark to me.

Sell side analysts generally recommend stocks based on what is known, not what could happen in the future. Even though the public knew a successful R&D guy from Apple was now heading up Palm and was slated to introduce a brand new operating system and product lineup in 2009, since the facts at the time were that Apple and RIM were crushing Palm, practically nobody on the Street liked the stock. At a buck or two though, Wall Street was pricing Palm shares based on the worst case scenario, so the risk-reward trade-off highly favored going long the stock, not betting against it.

Last month Elevation Partners increased their equity investment in Palm from $325 million to $425 million, obviously approving of the company's plan. Yesterday at the Consumer Electronics Show (CES) in Las Vegas Palm unveiled its new operating system and a model of the Palm Pre, the first of its next generation smart-phone products schedule to be released by Sprint in the U.S. sometime during the first half of this year. Palm stock soared 35% on Thursday and is up another 30% today to about $6, bringing its total gain since the December low of $1.14 to more than 400%.

Today analysts are more optimistic (I even saw at least one upgrade) based on the promise of the new operating system and Palm Pre product. Once again, the sell side has waited until the news is out and already priced into the stock (it's already gone from $1 to $6 in the last month) to become more optimistic on Palm's prospects. Therein lies the inherent flaw in most brokerage firm research; they base their recommendations on announcements that the market adjusts for immediately, thereby ensuring what they have to say has little or no added value by the time clients read it.

Now, you may insist that an analyst should not blindly assume that a new product being worked on will turn out to be good, so recommending Palm before knowing what the Pre phone looks like would not have been wise. I cannot argue with that, so maintaining a hold rating until seeing the new products is completely understandable if you did not want to put your neck out.

What I cannot understand is a sell rating on a company whose stock price is implying bankruptcy even though the company is getting private equity investments and you know that a highly respected former Apple exec has been leading a new R&D team for over a year. Are we supposed to act surprised that the Palm Pre looks promising? You may not have wanted to bet on it sight unseen, which is fine, but you can't say that what Palm introduced yesterday was surprising given what we already knew was happening over there.

As usual, Wall Street hated the stock at $1, $2, or $3 but likes it a lot more at $6. Now you know why I like to be a contrarian.

Full Disclosure: Peridot was long Palm shares at the time of writing but positions may change at any time

No, It Is Not A Bull Market

I have heard it twice on CNBC already this morning, and the market has not even opened yet. For some reason people are claiming that since the market is up more than 20% from its lows that we have entered a new bull market. This idea that any rise of at least 20% constitutes a bull market is just plain silly. If a stock falls from $10 to $1 and rebounds to $1.20 it's a new bull market? Oh, please! Sorry folks, but there is no bull market in stocks, or oil, or anything else that has been crushed in recent months but has recouped a small portion of the losses.

Retail Bottomfishers Have Better Options Than Saks

Last weekend's issue of Barron's highlighted a money manager's bullish stance on shares of luxury retailer Saks (SKS). The stock is up more than 10% since then, and now fetches $4.50 per share. The manager in question believes Saks has normalized earnings potential of 50 to 60 cents per share, which he thinks will translate into a stock price of between $5 and $7 per share in more "normal" times.

I took a look myself and quite frankly I think retail bargain hunters have better options. Here are a few reasons why:

1) Normalized earnings of 50-60 cents per share seems high

Saks earned $0.42 in 2007, which most people would agree was the peak in the retail cycle. Therefore, assuming Saks will earn between 20% and 45% more than that during "normal" times is not a bet I would feel confident making.

2) In the red even during Q4

I am relying on analyst estimates here, but not only did Saks lose money in the second and third quarters of this year (before retail really started to get clobbered after the market collapse and subsequent increase in unemployment), but they are projected to lose money in the fourth quarter too. Good retailers tend to make money all four quarters even though the fourth quarter is by far the strongest. Historically, sub-par retailers have lost a bit or broken even during the first three quarters of the year and then clean up handily during the holiday season (bookstores and toy retailers fall into this category a lot). Even in a bad economy, if you are losing money in the fourth quarter, that is a sign of poor management or a severely tarnished market position (the former is more likely in this case).

3) Unimpressive gross margins

A premium store like Saks should have very impressive profit margins due to the luxury items they sell. In both 2006 and 2007 Saks posted gross margins of only 39%, and that was in a very strong retail cycle. For comparison, JC Penney (JCP) also had a 39% gross margin for both of those years. This signals some deficiencies in merchandising at Saks, as they should have more pricing power (less of a need to discount) than a lower tier department store.

4) There are competitors that are doing better and also have cheap stocks

I picked Nordstrom (JWN) here as an example. Their market sits between JC Penney and Saks, but they are viewed as a little higher end, approaching if not matching Saks. Nordstrom has made money every quarter this year and will continue that trend in the fourth quarter. Their stock price is similarly depressed, as are most retailers, so you are getting both value and what appears to be a better run company.

All in all I think there are better bargains than Saks on the retail racks right now.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time

Lesson from the Bernie Madoff Ponzi Scheme

As more and more news comes out about Bernie Madoff and how he managed to defraud many very smart people out of billions of dollars, it is useful to ask a simple question; what should we learn from what happened? From my perch the answer is very basic.

The few people who avoided Madoff's funds did so due to doubts over the highly suspicious consistent returns he claimed (many concluded he could not produce such steady profits from the strategies he claimed to be using). They avoided disaster because they lacked information and without knowledge of what their money was invested in, they were not comfortable investing with Madoff.

The others were not as fortunate, but it begs the question, does it make sense for anyone to invest money with a money manager if they are forbidden from knowing where the money is invested? I don't think so. I know I certainly could never look one of my clients in the eye and ask them to stop receiving account statements so their holdings could be secret. Trusting someone, as Madoff's investors have learned the hard way, is not a good enough reason to put a blindfold on and hand someone millions of dollars.

Now, many hedge funds will argue that disclosing their holdings strips them of their "edge" since many people will simply mimic top managers' trades and thereby reduce returns for the people coming up with the ideas. To curb this concern it is certainly reasonable to allow a slight delay in the reporting of actual holdings to ensure that a hedge fund manager can establish a full position before disclosing it to the public. You could also have investors sign a contract saying they will not act on or alert anyone to the nature of the fund's investments.

Regardless, if you are investing in any fund that does not adequately disclose where your money is allocated, I would strongly consider ceasing such an investment. It sounds obvious to many, but given what has transpired recently, it warrants mention.