Monday, July 31, 2017

Are Banks Overvalued?

The S&P 500 Bank Index is up 41% in one year. US Regional Banks' price-earnings multiple was 16.6x and price to tangible book value was over 2x (see chart). So are banks over-valued?

It depends. One way to compare is to look at the p/e ratio compared to the market. The S&P 500 p/e currently stands at 24.6x. So it looks like bank stocks are not overvalued.

But hold on. One ratio that can help us out is the PEG ratio. Remember that in Finance class? It's the p/e ratio divided by the earnings growth rate. According to Peter Lynch's iconic book One Up on Wall Street, a stock is fairly priced if its PEG ratio was 1. Meaning if it's p/e is 16.6x, like the US Regional Banks mentioned above, then the earnings growth rate should be 16.6%. I know I'm comparing a multiple to a growth percent. But, hey, I didn't invent the PEG ratio.

The challenge with banks' PEG ratio, as the chart shows, is that it is way over 1, by a factor of over 5 (5.7). I checked it against other industries in the Financial Services sector. Insurance brokerage has a PEG of 3.4. Specialty Finance: 0.4. The regional banks' PEG ratio, if I do the reverse math, implies that earnings are growing around 3% for the banks in that index. Which is very close to the 3-year annual net income growth for all FDIC insured banks.

So by the PEG ratio, banks would appear to be over-valued. Which may be true. But I want to bring up two mitigating points about banks:

1.  Banks are capital intensive. We must contemplate that implicit in their p/e ratio is some level of their tangible book value.

2.  Banks are not, in general, growth stocks long term. Risk management and the legions of regulators work in tandem to limit growth. 

Relating to 1, I did a data run of all banks and thrifts between $1 billion and $10 billion in total assets that were profitable. I checked their median p/e ratio. I then took their market cap and deducted their tangible common equity to deconstruct their p/e between tangible book and their market cap over tangible book (see chart). 

It is true that other industries can deconstruct p/e in this fashion. But would such an analysis of other industries equate 56% of an industry's p/e to it's tangible book value?

Even if we deducted tangible book from p/e, the industry PEG would still be 2.53 (7.6x / 3% growth), more than double Peter Lynch's prediction of fairly valued.

Which brings me to 2. How long can a company, a sector, and an industry grow faster than its markets? Certainly not forever. And for many, earning their p/e's means stoking growth either through acquisition, or greater risk taking. One is risky, and the other can be deadly. 

For these reasons, bankers may want to consider more moderate growth objectives, maximize earnings, and pay a larger portion of shareholder returns in dividends. 

What is your opinion on bank valuations?

~ Jeff

Note: I make no investment recommendations in my blog. I have a difficult time with my own portfolio. 

Friday, July 21, 2017

Health Insurance: A Bank Problem Too

Bank health insurance premiums have escalated to the point of cutting back benefits. As a nation, our system is not working, whether it be Obamacare or pre-Obamacare. The cost continues to escalate.

An industry publication recently contacted me for some commentary on their "Best Banks to Work For" annual piece. Naturally, I had opinions. When I analyzed their list two years ago, I noted that the financial performance of those banks was similar to banks that didn't make the list. Greater investments in personnel and employee benefits did not result in inferior financial performance.

I also noted that the most cited benefit by employees of banks on the list was gym and health initiatives. And generous benefits was near the top, at fourth. Remember the days that employees would seek banks out for stability, fair pay, and employee benefits? Merger mania has nearly eliminated stability, and the rising cost of healthcare has led to many banks cutting back on generous benefits, removing another competitive advantage in the employee marketplace.

It should be noted that the data in the accompanying charts came from employers. Not premiums in the Affordable Care Act marketplaces so often cited by lawmakers. But the escalation of premiums continues to far exceed inflation and will continue to put pressure on banks' bottom line unless they prune benefits even more.

So I would like to chime in on the healthcare debate, because we can no longer rely on media outlets to provide us with the information to make informed decisions. They cover protests. And protesters are likely to be people that receive free or highly subsidized insurance. I doubt there are net payers to the health care system out there protesting that they should pony up even more for the net takers.

The media covers inflammatory political rhetoric. Like saying one proposal or another will kill people. Not fact-based debate. Too boring. As evidence, look for the oft-quoted CBO stat that one proposal will result in 20 million more uninsured people. The next sentence should say, "the vast majority of which would choose to not participate". Does the media coverage say that? There ya go.

Any health care proposal should be: 1) private, 2) widespread, 3) transparent, 4) favor freedom.

So here are my thoughts:

Health care is a group system. If someone gets sick and consumes more than they contribute, the cost is made up through a pool of people that are paying more than their consumption. That is truth no matter if it's private insurance or government paid. But single payer, or government paid insurance where it's a continual transfer from one group to another is a bad idea. Look at the VA. True competition will come when the payer of services is the consumer of services. Look at auto insurance. We're forced to buy it, and we do so privately. Bad drivers pay more than good drivers. And the Camaro owner pays more than the Camry owner.  

So the JFB health care plan would be private health insurers.

To give small business, the life-blood of our economy, negotiating leverage with private insurers, I propose we allow businesses to affiliate through trade associations, unions, etc. across the country, not state lines. This also applies to an individual market. Allow them to affiliate, through churches, trade associations, etc. 

I propose there be a required minimum basic coverage that keeps families out of bankruptcy should they fall ill and encourages preventative care. Such as a high-deductible Health Savings Account (HSA) plan that has a maximum out of pocket (MOOP) per annum per family of about $10,000, adjusted for inflation. There must be language to limit political influence in this law. One of the failings of Obamacare was putting in political wish-list stuff for social engineering. Such as birth control. To keep teenagers from making babies. Sort of like mandatory parenting. The Basic Plan should be simple and protect families from bankruptcy for extraordinary medical expenses and encourage preventative care. 

I like HSA plans because it puts individual skin in the game. You want to load the shopping cart with Oreos or smoke a pack a day. It will cost you much more than me. Skin in the game. Put behavior and cost of the behavior as close to the individual as possible so there is consequence. I'm an accountability type of guy.

States can have overlays to keep state control. Especially since the Federal mandate will be Basic. But regulation and enforcement of the national law would be national. Regulation of overlays can be state-based. So if California wants to jack up the prices of plans to include medical, recreational, and Cheech and Chong level marijuana use, it's on Californians. We're not going to charge Kentucky for it.

My apologies to the freedom lovers, but we must compel people to buy insurance. In 1985 we required hospitals to treat whoever came to the emergency room, regardless of their ability to pay. That is why you would have to wait so long to get your broken arm fixed. Someone checked in before you with a head cold. Remember those long wait lines in the emergency room? Free health care for those that chose not to buy health insurance. Free riders. No more. This also solves the adverse selection problem in health insurance. People that don't participate in a health insurance plan if they are healthy (i.e. net payers). Many wait until they are likely to be net takers.

Make insurance transparent through a pricing portal run by your insurance company. Insurance companies negotiate different rates for different services by provider, and by insurance plan. It is nearly impossible to make an economic decision. I remember my daughter being at the doctor and was diagnosed with hip dysplasia, a common problem for growing female athletes. The doc said he was 95% sure this was the issue. If we wanted him to be 100% sure, he would need an MRI. I asked how much that would cost. He was taken back by the question, but left the room and asked his admin staff, and they came back with somewhere in the $900 range. That would come out of my HSA. So I decided his 95% was enough. I balanced an economic and medical decision. If a third party paid for it all, I probably would have gotten the MRI. See the problem?

Under the JFB plan, there would be an app that prices out services and service providers so everyone knows the price of their decision, including the prices of local doctors.

Medicaid should be transitory. We are creating a lifelong needy class in our society. It's moving closer towards indentured servitude to the government. Which is dangerous. Check history. However, keeping with the theme of pushing things more local, states can keep ponying up for people that aren't employed, lack the basic plan, and have lots of protest time. Their choice.

Companies can compete for talent based, in part, on their additions to basic coverage. They have the option to make HSA contributions and premium contributions to the basic plan, add benefits, or all of the above. Making it easier for would-be employees to determine which insurance offering is better, and tilt the scales towards those that are more generous, and creating transparent competition for talent. 

That's it. Simple. Transparent.

What do you think?

~ Jeff

Saturday, July 08, 2017

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Here we are in July already!  The markets continue to roll and bond markets continue to trade in a 25 basis point range, hitting the higher end when they think the economy is strong (why else would the Fed raise rates?) and hitting the lower end when the weak economic data smacks them in the face.  I usually write with a cautious tone.  Many of my economic views contain the word “weak.”  I do not take this lightly.  I believe that we are in this era of weak growth, now eight years old, for the long haul unless changes are made to regulation and we stop adding debt at break-neck speed.  In this environment, it has been an achievement for our economy to grow at 2%. 

OMG- The Phillips Curve!
Janet Yellen, like Ben Bernanke before her, is using the Phillips curve to shape policy.  Remember that the Phillips curve is based on a set of formulas where unemployment and inflation have an inverse relationship.  With unemployment going down, inflation must go up, right?  Well, it did for a while, and now it is heading down, too.  The Fed must think it will rise again and they are raising rates in anticipation.  They must not see falling oil prices, weak GDP growth, falling gold prices, a narrowing Treasury-TIPS spread, rising debt levels, lower consumer spending, a low labor force participation rate, low productivity, and consumer prices so weak that major retail companies are closing stores at a record pace.  Someday, we will all simply shop online at Amazon and Walmart.  We will not even have to drive anywhere, since everything will be delivered to our front door.

The Fed has raised rates by 25 basis points twice so far in 2017 and has promised one more increase.  They believe that inflation is coming and that is fine.  They believe that they should raise rates because they were too low and that is fine, too.  If the Fed was motivated by the data, or their moves “data dependent” as they always claimed, they would not have raised interest rates.  Weak readings on employment, housing data, and retail sales won’t stop them.  Rising debt levels will not stop them.  Household debt in 1Q17 totaled $12.73 trillion, crossing the previous high mark of $12.68 trillion in 2008.  They are moving ever closer to a flat yield curve and slowing down 2% growth.  For what reason?  Well, maybe the Phillips curve…

The Fed also announced at their June meeting that they would be “normalizing” their balance sheet “soon,” which means reducing it by letting bonds mature and not replacing maturities or cash flows.  Remember all of the quantitative easing, or “QE,” purchase programs?  All of those bonds are on the Fed’s balance sheet to the tune of $2.5 trillion in Treasuries and $1.8 trillion in Agency mortgage backed securities.  Their “normal” balance sheet size would be under $1 trillion.  It is expected that $50 billion will not be reinvested monthly.  They also stated that they will do this “normalization” provided that “the economy evolves broadly.”  Who has any idea what that means?  It is my belief that they will proceed with this “normalization” no matter what, regardless of the cost.  Longer interest rates will tend to rise after losing a buyer for longer term MBS and mortgage rates will rise as a result.  With housing weak, our economy will be weak, and no one should be surprised.  Incidentally, Chair Janet Yellen’s term at the Fed expires in February, 2018.  There is already speculation that she will not be re-nominated.  That may be just in time for the easing to begin.

Presidential Agenda
I am very surprised that the markets are not having fits over the lack of progress on the presidential agenda.  The promises included tax cuts to 15% (although a much less dramatic decrease is expected), repeal and replacement of ObamaCare (stalled in the Senate), regulatory reform (some energy rules relaxed, but not much else), infrastructure spending to repair and replace our crumbling structures, roads, airports, electrical grids, etc.  Patience, they say!!  I believe that the stock markets believe that eventually the agenda will be accomplished.  And some good ideas have been presented, including job training and increased education for those whose skills may not match available job openings.

The Pool of Available Workers
When Alan Greenspan was Fed Chairman, he always looked at “augmented” unemployment numbers which were calculated using the pool of available workers (sum of the unemployed plus persons who want a job but are not counted in the labor force).  The augmented rate for May, 2017 was 7.5%, compared to the headline rate of 4.3%.  The pool stands at 12.4 million persons, including unemployed of 6.9 million, at the end of May, 2017.  This level compares to 12.3 million at the end of December, 2007, before the crisis hit in 2008.  The level reached 16.7 million in December, 2008 and the peak occurred in October, 2009 at 21.4 million.  It took nine years to return to pre-crisis levels.  It seems we have achieved the recovery of employment.  But why does it not seem so?  Maybe it does not feel right because wages have not kept pace, meaning inflation remains low.  We shall see.

Company Expenses Seen Rising
Corporate expenses are on the rise.  For years, regulatory and compliance costs have been growing dramatically.  Physical security costs ramped up over the past 15 years; just ask the airlines and Homeland Security.  Now an even greater threat promises to raise costs even more- the threat of cyber attacks.  Recently, we have seen ransomware virtually cripple company’s networks and Internet access, as criminals exploit vulnerabilities in Microsoft’s Windows operating system.  Some of the ransomware even has names:  WannaCry and Petya Clone.  Thieves lock up computers by encrypting files and access and demand ransoms, usually small amounts such as $300 in bitcoin.  This is becoming an increasingly frightening scenario.  In the age of
“The Internet of Things,” where every appliance and device under the sun is connected to the Internet, someone should be losing sleep.

An Even Larger Hadron Collider

Where else can you get updates on our favorite machine?  There is some excitement about the plans to build a new Hadron Collider that will be bigger and better than the machine today.  The new one, called the Future Circular Collider, will be three times as long and ten times as powerful.  It is in the planning stages and will be ready by 2035.  Considering that the current Collider took 30 years to build, that’s not a long time to wait.  Expect digging to occur under the mountains of Europe in a few years.  Let’s just hope that they put covers on this one so that birds cannot drop baguettes inside!   

Thanks for reading!  DJ 07/04/17

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.