An Attractive Stock In An Industry Of "Black Boxes"

By Bill Edson - September 20, 2012 | Tickers: AIG, COF, C, NES.DL | 0 Comments

• Email
• Print

The fundamentals of investing in the financial sector change rapidly. But, you can reduce the risk of being surprised if you have updated information and come to understand that financial companies are much like black boxes. Those wishing to speculate on financial companies should consider how funding for these companies changes dramatically.

Bailout Capital Leaving the Market

One major change that is happening in the financial sector is the buyback of shares from the TARP (Troubled Asset Relief Program) era bailouts. Consider the United States bailout of American International Group (NYSE: AIG) and its consequences. AIG recently bought back shares from the U.S. government. These shares were valued at nearly $18 billion. In this way, the government was able to convert a 4 year old bailout into a paper for the taxpayers.  The treasury department recently stated that the U.S.  Government sold around 554 million shares at a price of $32.50 per piece.  Of these shares, $5 billion of the stock was bought by a New York-based insurer. The Treasury stated that the United States government has been able to recover the entire $183 billion of its investment, making a gain of $13 billion. The Treasury further mentioned that the U.S. continues to hold around 22% of the shares of AIG meant for future sale. Treasury Secretary Tim Geithner said that the government’s involvement in AIG was a great achievement which stabilized the company while earning a lucrative positive profit for American taxpayers.

Mr. Geithner’s assessment wouldn’t hold water in a basic finance course. First, such analysis ignores that any investment returns should be adjusted for risk, and that the government’s stake in AIG would have had a high required return in the private markets. Investors would have required very steep discounts in order to recapitalize AIG, and this should be the measure of investment success, not nominal gains. Furthermore, this bailout has encouraged moral hazard in finance and codified bailouts as a probable outcome if risks work against a company.

Putting societal considerations aside, AIG is a rough investment for several qualitative reasons. First, financial distress is a good predictor of future financial distress. Bankruptcy, for example, is often a revolving door which finds the same companies who once filed for bankruptcy returning to bankruptcy court after reorganization. AIG’s distress in the past is symptomatic deeper risks which could lead to future distress. Second, the government’s financial assistance, no matter how generous, has not made AIG any less of a black box for investors. Good luck valuing such a company.

Changing Ownership of Business Units

ING Groep (INGA) will sell a stake valuing greater than 9% (entire amount) in Capital One Financial (NYSE: COF) that was acquired by the largest Dutch financial-services firm in 2012. ING will sell the stake for $3 billion to boost its capital ratios. The ING stock posted a 3.58% daily boost on this news.

This is bad news for Capital One shareholders who will compete against more sellers in the market. Supply of shares has gone up while demand for these shares has not substantially changed, which does not bode well for the price of Capital One stock.

Morgan Stanley (NYSE: MS) has decided to take charge of its Morgan Stanley Smith Barney brokerage joint venture with Citigroup (NYSE: C) by agreeing to pay $13.5 billion. Once this deal goes through, it would end the partnership by Morgan Stanley and Citigroup formed in 2009. Morgan Stanley shares moved higher on this news, as did shares of Citigroup.

Is this really a win-win situation for both these financial firms? There had been news of some disagreements happening between the two partners from the past few months. The decision to take over Morgan Stanley Smith Barney came out on Tuesday after a long discussion done by the two companies. This buy-out will relieve tension between these two companies. Also, the deal will simplify the financial statements of both companies and focus the attention of management teams on core business instead of distracting them with a joint venture.

But, Morgan Stanley seems to have gotten the best in this deal. Citigroup expected 40% more than what it will get from Morgan Stanley for its stake the brokerage joint venture. All in all, this deal seems to work more for Morgan Stanley than for Citigroup.

Valuation Analysis

Are the consequences of these events reflected in these firm valuations? Consider the following price multiples:

This table contains many reasonable trends. First, the firms which are have the greatest debt-to-equity ratios tend to be the cheapest, using the price-to-book ratio as a measure of cheapness. Second, the cheapest firm on this list is an insurance company based in the Eurozone.

Insurance companies are negatively impacted by declining rates in the market more than many other industries are impacted. This makes ING more of a macro play on a Eurozone recovery than an investment based on intrinsic value. Investors also cannot take solace in net cash outflows for the firm.

Fortunately, the other firm which enjoyed good news, Morgan Stanley, remains an attractive buy candidate. Morgan Stanley trades at a discount to book value and has a very healthy price-to-free cash flow multiple of 1.39. These low valuations are not consistent with a firm that recently acquired a joint venture at a 40% discount to its expected deal price.

I caution investors to scrutinize the remaining firms on this list. As financial companies, they are very hard to understand and remain black boxes for even the most seasoned, sophisticated industry analysts.

• Email
• Print
• Feedback