At RealMoney, I wrote an article in 2005 called, Buyers Beware: Financials are Different. In addition to many other things I mentioned there, I gave six ways that financials were different:
- Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. Demand is the ultimate limiting factor, but this affects financial, industrial and services businesses alike. But with a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps”), but more often, capital limits growth.
- The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed with the business remaining as functional as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
- Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint. This is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims-paying-ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
- Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk or systemic risk; guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.); and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification. In a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence cannot be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
- Rapid growth is typically a negative. Financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
- Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company. The regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.
In general, accruals are weaker than cash entries in accounting. Not all accruals are created equal either. Some are less certain to be collected/paid, and some are further out in the future than others.
Financial stocks are generally bags of accrual entries in an accounting sense, with some more certain than others. E.g., a short-tail personal lines P&C insurer’s accounting is a lot more certain than that of an investment bank.
This is why management quality matters so much with financial stocks. The managements of financial companies must be competent and conservative, and all the more so to the degree that the accruals that they post are less certain. Companies that grow too rapidly, or lack obvious risk control are to be avoided.
Looking at the Present Concerns
I own a bunch of insurance companies, but no banks or other financials. Why? Insurers are profitable and cheap, and are not under threat from credit risk to the degree that other financials are. Consider the threats to AIG, Citi, Lehman, Merrill, GM, Ford, Wamu, etc. The companies that got into trouble grew too fast, levered up too much, neglected risk control disciplines, and more.
Now their valuations have been crunched, and their financing options are limited. Fortunately there are the options of last resort:
- Have you maxed out trust preferred obligations? Other subordinated debt?
- Have you maxed out preferred stock?
- Have you issued convertible debt to monetize volatility?
- Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
- Have you sounded out investors in your corporate bonds about debt-for equity swaps?
- And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?
Given that Bear got a guarantee, perhaps others could too, though I think the US Government is far less willing now. I could also add another point: have you sold your most valuable liquid assets?
With the crises being faced by financial companies, there is a rule that separates the survivors from the losers: Losers sell their best assets, and play for time. Survivors/winners sell their worst assets and hunker down — they have enough financial slack that they don’t have to engage in panic behavior.
In an environment like this, where there is a lot of uncertainty, avoiding suspect financials is prudent. This applies to those who take on the risks from such institutions when the decisions have to be made quickly on whether to buy them or not. Thus I would be careful on the equities of any buyers in this environment, and would be a seller of any company that is a rapid buyer during this time of financial stress.
Full disclosure: no positions in companies mentioned. I own SAFT LNC AIZ MET RGA HIG UAM among insurers, and might buy some more….