Value Investing and Financials

Disproportionately, value managers are buyers of financial stocks.? This is a result of index construction, because financials trade at relatively low multiples of book value.? Financial stocks led the rally from 1987-2007, and for the most part, it was a good era for value investors.? Value investors tend not to focus on macro concerns; they just want to pick good stocks.

But what the value managers did not appreciate was that a lot of the outperformance of financials stemmed from the willingness of the Fed to engage in a reckless monetary policy that never allowed recessions to clear away the bad debt, and thus the debt/GDP ratio kept on building.? Along with that, poor bank regulation, led by the Fed, drove a decline in underwriting standards.

Well, no surprise that value managers did badly 2007 to the present.? And they will still do badly as debts are deflated, to the extent that they own banks.? There will come a time to own banks, but I think we have to go through one or two more macro-shocks before overall debt levels are reconciled.

I own no banks or REITs.? I own a number of insurers, all of which are conservatively managed.

10 thoughts on “Value Investing and Financials

  1. David – Smart and simple commentary.

    Curious as to your thoughts on non-Agency mortgage REITs – seems to me that more than a few value folks are evaluating some of these names, primarily focusing on the most senior tranches.

    1. I would stay away from the non-agency REITs because there is no telling when people will default, so the risk is just too high. I would stick with NLY and AGNC because I do not see how anyone could lost with these investments as long as rates stay low and gov. continues to guarantee them. If anyone can prove otherwise, I’m all ears.

    2. Though mortgage REITs have done well recently, I am not a big backer of them because they have weak capital structures because they have to pay out 90% of taxable income.

      I am more interested in REITs thtat are not paying dividends.

      1. Do you like any specific REITs that do not pay any dividends? I know what you mean about their business structure, but I figure that companies have been doing it since 1986, and mREITs must have low overhead. Any thoughts?

  2. Do you worry about deflation and its effect on insurance companies? There was quiet a few articles in Canada about Fairfax buying hedges against deflation and I thought it was a good thing for them to have bought insurance against 100 year flood that could kill a insurance company. Do you think a good insurance would come out ok even if there is a bit of deflation?

  3. I think deflation is a likely probability similar to what we have seen in Japan the past two decades. If there is deflation, interest rates will stay at 0% by the Fed which is good for NLY and AGNC and mortgage rates will continue to stay low which has not been a problem for them either. As for insurance, I have no idea what you are talking about. Sorry!

  4. Thank you for your answer. Regarding the insurance companies, I was talking about articles like:

    http://www.google.ca/url?sa=t&source=web&cd=1&ved=0CCIQFjAA&url=http%3A%2F%2Fwww.ifa-ulm.de%2Fdownloads%2FImpact_of_deflation-APRIA.pdf&rct=j&q=japan%20insurance%20company%20deflation&ei=xux1Tp2RKsfw0gG0hOy9DQ&usg=AFQjCNGvi2NftYnOaeo7YnMyw-za-b-1YA

    and

    http://www.annuitynewsjournal.com/life-insurance-companies-wary-of-possible-deflation/

    What is your opnion on these articles?

    BTW, thank you for a great blog. I think your clear insights have really helped outsiders to better understand the complexity of insurance.

    1. Yeah, I understand about insurance companies not being able to depend on steady returns because of deflation which I think is a real possibility. I think this further makes the case for NLY and AGNC because that is where people will go for returns and they can deliver because of low overhead and a law that states they need to distribute 90% of profits to shareholders.

  5. On deflation and insurers, if the insurer has invested shorter than the length of its liabilities, deflation could hurt them, as they must reinvest at lower rates.

    The greater question is credit risk. If credit conditions get so bad that relatively strong credit risks come under pressure, then even the insurance industry would be in trouble.

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