Francis Chou, the award-winning Canadian mutual-fund manager, recently released the semi-annual reportfor his family of funds, the Chou Funds. Most of his commentary discusses why he is now investing in financial stocks after years of avoiding them. His views are an interesting counterpoint to some of the bearish views, such as the financial-sector-is-too-bigand the artificial-recoveryschools of thought.
Whats changed his mind? He says; i) the spread between deposit and loan rates is enormous, ii) the quality of loans has become quite high, iii) the majority of the costs of new regulations will likely be passed on to customers, and iv) the banks’ hoarding of capital gives them a cushion against a slowdown.
He adds: For an economy to flourish we need sound financial institutions that can generate reasonable profits. He estimates most of the big banks are selling below 10 times their potential earning power in the future.
He has an interesting way of gaining exposure, namely the stock warrants issued to the U.S. Treasury by the banks when they received funds under TARP. Some were auctioned off and now trade on the exchanges, such as those for JP Morgan ( JPM-WT), Bank of America ( BAC-WS.Aand BAC-WS.B) and Wells Fargo ( WFC-WS).
The warrants expire in 2018 or 2019, a time frame that allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price. Strike prices are adjusted downward for any quarterly dividend that exceeds a certain level.
Still, the banks face many issues. Here is Chou’s list:
a) We still do not fully understand or trust the numbers b) Financial regulatory reform may reduce earning power c) New Basel rules may require more capital and reduce profits d) There may be a double dip recession e) The unemployment rate may go higher and create more defaults f) Commercial real estate prices may fall dramatically g) Banks are still not marking loans in their books properly h) Residential real estate prices may fall further i) States and municipalities are in bad shape
Nevertheless, Chou views the glass as half full, not half empty. He has a long-term horizon of eight years or more and believes the odds are it will work out to be decent investment – more so for the better capitalized banks.
Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk averse. Too bad we had to go through so much turmoil to get there.