Risk and Return

Back in February of 2007 we began to scrub our portfolio’s of all exposure to financials, which wasn’t very high at that point anyway. Needless to say, instant alpha.

Of course, the follow on question I get repeatedly, especially those who have been investing with Bill Miller and Legg Mason Capital all the way down, is that surely it is time to get back in?

Obviously Bill, and Legg Mason in general, believe that the sell off in financials is overdone, and that long term investors will be rewarded at this point. Of course, they have said that all along to disastrous effect. The question moving forward is whether they are right now, or is it that they still don’t understand the situation?

I am not one to assume I know the future, but what I do believe is that it is important to assess the risk to any investment thesis. So let is start with the general issues:

• Maybe financials are undervalued, but how can anyone have confidence in what the value of many of these institutions is? What are their assets worth?
• The thesis seems to assume that once credit markets ease and the economy improves it will be back to business as usual. However, whole lines of business are not only going to be weak for some time, such as mortgage origination and lending, but in many cases may not exist going forward.
• The money they made in the past was based on ways of doing business, and with amounts of leverage, that they, regulators and investors will not want to see going forward.
• How diluted will any investment one makes today be once the turnaround starts? Repeated capital raising has already decreased existing investors share of the companies dramatically. So even if business gets back to its past levels each share will still be worth a lot less. How much more capital will they need to raise?
• What is the risk of failure of many of these institutions?
• Finally, how much worse will it get in terms of losses, and thus how much capital will need to be raised if they are to survive?

To get a handle on these risks let us take a quick look at a few things.

Remember when the losses would be less than 100 billion, then maybe 200 billion? The 500 billion mark has now been crossed. I still stand by my estimate of at least 1.2 trillion before it is all said and done. Given the strains the financial sector has shown so far, how is it going to weather more than double the hit it has already taken?

Before speculating about that, lets look at this chart:

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As you can see, the massive attempts to raise capitalhas resulted in little more than a loud poof!

All charts via Jake at Econompic Data

Thanks to Barry Ritholtz for the charts.

Most institutions have seen more capital destroyed than they have raised, and essentially all have a much weaker capital base than when they started. So, if we assume that more losses are forthcoming, and the most optimistic estimates are in the 400 billion range, we will see even more raising of capital, further diluting the worth of every share outstanding.

Given the losses and further dilution alone I would suggest the risk factors are extremely high. Except it gets worse. Who is going to give them the capital to survive future losses? At this point the largest sources of capital, private equity firms and soveriegn wealth funds, have already committed vast sums to this sector. How much more are they willing to cough up given the risks? Thus many of these institutions may go under. Of course, normally they would be acquired by a stronger institution,  but that also requires stronger institutions. The breadth of this crisis means that hardly anyone is strong enough to acquire a failing institution, especially with their own losses mounting.

The gist? While the future is unknown, and there may be factors which make the worst case scenario’s less likely than it appears, and we should never underestimate Wall Streets ability to find ways to squeeze money out of us, at this point the risks move any capital devoted to the banks, brokerage houses, Fannie, Freddie and the others is not investment, but speculation. Extremely risky speculation at that. Sometimes speculation pays off, but the odds seem stacked against it at this point.

Technorati Tags banks, Bill Miller, broker dealers, credit crisis, financials, Legg Mason

Tags: banks, Bill Miller, broker dealers, credit crisis, financials, Legg Mason

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