Investing: Windows of Opportunity

Judging by the last month in the stock market, you might think it’s time to get out. Or give up stocks all together. Last week I had lunch with a friend. In August, he was pretty happy with his money managers. They were up 20%, maybe 30%. This week, it was a whole different story. His stocks were down, significantly. His gains for the last three years, erased. Basically, the bank savings account would have done better than his prominent Wall Street money managers.

Unfortunately, there’s not much I can do for my friend at the moment. But going forward, times like these make me optimistic. Very optimistic. Why? Because we’re entering a window of opportunity.

Bottom Fishing the Financials

Let’s start by taking a look at the financials. When I follow stocks, I like to keep tabs on the price and where it falls within the 52-week range. One look at the following table is all you need to understand where the banks are today:
Now me, being an admitted geek in these matters, I find this fascinating. First, it tells you that the entire banking sector is down. I know you didn’t need me to tell you that (given the headlines), but when people tell you that sector movements have a big impact on stock price, you can see that it’s true. But keep in mind, every stock is different, and that’s where the opportunity is.

Second, you can’t miss the obvious big losers: Citigroup and Washington Mutual. Being the bottom fisher that I am, these are the first two that catch my eye; the biggest drops may have the biggest potential for recovery.

You might think that Washington Mutual, having declined 58%, might be more interesting than Citigroup, which only declined 42% (“only” being relative, of course). But of the two, I think Citigroup is the more interesting play. Here’s why:

• Citigroup is more diversified, and Washington Mutual is more tied to domestic consumer and small business lending. Citigroup is more international, and offers banking, lending, insurance and investment services. Washington Mutual focuses on domestic retail banking, card services, commercial and home loans.
• As a result, Washington Mutual is more tied to the real estate and consumer markets. Some people think that the real estate market will bottom within the next year. I don’t. I think real estate has a long way to go. If that’s true, Washington Mutual has a long way to go too.
• Citigroup is just huge. At the end of 2006, WAMU had $346 billion in assets. Citigroup had $1.884 trillion. Honestly, I can’t even begin to understand what that number means. And size matters. Citigroup can take a big hit.
• Citigroup has better operating leverage. Citigroup’s return on equity (ROE) is 15.2%; WAMU’s is 9.7%. For those of you not familiar with ROE, that just means how much a company returns on the money invested. So if you put $100 into Citigroup, the company will make $115.20. If you put it into WAMU, the company generates $109.70. And by the way, that ROE number gets better in good times. I’ll take Citigroup.

All these things do matter. Add them up, and a company like Citigroup has more options than WAMU. Last week, when Citigroup’s stock fell to under $30 and the company needed cash, the Abu Dhabi Investment Authority invested $7.5 billion. I can’t say for sure, but I don’t think the Abu Dhabi fund was going to call WAMU first.

Looking Past the Turmoil

Just in case you haven’t been following the markets, Citigroup, and all the financials, have had problems because they invested in subprime-related assets. As the value of those assets deteriorated, the financials took hits to their earnings. Since August, there have been continuous negative headlines. There have been some up times, but for the most part, the negative earnings news has far outweighed the positive.

So the next question is, will Citigroup make it past all these problems? Will there be a day when all these rotten assets will be off its balance sheet?

It’s hard to imagine Citibank going under. At this point, no one thinks this will happen. If we want some numbers to back this up, we have to keep in mind Citibank’s assets – “ $1.9 trillion by the end of 2006, as mentioned. By the end of September, 2007, that number was $2.4 trillion. Morgan Stanley estimates that there might be as much as $150 billion of subprime assets on the books. If you assumed that all that disappeared, that would mean a 6.4% cut in assets. Not a good number, but very far from getting completely wiped out. Truth is, some fraction – “ say anywhere from 20-40% of the $150 billion – “ will be written off as a loss. So the actual number is more like 1.3-2.4% of assets.

We’ll do another calculation in a minute, but a quick historical check at this point is very, very interesting. Citigroup stock has taken big hits before, and has recovered. Let’s take a look at a chart from 1990 to November 1, 2007.

In 1998, the collapse of Long Term Capital led to the savings and loan crisis. Citigroup fell from $36.10 in July 1998 to a low of $14.25 in August of 1998 – a 61% drop in two months. It wasn’t until April 1999 that the stock recovered and hit its next peak of $38.13.

Starting with the tech bust in August 2000, Citigroup fell from a high of $59.13 to a post-Enron low of $26.15 in September, 2002. That was a 56% drop over a period of just over two years. A year and a half later, in March 2004, the stock had recovered and was up to $52.88.

Starting last December 2006, Citigroup fell from a high of $57.00 to a low of $29.60 this month – “ 48% drop in less than a year. Today, Citigroup trades at about $33. If it returned to $57, that would be a 73% gain. If that occurred within 2-3 years, then that would be a 25-35% annual return. And if you expect a 10-15% annual return on your investments, then we’ve even got a margin of safety.

The thing is, history would suggest that Citigroup might drop even further, another 5-10% or so. But as we all know, history is not a great predictor of the future in stocks. So we must ask, does the stock’s fundamentals indicate a further decline?

It’s Going to Get Worse Before It Gets Better
Unfortunately, the answer is yes. There’s a lot of subprime exposure on the books, and more write-downs can be expected. Citibank says that it has $55 billion of subprime assets in its Securities and Banking Business. The company had a $1.6 billion writedown in Q3, and as much as $11 billion is expected in Q4. That would mean a $12.6 billion loss, or 23% of the $55 billion of subprime assets.

If you’re not familiar with all this, think of it this way. Citigroup invested in $55 billion of subprime related securities. Because no one is buying these securities, Citigroup is saying that these securities are worth $12.6 billion less. Kind of like a house that is worth 23% less than when it was purchased.

As more adjustable rate mortgages reset next year, additional defaults are expected. And it’s possible that Citigroup will have further write-downs. Again, kinda like a house that’s just worth less and less as time goes by.

In addition, Citigroup has more subprime exposure in other parts of its business. Morgan Stanley estimates that 13% of Citigroup’s loans, or $95 billion worth, are subprime loans. That’s comprised of $41 billion in mortgages, $2.3 billion in home equity, $35 billion in credit cards and $17 billion in automobiles. Losses in these areas have yet to be estimated and recognized.

How bad could it be? Here’s where the quick calculation is in order. If 30% of the $95 billion were written off, then that’s a $28.5 billion hit to the income statement. If we assume a tax rate of 34%, that’s a $18.8 billion after-tax deduction from net income. In 2006, Citigroup had $21.6 billion in earnings. In other words, that level of losses would wipe out 90% of earnings for the year, but Citigroup would still have some profit.

And most of the time, I don’t believe in white knights coming to the rescue, but I seriously think that if Citigroup gets into trouble with it’s capital ratios, there will be a bottom fisher (much, much bigger than me) who will come in invest some money. That money might be expensive, and may very well dilute existing shareholders, but it will be there.

In sum, there is a very good argument for expecting further writedowns in Q1 and Q2 of 2008. That would reduce earnings expectations. And the stock may very well take an additional hit. But I do think the company will survive and recover.

How to Play It

Sometime over the next six to nine months, it will be time to buy Citigroup. Actually, I should say several times over the next six to nine months, because we are in a window of opportunity, and it’s notoriously hard to call a bottom.

So rather than buy all at once, you can buy in stages. Some would say buy some now, and buy more later. Others would say wait until more bad news hits. For me, I already have some Citigroup stock, but expect to buy more over the next year.

Keep in mind that even the pros, the gurus, and even the Oracle Warren Buffet don’t expect to call they bottom. They buy in stages, building a position over time. As long as they stay in the range of the trough, they’ll do fine. And so will you.

Also, the “pros” usually “pyramid” – “ meaning they buy small amounts in the beginning, and buy larger volumes as the price declines. As a result, the weighted average cost stays low.

Finally, keep in mind is that this is a long-term investment. You need to expect to hold the stock for 2-3 years, at least. A quick solution to Citigroup’s problems is very unlikely.

Before going on, I can’t forget to mention the dividend. Today it’s at 6.7%, pretty hefty by any standard. You need to know that there have already been questions about whether Citigroup can maintain it’s dividend. Within the last few weeks, Citigroup’s capital ratios had started to look weak, and the Abu Dhabi investment gave the company some much needed cash. No doubt that when further writedowns occur, the dividend could very well be challenged again. Still, I’m estimating, based on history, that it’s unlikely the dividend will fall below 3.5%.

For Risk Takers – “ The Options Play

Normally, I don’t trade options. Some people love “em because there’s a lot of leverage in options; you don’t have to put as much money down. But they are riskier because there’s a time limit on them. Stocks will often surprise you, and turnarounds and stock moves can take much longer than expected. If you’re stock doesn’t move in the right direction by the expiration date, then the option goes to zero. And that’s a 100% loss.

On the other hand, if you have high confidence in a stock’s direction, then there’s some interesting opportunities. Consider that today, Citigroup is trading at $33.20. A long-term January 2009 option to buy at a strike price of $32.50 would cost $5.85.

Normally, you buy in lots of 100, so the option to buy 100 shares would cost $585. If you want to buy the stock, you break even when the stock hits $38.35 – “ the $32.50 + $5.85. So if in January 2009, the stock is at $40, you could exercise your option and buy 100 shares for $3,250, and sell them immediately for $4,000, netting $750. Subtracting out your investment of $585, you’re left with a $165 return on your original investment of $585. That’s a 28% return.

The other possibility is to sell the option just before expiration. I can’t tell you exactly how much the option will be worth, but if the option is at $32.50, and the stock is at $40, it’s in money by $7.50, or 28%. Right at expiration, the gain would be the same – “ 28%, no surprise there. But if the stock hits $40 a month or two before expiration, then the option will be worth more than $7.50. That’s because there is still time left until expiration, and that time value will add some value to the option.

This works only if you have high confidence that the stock will go above breakeven before the expiration. There’s a fair possibility that Citigroup can hit $40 in a year, but given that I believe Citigroup will fall further, it may very well be worth waiting. So keep an eye out on the situation.

The Conservative Investment Option – “ US Bancorp

While I expect to make a further investment in Citigroup, it’s clearly not an investment without risk. There are still several issues that could affect the stock – “ the choice of CEO (Citigroup’s CEO, Chuck Prince, recently resigned because of the subprime problems, and a successor has yet to be named); larger than expected write-offs; dividend cut; general economic conditions, and so forth.

At the beginning of this article, we looked at several banks. You’ll notice that the bank with the smallest drop in price is US Bancorp. Warren Buffett, the classic value investor, has been adding to his position in this company. It’s worth asking why.

You really learn about companies when you put them side by side:

Source: 1Yahoo.com; 2US Bancorp Q3 Earnings Release; 3Citigroup Q3 Annual Report.

I’m sure these numbers make you dizzy. Trust me, finding them made me dizzier. But let’s go through these and see what they say.

First, the performance metrics. Net interest margin is basically interest earned (less cost of earning that interest) divided by the assets that produced that interest. It’s a measure on how much the bank earns on the assets it has. You see that US Bancorp’s margin is 3.44%, vs. Citigroup’s 2.62%, almost a full percentage point more.

Return on assets is net income divided by assets. What’s the difference between net interest margin and return on assets? Interest isn’t the only way a bank earns money. Net interest margin measures only the way a bank earns money through interest; return on assets measures how well the bank uses all of it’s assets. Here, US Bancorp’s return is 2.06%, Citigroup’s is 0.91%. Again, US Bancorp is stronger on this measure.

As mentioned, return on equity is net income divided by the equity base. So for every $100 invested, US Bancorp would return $123.30, Citigroup would return $115.2.

Finally, the efficiency ratio, which is defined as operating expenses divided by revenues. This tells you how much a bank spends to generate revenue. US Bancorp’s expenses are far lower – “ 46.7%, vs. 63.5% for Citigroup.

So when you looking at all these metrics, you don’t have to be a stock whiz to realize that US Bancorp is the leaner, meaner machine. It’s basically better at generating profits.

Let’s take a look at the credit side. Banks set aside money to cover expected credit losses, and this is listed under “provision for credit losses”. Citigroup’s provision was $4.8 billion for Q3, US Bancorp’s was $199 million. Yes, I said million. That really ought to tell you something. And guess what. That doesn’t include the $5-7 billion after-tax charge that Citigroup has announced for Q4.

No bank is immune from the recent credit problems, but it seems that US Bancorp has done a much better job of managing it’s risk.

And that also shows in two popular valuation metrics, price to book and price to earnings. Price to book is the stock’s assets minus liabilities per share. It reflects the value of the company based on its balance sheet, and a lot of analysts like to use this measure to look at banks. The larger the asset base (e.g., more deposits), the more a bank can earn. US Bancorp’s price to book is 2.9x, vs. 1.3x for Citigroup.

On a price to earnings ratio, US Bancorp is also more expensive. The PE represents the multiple of earnings that you would pay for a stock. US Bancorp’s current PE is 12.7; Citigroup’s is 8.9.

It’s pretty reasonable that you would pay more for a stock like US Bancorp, and we see now why Buffet is buying the stock. US Bancorp is a conservative, steady performer. Citigroup takes more risk and hasn’t managed it well.

The interesting thing is, you’re not paying that much more. US Bancorp is expected to grow at 8.1% and has a dividend yield of 5.1%, which could drop to 4% in more normal times. You could expect a return in the 12-13% range over time. Citigroup has a 6.7% yield, which could drop to 4% as well in more normal times, and is expected to grow at 10.3%. So with Citibank, you’re hoping for something in the 14-17% range.

Now, these are guesstimates, and actual results vary because realty and projections don’t often mix well. But if you look at the numbers, the bottom line is that US Bancorp is likely to offer steady (and probably boring) earnings, but at a return that’s a handful of percentage points less. Given the historical variability of Citigroup’s earnings, Citigroup’s are more likely to fall short of expectations. That’s why Buffet owns US Bancorp. He wants the steady, boring and more certain earner.

In this environment, US Bancorp is a good deal. It’s a weaker environment for all banks, and US Bancorp will take some dings along with everyone else. As a result, the price will drop along with the rest of the sector, just not as much. In better times, the company will also have better pricing. So it’s a very good time to look at the company.

So for this month, there are a couple stock options to look at going forward. Until next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.