Fund Managers Still Believe in Financials

For quite a while now, I've been looking for the bottom in the financials along with many others watching the market. This article about fund managers certainly seems to support my thinking, but also makes me glad that I haven't taken the plunge just yet. With the best fund managers seeing their portfolios hit by as much as 60% year-over-year, that represents a lot of explaining to investors.

Are these fund managers just fooling themselves? Are they just too stubborn to see what's going-on? Many believe that the financials have been unfairly pummeled by the markets. To some extent, I agree, but there's no denying that they deserve much of their stock price declines resulting from the CDOs and the continuing housing slump. That said, there I do also believe that investors have been so scared-off from this industry that the stocks have fallen harder than they should have. Of course, the question then becomes when will we see a bottom in the financial and when is the best time to get back in. Looking at the performance of the funds managed by the vest best of Wall Street, it would seem that even those in the know don't really know.

What do Analysts Actually Consider?

Many are pointing at Goldman Sachs this week and laughing a bit. A week ago, they suggested that the financials had hit (or were at least approaching) a bottom and that investors would be well to reinvest in the sector. A few days later, of course, they reversed their position and now recommend an underweight investment. My question has little to do with this particular recommendation or the financial sector, but rather how analysts could waiver between such extremes within such a short period of time. What is it that they look at?

It's certainly not the fundamentals! The fundamentals of a company do not change overnight and nor do they change within a week. Analysts are supposed to be the insiders who have a window into a sector, industry and a small group of companies - providing investors with greater clarity on a publicly traded company's viability as a going-concern. When I see such a respected firm reverse their position within such a short period of time, however, they come across as just another investor on the street that's watching the headlines on the ticker tape; they're just reacting to the latest news and speculation rather than actually investigating the underlying truths.

Is the downgrade of the financials warranted?

In short, no. The downgrade of the investment banks just doesn't make sense. Why? Simple. With access to the Federal Reserve's credit facilities, the same facilities made available to the commercial banks, these investment banks have access to plentiful, and cheap, capital whenever they need. A credit rating downgrade, by definition, presumes that the ability of the entity being downgraded to satisfy its debt obligations has somehow worsened. The fact that these banks now have access to more, not less, capital directly contradicts this action by the ratings agencies.

So, then, why did they do it? Good question - I'm not sure I know the answer. The consensus, however, seems to be that the ratings agencies are late to the game and are now reacting to popular fears that have all but disappeared since the first fall-out from the collateralized debt obligation defaults and, more recently, swap defaults and associated insurance scandals. Furthermore, the spotlight that was placed on ratings agencies following the aforementioned collapse when they did has placed the integrity of their models and practices into question. It could very well be that they are now simply trying to follow the herd rather than lead.

Timing Losses & Financial Institutional Strength

Let me tell you a story to prove a point. Assume that you loaned me $1,000 2-years ago (thanks, by the way) and I had not paid you any interest or principal ever since. Assume further that we met today to negotiate a settlement and I offered to pay you $200 as a one-time payment to satisfy the entire amount of the loan. The question: how much money did you lose and when did you lose it?

Those of you who are financial inclined are likely already doing some discounted cash flow calculations, but let's keep things simple; let's ignore the time-value of money. Many of you, then, are likely shouting a loss of $800 today, and I'm sure that many more of you would be tempted to agree, but to see why this is the wrong answer, we need to differentiate between paper-losses (accounting) and actual losses (cash flows).

From an accounting perspective, you, the lender, had created an account to represent the account loan and the expected future repayment. What is important to acknowledge, however, is that the $1,000 that you lent to me flowed out from your bank account 2-years ago - not today. Put differently, you have had $1,000 less funds for 2-years; my offer to repay you only $200 of the full amount does not represent a loss, but rather a positive cash flow today. Actually, it's as simple as:

-$1,000 :: cash flow out to me in the form of a loan

$0 :: cash flows from my repayment of principal and interest

+$200 :: cash flow from my repayment and settlement of the loan today

Now, I'm sure you're asking yourself why this revelation is important. Well, let's consider the banks that are scrambling for credit and new sources of financing in light of the so-called credit crisis spurred by the billions of dollars in write-downs. Ask yourself when those related losses actually occurred. Also, ask yourself whether the settlement of these debts at $0.20 on the dollar leaves more or less cash on the balance sheets of these banks. Notice, that I asked about whether this left more or less cash - I didn't ask about net assets. This is the difference between accounting losses and actual (cash flow) losses.

The interesting conclusion that many of you are now likely making is that the settlement of these bad debts is actually leaving these banks in a stronger, rather than weaker, financial position. So why are they scrambling to borrow from the Federal Reserves auction facilities? Good question. They certainly don't need the cash - their cash positions haven't changed! Only their accounting positions have changed. It is true that this does affect their ability to lend as it leaves them with fewer assets and collateral, but fears over bank failures is certainly unfounded. Now, as an investor watching the markets and seeing the tumbling stock prices of many, if not all, financial institutions, ask yourself if the broader market has misinterpreted the events over the past few months. Lastly, ask yourself the market's overreaction leaves you with an opportunity to profit from the rebound that is unquestionably going to happen - given enough time for the banks to restart their lending engines.