Why #Value Investors Should Buy #Bank Stocks

I recently discussed (in Investment Styles) the two major different styles of investing: value and momentum.  One difficulty with following a value approach is the difficulty in measuring value, since much of it these days is tied up in intangible assets.  I will suggest here that, counter-intuitively, buying bank stocks is the solution to this problem.

bank bars business commerce
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The value approach to investing is simple to understand, though perhaps a little harder to implement.  The basic idea is that you buy things when they are cheap.  Finding cheap assets would classically rely on looking at concepts like “book value,”  which is just the accounting value of everything owned by the firm in which you are thinking of investing.

In previous decades, book value would have been simple to calculate: you could just look at the published accounts and examine how much the accountants said each asset was worth.  A company making cars, say, would own a lot of items like factories, car parts, machinery and land.  You could look at all of those items that you could walk up to and touch, and add up all the values, and that’s it: you have calculated book value.  If you can buy the stock for less than book value per stock, you have made a good investment.  If the company sold all of its assets, and turned that book value into actual cash, each shareholder would get more than book value.  That’s why value investing is a good idea, and why you should try to buy stocks at less than book value.

This simple approach is more difficult in modern times, because IP — Intellectual Property — is much more important than it used to be.  IP is anything the company owns which is valuable but that you can’t touch.  It could be a suite of software, the value of a brand, or

close up of computer keyboard
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simply the know-how involved in producing the products or services that the company produces.  To illustrate the scale of this IP problem for value investors, consider the following estimate.  Ocean Tomo, an investment bank, reckoned that the proportion of the value of S&P500 companies which was tied up in IP increased from 17% in 1975 to a huge 84% in 2015.  So it is clear that there is a very serious problem in adopting a value investment approach these days, and that’s unfortunate because in my opinion, it is the only approach that works.

So what should investors do about this?  I think they should look at bank stocks.  This will seem dramatically strange at first sight, because banks own hardly anything at all that is tangible.  However, we already saw above that this is true for all companies now, so it can’t be avoided.  The key point though is this: there is a well-determined market value for everything owned by a bank.

business charts commerce computer
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If you look at the balance sheet for Deutsche Bank, for example, you will see a very large number of items.  They will all have market values though.  That will be true of shares, bonds, interest rate swaps, credit default swaps, loans to corporates, futures and options, office buildings, warrants, cash in various currencies and any of the other myriad financial assets.  There will also be a certain amount of brand value but I think that will be fairly low in the mix.  So basically everything owned by Deutsche Bank could be turned into cash, and a known amount of cash, quite quickly.

Banks typically traded at 2.0x book value before the crisis.  The rule of thumb for value investors in the sector was “buy at 1.0x book value, sell at 2.0.”  Something like this is still true: you can buy Deutsche Bank at 0.3x book value and I think you should.  That’s the right approach for value investors today.

See Also:

Investment Styles

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

The #Bitcoin Bubble Is Caused By The Halo Effect

Investing Like Geoffrey Boycott

Investors are very bad at forecasting political events.  This is well-known to me after many years of trying.  It is discussed in a good recent article in The Economist:

https://www.economist.com/news/finance-and-economics/21726084-wishful-thinking-may-lead-them-astray-investors-are-not-great-predicting

For example, they — and I include myself in this — were wrong about all of the following events.

  • The election of Trump
  • The effects that election would have on markets
  • Whether Trump would pass any legislation
  • The Brexit Referendum
  • The subsequent UK General Election

Interestingly, many non-experts were “right” about these events.  I put “right” in quotation marks because I think that The Economist is right to say that wishful thinking is partly what got people to their forecasts, rather than pure rational analysis.  This is an example of what Kunda(1990) calls motivated reasoning.  In other words, it is a psychological bias operative in financial markets.  In my new book:

https://www.routledge.com/The-Psychology-of-Successful-Trading-Behavioral-Strategies-for-Profitability/Short/p/book/9781138096288

— I argue that understanding the wide array of psychological biases active in oneself and other market participants is crucial to driving financial performance.

Now we come to Geoffrey Boycott.  I will briefly explain cricket to the extent we need to IMG_0042know about it here.  It is somewhat like baseball.  You want to score without getting out.  The parallel with financial markets is that you want to make money without “getting out” — which I interpret as meaning you take a loss so large that you abandon markets.

Now, Boycott was famous for patience.  He would score freely when opportunity presented itself, but otherwise he would just make sure he didn’t get out.  In the jargon, he “occupied the crease.”  This meant he might be there all day.  The key point is this: if you stay there long enough, the runs will come.  Similarly, in financial markets, if you stay the course, the profits will come.

So I did not see Brexit.  But I was invested in US equities at the time.  So I got the overnight 15% boost from sterling depreciation.  You might call that luck.  I call it occupying the crease.

See Also:

If You Like Gin And Marmite, You Are Probably A Better Trader

The Psychology of Successful Trading: see clip below of me explaining my new book!

The Forthcoming #Bitcoin Crash Will Kill The #Trump Demographic

UK Deficit No Longer A Problem