Reflections on banking (I) - maybe George Soros was right

One of George Soros’s most interesting contributions to finance and social theory is the idea of reflexivity. It is not an idea that originated with him, but he has done a lot over the years (often to the sneers and jeers of the academic community) to popularise its importance in determining social outcomes. Its basic premise is that in many social situations the theories and beliefs of the participants affect the situation itself. As defined on Wikipedia:

“...[R]eflexivity is considered to occur when the observations or actions of observers in the social system affect the very situations they are observing, or theory being formulated is disseminated to and affects the behaviour of the individuals or systems the theory is meant to be objectively modelling. Thus for example an anthropologist living in an isolated village may affect the village and the behaviour of its citizens that he or she is studying. The observations are not independent of the participation of the observer.”

In his book, “The Alchemy of Finance”, Soros used numerous episodes from recent financial history to support the idea. For example, one of his long standing criticisms of the fundamental analysis of equity investments was that in many cases the share price was not independent of the fundamentals. Clearly, for fundamental analysis to work this cannot be the case - for fundamental analysis holds that (over time at least) the fundamentals will determine the share price.

Soros used as one of his examples the conglomerate boom over the late 1960s. Over this period, there was a bubble in many conglomerate mega-cap stocks in the US. The false belief (or “prevailing bias” as Soros called it) was that the diversification and scale offered by these companies meant they deserved a valuation premium over their smaller more focussed peers. The reality, as Soros argued, was that this very belief was determining the outcome. As more and more investors started believing in this false argument, the valuations of the mega-cap stocks – “the nifty fifty” as they were known at the time – were bid up to substantial premiums. The companies' then took advantage of their highly valued equity to acquire more and more of their smaller (lowly valued) peers. It didn’t matter if the deals were not earnings or cash flow accretive because the market would revalue the acquired earnings to that of the acquiring company. Thus, in this way, the share price served to determine the fundamentals.

What is interesting is that the fate of bank shares over the past 18 months has been largely determined by a similar process. One can attempt to undertake fundamental analysis of these companies - what do they have on their balance sheet? what is the net worth? size of write-downs? etc etc. However the reality seems to have been that the share prices themselves have been determining the fundamentals.

The problem with the banks has been their exposure to the wholesale markets - short term funding from money markets. Their business model consists (consisted is probably more accurate) of taking short term funding from these markets in order to finance long term assets. They have to be able to roll over these liabilities because most of their assets are not particularly liquid. Moreover in most cases the leverage was very considerable - often greater than twenty times. The value of the equity portion therefore depends on the position of the short term liabilities relative to the long term assets. Unfortunately for the banks, no matter what their managements' say, the share price acts as an indicator of the value of the assets relative to the liabilities. As the share prices fall (to reflect the fall in the value of the banks' assets), potential funding sources take it as an indicator that the bank is likely to fail. This makes it harder and harder for the bank to roll over its short term liabilities.

As Lehman Brothers discovered this process inevitably leads to insolvency. Beyond a certain point it does not actually matter what the value of the assets really is. Once market participants observe that the share price is cratering, they will take note and run for the hills. Funding dries up and the bank is insolvent.

Of course we will never know if Lehman was actually bust - i.e. if it had been possible to organise an orderly sale of all the company's assets at fair market values, would the proceeds have covered the liabilities? It is possible the answer was yes, but it does not really matter. The point is that the business model itself was bust.

I suggested to colleague that perhaps the short selling ban on financials imposed by the SEC was perhaps not such a bad idea. No doubt many hedge funds saw what was happening and realised that they could force the process along by shorting the equity even further. He made the good point that actually the problem lies with the lack of regulation. Because the regulators have no idea what the big market positions are, they are totally in the dark when they try to assess the systemic fallout of a big financial bankruptcy. If they had known who was exposed to what, they would never have allowed Lehman Brothers to go under.

The end of the world as we know it? Or the greatest buying opportunity in a generation?

The last couple of months have been truly hectic, such that I now feel glad just to have made it to the weekend.

Observing what is going on within the financial sector has led me to conclude that it is almost certainly the end of the world as we know it as far as banking is concerned. By all accounts the problems within banks are now starting to spill over into the real economy, with business is some parts of the economy pretty much grinding to a halt. The authorities now seem to really "get it", as was clear by the Brown and Darling plan announced earlier in the week. It is only a matter of time before the US goes down the same route. Perhaps something will come out of the G7 convention this weekend. Indeed one has to hope it does, for this is truly the first global financial crisis, the one that all the academic books warned of, the one that the current national system of regulation would not be able to deal with. Some sort of global coordinated response on a scale larger than seen so far is probably going to be necessary.

Unfortunately (or fortunately!?) for the banks, I think this is most likely to mean a complete sea-change. Now that the authorities are aware of the risks posed to the real economy they will not stop until the problem goes away, even if it means complete nationalisation, firing of all directors and senior management and replacement with regulatory bureaucrats. If the banks don't start lending to each again on their own then I think this will be what happens.

Yet when I look at stock market valuations, I cannot avoid the conclusion that this could well prove to be the greatest buying opportunity in a generation - much like 1933 or the early 1980s. Long term valuation metrics would certainly suggest so. For example, the Graham-Dodd 5yr p/e for the European market is currently at 11.7, only slightly above its historical trough of 9.8, and well below the average of 18.6. Admittedly, using 10 year data would probably be less favourable but the conclusion still holds. The US market looks less cheap on this measure, although still well below its long run average. Tobin's q - a measure of market value of assets versus their replacement cost - currently stands at 0.5 for the US market, versus its 50 year trough of 0.4

Before this week, the FTSE 100 was trading on a 2009 p/e of around 10X. So after this week's dramatic move, it will be down to around 8X. For sure the "e" for 2009 is wrong (too high), but even correcting by 30-40% still leaves the market looking far from expensive.

The sector I focus on (media) has some pretty resilient companies trading at what looks like absurd valuations. For example all the advertising agencies are on huge discounts to their historical valuations - 50% off trough multiples. Perhaps the long term future is not as bright as it was in the past, but these business services companies are not going to disappear, and neither are companies going to stop advertising. Earnings will almost certainly fall next year, but this is more than priced into the shares already.

Opportunities are being thrown up in other sectors too. The recent move down has been driven heavily by industrials and mining, sectors that had previously been holding up OK. Some defence and engineering companies such as Cobham and Meggitt are on multi-year valuation lows. These business have many highly defensive and long-term revenue streams. Within financials asset managers (Legg Mason, Ashmore) also look exceptionally cheap. Despite what markets are doing, people are not going to stop needing their assets managed.

All of this leads me to conclude that now is actually a fantastic entry point for any unleveraged investor with a reasonable time horizon (i.e. more than 2 years). Indeed, this is actually a natural part of the credit cycle. Despite all the media hype surrounding this crisis, it is actually following all the normal stages of a credit cycle (all be it on a slightly grander cycle). What we are witnessing now is a great de-leveraging, as all the excesses of the past few years are unwound causing asset prices to fall. With money markets not really functioning, the equity market is currently the only liquid market. This means it is suffering particularly badly as leveraged market participants facing margin calls or debt maturities become forced sellers. It is natural in such an environment for unleveraged market participants to enter the market, pick up a lot of bargains, and in the process restore the market to fair value.