Bargain hunters still cautious about financials

Financials look like a sure value play yet some managers, most notably Legg Mason’s Bill Miller, have admitted they are unsure whether to add to their holdings in this sector right now.

In his widely read letter to shareholders, Miller, the legendary value manager of the Legg Mason Value Trust and its Canadian version, CI Value Trust, says it’s now the worst market for value investing that he’s ever seen. After 15 consecutive years of outperforming the S&P 500 index, he’s now experienced outsized underperformance. While the index is down 16.78% as of July, the CI Value Trust has declined 37%.

“John Rogers, the founder of Ariel Investments, came in to see us last week. John has been an outstanding investor for 25 years or so, but like almost all value types, is going through one of his toughest periods now,” Miller writes. “His assets are down, similar to the experience we’ve had. He said it was the most difficult market he’d seen, a judgment I would have given to the 1989-1990 market, up until the frenzy erupted over Fannie Mae and Freddie Mac, which sent financials to what looks like a capitulation low on July 15th. I am now in John’s camp.”

He also admits he’s made mistakes in adding to his financial holdings when their share prices first started to plummet last year. Miller’s heavy holdings in financials and homebuilders have been viewed as a leading contributor to his fund’s dismal performance of late. Even though U.S. financials are the most oversold they have been in 20 years, he’s still not sure it’s safe to buy yet.

“While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious now, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it,” he writes. “Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?”

Miller doesn’t explain which way he’s leaning right now. But he does say over the long term, things will improve.

“I do think some things are obvious: it is obvious the credit crisis will end, and it is obvious the housing crisis will end, and that credit markets will function satisfactorily and house prices will stop going down and then start moving higher. It is obvious that the American consumer will spend sufficiently to keep the economy moving forward long term,” he adds, “It is obvious that the U.S. economy, already the most productive in the world, will get even more productive and will adapt and grow. It is obvious stock prices will be higher in the future than they are now.”

Miller’s view would suggest patient investors will be rewarded. In Canada, however, financials which have not been as heavily exposed to the U.S. subprime and credit meltdown, are looking like a good opportunity, says Marc-Andre Robitaille, the president of Montreal-based Robitaille Asset Management and the manager of the AGF Dividend Income Fund.

Robitaille says Canadian investors had almost forgotten that blue chip financial stocks had almost been viewed as a sure thing the last few years. However, they are still equities and subject to volatility, and he thinks it has forced investors to take a harder look at their valuations.

“People had become accustomed to steady dividend increases, earnings increase and payout ratios,” he explains. “These dividend increases are likely going to be less aggressive going forward at least in the medium term than they were in the past couple of years. Earnings growth is forecast to be still negative for the coming quarter or two. This has been more than reflected in the current multiples [on share price] and where they are right now.”

Robitaille says the fundamentals on Canada’s financial stocks remain strong. He notes that during the recent plummet in share prices, none of the big Canadian banks have cut their dividends, unlike some of the U.S. banking giants such as Citigroup. This means investors looking for an income stream are able to attain dividend payout at a cheaper price.

“We went from 13.5 times or even 14 times forward earnings, to probably below nine times right now. That’s a big drop, nearly a 50% contraction in multiples in the banks. The same thing can be said about the life insurance companies, forward multiples have gone from 14.5 to 10 times forward earnings,” Robitaille says. “That contraction in multiples is very aggressive because the trading return on equity of the bank is still north of 20% and they are paying out a dividend yield of almost 5%.”

On a stock like BMO, investors are getting a yield which is closer to 6%, he notes.

“If BMO is trading at $47.60, and pays a dividend of 70 cents per quarter, $2.80 a year, that gives you a dividend yield of roughly 5.97%,” he says. “If you had bought BMO a year ago, you would have paid a lot more for the stock, around $65 or $70 with a similar payout.”

Still, as yields increase, Robitaille cautions investors looking for income streams to keep in mind that financial stocks are equities, not bonds.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(08/01/08)