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Investing in Financial Stocks

Written By Brian Hicks

Posted July 31, 2008

For the average investor, the urge to buy low is practically etched into their DNA. That’s why anything they find on the bargain rack is just too tempting for most retail buyers to ignore.

But as wise as that strategy obviously is, it is often a temptation that leads to disaster—particularly when buying in the universe of fallen but can’t miss high flyers.

That’s because when a stock has fallen heavily from a very high price to a much lower price, some investors just can’t seem to help themselves.

"It’s an absolute bargain," they say to themselves as they "scoop up" what they are convinced are great values.

But more often than not those former big winners turn out to be nothing more lead weights around their ankles as the shares of those companies continue to get "cheaper". In short, they are not values, but value traps.

That, of course, is one of the big dangers these days when it comes to investing in financial stocks, even though most of them have fallen as much as 50% or more off of their highs.

The challenge then for all "value" investors is in determining if a company’s misfortune is either temporary or if it reflects protracted problems with the business itself.

That’s what makes financial stocks so difficult to buy these days even at these levels, because the banks can’t really recover until the housing market bottoms. And until that begins to happen these institutions face the types of write-offs that make things like book value and earnings as elusive as the Loch Ness monster.

So in these circumstances you have to ask yourself, how exactly can you arrive at a "true value" with wildly squishy numbers. The short answer, of course, is that you can’t. That means you need to check emotions at the door before you decide to pick up one of these "values."

Financial Stock Investing….No Bargains Here

Of cousre, that was easier said than done for Richard Bove, the famed banking analyst at Punk Ziegel & Co.

In March, Bove just couldn’t help himself as the financials melted down. In fact, he even went so far as to call Citigroup a generational buy.

"I think the stock will be trading at $55 in the next 3 years, concluded Bove, "which is double from where it is at the present time. You only get a once in a generation chance to buy a stock like this at this price."

"This is it," he said.

But the markets only shrugged and sent Citigroup Inc.( NYSE:C) even lower. Since then the financial powerhouse is down another 20%. Some value.

According to the International Monetary Fund (IMF) that is a trend that will likely continue as the mortage crisis digs deeper into the balance sheets.

The fund warned on Monday, that while likely losses on US subprime mortgages have "largely been acknowledged" in the form of writedowns, financial institutions faced a second wave of losses on other loans. Think Alt-A and prime here.

As a result, credit quality "across many loan classes has begun to deteriorate with declining house prices and slowing economic growth." The toxic stew, in other words, continues to grow putting balance sheets were under "renewed stress" making it more difficult for the financials to raise new capital without massive dilution.

Moreover, the IMF reaffirmed its controversial earlier estimate that total losses in this cycle could total $945 billion – a number that combines mark-to-market losses on subprime-related securities and estimates of likely losses on loans.

That put the game roughly in the 4th inning since financial institutions globally have written off about $400 billion in losses since the crisis began last August. But the truth is the losses are going to be much higher than that so this is a game that could easily go extra innings.

And needless to say, the longer the game goes on the deeper and deeper the financials will fall into the pit. Some simply won’t live to the see the end. Is that a chance you are willing to take?

Even still, some investors are still taking the value bait hook, line, and sinker.


Merrill’s Little Game

Take Merrill Lynch & Co. Inc. (NYSE:MER) for example. It’s the financial value scam Du Jour.

Shares of the company traded above $30.00 a share 12 sessions ago when the brokerage announced one of its worst quarters in history, losing $4.65 billion, or $4.95 a share.

But that clearly wasn’t everthing going on at Merrill—-not by a long shot.

Just 10 days later, Merrill…Ahem…coughed up some "new" news revealing a massive dilution of the shareholders, an $8.9 billion capital raise, and $5.7 billion in further losses on its vanishing CDO portfolio.

All told, the company sold 380 million shares for $22.50 each diluting shareholders by 36% since June. That, of course, was a 26% haircut vs. only 2 weeks ago. Shareholdes should be outraged.

Nonetheless, the stock actually traded over 3% to upside on Tuesday. It is absolutely insane.

However, the truth behind Merrill’s little shell game was more onerous for the rest of the financials.

Here’s why.

Merrill took a marked-to-market loss of 78% on the super senior CDOs it dumped in Lone Star Capital Management for 22 cents on the dollar. Even worse, Merrill had to finance 75% of their own deal meaning the real price is possibly on the order of 5 cents on the dollar.

That means that the value of every slice of those CDOs below the "super senior" level is worthless. In Merrill’s case, a $30.1 billion asset was dumped for a measly $1.6 billion. Nice job fellas.

Those are marked-to-market realities that every other financial that is still holding this toxic garbage will have to take. When they do shareholders will be crushed. In other words,this wasn’t an end, but a beginning.

So the advice here is simple: Never try to guess the value of a moving target even if it looks "cheap."

The financials are on the bargain rack for a reason. Leave them there for someone else.

The shorts aren’t evil. They are right.

By the Way, here’s the running commentary out of Merrill since the first of the year. Keep in mind that Merrill was a $57.00 stock in January.


Source: Bespoke Investment Group

It’s nothing more then a shell game.

Until next time….

Your bargain-hunting analyst,

steve sig

Steve Christ

Chief Investment Analyst

The Wealth Advisory


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