Dan Culloton: Hello. I am Dan Culloton, associate director of fund analysis with Morningstar, and I'm here today with Chris Davis, who is portfolio manager of some very prominent large blend funds, including Selected American Shares SLASX, Davis New York Venture NYVCX, and the much more concentrated Clipper Fund CFIMX. Thank you for being here today Chris.
Chris Davis: Sure, Dan. It's good to be here.
Dan: Your firm and your funds are known for investing in financials. In the last three months we've had a very sharp rally in financials. We've seen some of the stocks in your portfolio, American Express AXP, Goldman-Sacks GSP, Wells Fargo WFC increase by 50% to 100% in some cases. Have we gone too far too soon? What has this done to the valuation of these stocks in the financial sector in general?Read Full Transcript
Chris: Well, there is such a deep desire to make predictions about, "Have we seen the bottom?" We've heard people declare the bottom two or three times, only to have another drop and another significant drop. So everything in me makes me feel like this is sort of a premature rally. But aside from what the stocks do in the near term, the real question is, what is the earnings power of these businesses relative to their current market capitalization?
And if they don't realize that earnings power for two years, or three years, or four years, they are probably still compelling values at these prices, even though they may trade down in the near term.
This is always the hard question: What is discounted? We know Wells Fargo's losses are going to get a lot worse. And we know what the earnings power is two or three years out. What we don't know is how the market will react to those losses being realized.
And I think that's too tough to predict. But my gut says maybe they have gone a little bit too far too fast. But on the other hand, I've been a holder of these and a buyer of some of them over the last few months. So my inclination is to focus on where I think they can be in three years rather than where they are going to be in the next three months or six months.
Dan: There's a lot of talk about how the financial sector is going to change, and we really don't know where that's going to go with additional regulation and capital requirements. How do you factor that into your analysis of these companies when you're trying to figure out how much they can grow going forward?
Chris: Well, if you think about the different factors that are being uncovered everyday and you imagine putting them on a scale, there are some that reduce the value. So companies carrying less leverage often will have lower returns on equity. On the other hand, they often will have higher multiples. So there is some offset in terms of the leverage requirements. Most of the financials we've owned have tended to have lower leverage than their peers. That is not always the case, but it's something that we focus on.
Then you think about, well, there is this adverse development in terms of the near term credit environment, but that is so dramatically offset by the demise of competition. I mean, the market shares are so much larger.
Then the third thing you think about is funding costs, because what is amazing...For a financial company, that is your cost of goods sold. It's your raw material. Funding costs relative to asset yields, we'll probably never see spreads like this again in my career. It's that dramatic. We are in banking heaven in terms of the spreads.
So although the credit losses are going up, the earnings power, the pre-tax, pre-provisions have gone up so much too that they can afford the bigger losses. So there is some offset there.
The wild card is really what will be the unintended consequences, or unexpected consequences, of large government ownership in some of these businesses?
Now many of them are anxiously repaying TARP as fast as possible because they don't want to find out. But when there is a backlash -- and in some ways it deserved backlash against the malpractice at so many financial institutions -- the regulatory consequences of that, the fiscal consequences, are hard to anticipate.
Our feeling is that they will probably be pretty bad, but that they will be offset by the improvement in the competitive landscape.
So if you end up with businesses that are confined to traditional financial intermediate functions with only modest amounts of leverage in an environment where catastrophe is much lower, you may end up with slightly lower returns on equity than we had at the peak. But I think they will still be very satisfactory, and the predictability or the sureness of them may actually mean that they trade at higher valuations than they have historically.
So all said, I think the regulatory consequences are not likely to be good, but I think are going to be durable, or they will be able to endure them, and that the valuations, in some sense, and the earnings power compensate us for taking that risk.
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