It’s almost impossible to value big financial institutions like Citigroup (C), Bank of America (BAC), or Goldman Sachs (GS) — they’re a lot like hot dogs — you don’t really know what’s inside of them; for the most part, they’re leveraged hedge funds.

They may appear to be cheap on a price-to-book basis, but the book is an illusive concept when it comes to financial stocks, especially when leverage, a deteriorating economy, and accounting assumptions may transform the book into a pamphlet in a New York second.

There are very few financial companies that one can actually analyze and thus value — American Express (AXP) is one of them, and I believe it’s a great proxy for other financial stocks. American Express’s financials are transparent, thus you can make some fairly reasonable assumptions of its normalized credit losses (net write-offs), borrowing costs, fixed costs, etc… and come up with a ballpark earnings power.

In 2007, American Express earned $3.26, however, at the time, its net write-offs of its credit-card portfolio were hovering at an all-time low of 3.3%.

American Express was benefiting from the temporary impact of a new bankruptcy law passed in 2005 (people rushed to file for bankruptcy before the stricter law went into effect, which lead to lower bankruptcy filings in 2006 and 2007), in addition to easy access of credit through home equity loans, low unemployment, and expanding economy.

The 3.3% net write-offs are not coming back anytime soon, so $3.26 of earnings (which implies a price-to-earnings ratio of 10 at today’s price) is a number we can dream and fantasize about, but won’t see for a long, long time.

Fast-forward to today: American Express’s losses almost tripled, approaching 10% (though this number is a bit exaggerated by American Express proactively cutting available credit to its customers). Wall Street expects the company to earn $1 per share in 2009. However, similar to $3.26 earnings per share, this number is not really meaningful either – bad times, as good times, will not persist forever.

To figure out American Express’s normalized earnings power, you need to make an assumption of its normalized net write-offs, among other assumptions (borrowing costs, new level of fixed costs, size of the portfolio, growth of discount fees, etc…) with which I’ll not bore you here.

Though American Express’ credit card portfolio losses may go even higher in the short run, in the long run they’ll decline toward their historical average of 4.5% to 5.5%. In this case, the company’s earnings will be somewhere between $1.9 to $2.3, thus creating a price-to-earnings ratio of 14 to 17 times, turning American Express into a fairly valued stock. (If the “new” norm for net write-off will settle at a higher number, my earnings estimates are off. FYI: 0.5% of higher write-offs reduces earnings power by about 20 cents a share).

Today’s American Express price reflects a return to a normal environment – to which we have not returned yet – and the road to that goal may be longer than we expect and bumpier than we’d like (unemployment – the most important factor driving credit card defaults – is still rising).

But even if American Express has earned its normalized earnings today, the stock would be fairly valued at best. What’s the upside? The same is true for many other financial stocks.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles my email, click here.

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“This company can weather a huge hurricane and come out fine,” says Vitaliy Katsenelson, head of research at Investment Management Associates in Denver. “American Express is one the simplest financial companies to analyze. It’s much more transparent than Citigroup or JPMorgan or Goldman Sachs.

He argues that the government safety net removes a key risk with AmEx: funding. AmEx has relied on commercial paper and on securitization of credit-card loans, two markets that are difficult now to access. AmEx says it’s comfortable about its ability to refinance some $24 billion in debt maturing in the next year.

But here is a very significant positive – it will be able to borrow from the Fed, paying a puny 1-1.5% to fund its credit card portfolio. AmEx becoming a BHC removed a liquidity risk a risk that AmEx will not be able to fund float and provide credit in its credit portfolio. Fed funds and discount rates will not stay at these levels forever but an increase in the rate will coincide with an improved economy and stabilized credit markets and thus AmEx will not need the Fed anymore.

I did a fairly in-depth analysis of AmEx in March 2008, though many things have changed since the thesis has not changed that much.

Investing vs. speculating

Let’s talk about financial stocks for a second, because I’m sure they are on investors’ minds right now. You want to be an investor rather than a speculator; at least I am talking about investing. If you own financial stocks, you want to make sure that you own the ones that you can analyze. I dare anybody to analyze Citigroup (C) or Bank of America (BAC). Those stocks could be cheap and they may end up having great returns, but most generalists, including myself, can’t analyze those companies; they are too complex.

If you are buying a company whose fair value you can determine, you can analyze and access risk and required margin of safety – you are investing.   If you’re buying a company because it’s declined a lot and has a good reputation, and you think it’s going to go up but can’t fully determine how much it’s worth (or can barely analyze it), you are speculating. I encourage to only own financial stocks that you can analyze. Take American Express (AXP)– it is  a credit card company and processing company that you can actually sit down, look through the financial statements and figure out how much it’s worth – it is analyzable.  That’s just one example of that.  

Here is a very detailed analysis of American Express I completed in April (PDF).

Profit margins, profit margins, and profit margins

Another point, and this is where I spend a lot of time right now: when you look at companies you want to make sure that you normalize their profit margins. For a lot of companies, especially “stuff” stocks that have very high margins, you have to look at where they were historically, you have to look at their business and say what would happen if the global economy slowed down. (Though I believe the slowdown is a question of when, not if.) Would they be able to maintain these high margins? If not, you have to figure out their normal margin over a long-term cycle and value them that way. This way you’re going to avoid buying a lot of companies that see their margins contract and sudden, like housing stocks, go from 10 times earnings to 50 times earnings overnight.

 On selling

Even if you don’t want to become an active value investor, you should at least become a buy and sell investor. Selling is like a four letter word in a bull market.  Investing is about buying and selling; even long-term investments are about buying and selling. You want to buy companies when they are undervalued, and when they get fairly valued you want to sell them.  If you don’t sell them, you’re just going to see their PE keep contracting and contracting. So you want to be an active investor, a buy and sell investor.  Also realize this: return for any company or any stock really comes from three sources: dividends, earnings growth and P/E contraction or expansion. If you consider a stock that you are sure will continue to pay dividends and grow earnings, ask yourself a question: is it going to see PE contraction or expansion?

If you buy a company that is undervalued and whose P/E is undervalued and you receive dividends while you hold it and you receive return from earnings growth, and P/E goes from low to relatively normalized, guess what? You’ve already captured one source of return that may not be there in the future, the P/E expansion. Initially all you’re going to get is dividends and earnings growth. The sell question remains – “Is this company’s growth rate and dividend going to be high enough to justify holding the stock?” If the answer is yes, keep holding it. If the answer is no, move on to a different stock.  Exercise “sell” discipline.  Once P/E is normalized (increased) is not your friend, not anymore – the margin of safety is gone.

A stock idea

There is this little company that nobody ever heard of, Microsoft (MSFT). I’d tell you there are so many reasons to hate Microsoft. Their Vista product is a flop (at least there is a perception that it is a flop), Google (GOOG) is coming out with a new competing browser, the company’s too big, nobody understood what their Seinfeld and Gates advertisements were about. So the stock is hated.  I used Vista and hated it, at least at first; they have improved it since. By the way, think about the kind of competitive advantage the company must have to sell 160 million copies of Vista,  a failed product. Imagine what would happen if they actually had a successful product! This company has a tremendous competitive advantage.  

Google is coming out with a new browser, and it may possibly hurt Microsoft’s search and  advertisement businesses. However, Microsoft is losing money in its advertising business, in its online business. These businesses are not priced into the stock, they actually detract from its earnings and valuation. Even if Microsoft gives up and shuts them down, it should only be a positive. My point is, Microsoft may lose the war with Google on advertising (and that’s very possible), but it’s almost irrelevant. This is a company that’s trading at about 12 times earnings. If you take out cash, which they have $20 billion of, it’s trading at 11 times earnings.

There is another argument that Microsoft cannot grow at a very fast rate. In the last quarter they grew their earnings and sales in the mid-teens. How many companies do you know that actually can trade at 11 times, 12 times earnings; have returned capital in the mid-30s; have a competitive position that no other company in the world can match; have grown earnings in mid teens; and are trading at that valuation. But it gets better. When you value Microsoft, even if you take their earnings growth rates to zero, the stock is still too cheap. If I’m wrong on the growth rate and they say they’re going to start growing at 6% to 8% a year, even at that point the company still will be too cheap. In this economic environment, where you want to own very strong companies with bulletproof balance sheets, this is a perfect stock.  And yes, I do own it – as do my clients.

Amex is one of the best, most transparent (you can actually analyze it) financial companies I’d want to own in today’s environment.  We’ll probably get an opportunity to load up on it in the future, albeit at a lower price.

I ended up presenting my very contrarian case on Joseph A. Bank, 93% of float is short.  Here is a link to the full presentation, JOSB starts on slide 31.