But the comment that really drew my attention was not about the collusion, but what the best banker in the country – Jamie Dimon, the head of JPMorgan – thinks about the Chinese banking system.  In this excerpt, an employee who was present at the meeting sums up Jamie’s thoughts on China:  

Considering to buy a stake in a bank in China and asked if it makes sense to do so at current prices. Jamie replied that the concept is ok, but not now, too expensive, adding that so far “in China it is a one way street” with them wanting to get all and letting you get nothing, and that there will be more and better opportunities when China has a downturn. 

Also, too difficult to know what you are buying: many of them do not yet have integrated systems, possibly a meaningful amount of political loans, etc. [emphasis added] 

Jamie is not your typical banker; he doesn’t dance (like Chuck Prince) just because the music is playing.  His caution, long-term thinking, and contrarianism (he cut off risky lending before everyone else) made JPMorgan a  victor in the recent financial meltdown, at least in relative terms.  The stock price is still down from the pre-crisis level, but it is not in single digits or the teens, like Citigroup (C ) or Bank of America (BAC).  I’d be listening carefully to what he is saying about the soundness of the Chinese banking system. 

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 my future articles by email, click here.

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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.

Since 2007, most of the bubbles deflated, stocks plunged, profit margins reverted to their mean (i.e. declined from above to below average), which in turn caused earnings to collapse.  S&P 500 earnings estimates for 2008 were revised down to $28–a 67% drop from the highs.  Suddenly, investors found that at 20-plus times earnings, the market is not that cheap, even after stocks’ precipitous drop.  

As every action movie needs a hero, every cyclical bear market needs its bull.  Bull we’ve got–Jeremy Siegel, a Wharton professor, wrote an op-ed article in the Wall Street Journal proclaiming that for the most part, aforementioned factors were not the main causes of the earnings collapse.  Instead, flawed computation of the earnings of the S&P 500 is at fault.  He explains that because Standard and Poor’s, the creator of the S&P 500 index, doesn’t weigh earnings by market cap but simply aggregates them together, earnings misrepresent the true reality of corporate profitability and thus overstate the market’s true valuation.  

Siegel suggests weighing earnings by (today’s) market capitalization instead.  When he does just that, all of a sudden reported earnings skyrocket to $71.10 a share.  His conclusion is the market is dirt cheap.   It is brilliant, it is uplifting and it is just plain wrong. 

If you exclude the losers, the market will always be cheap.  In September 2007, General Electric was the second largest company in the S&P 500 index, Citigroup was number five, and Bank of America was number six.  Today GE is number nine, its weight in the index declined from 3.15% to 1.42%; Bank of America and Citigroup are numbers 41 and 111, respectively.   Financials (GE is a semi-financial stock, as a good chunk of its earnings–or now losses–comes from GE Money) have dropped almost from a 20% weight in the September 2007 index to an obscurity today as their losses ballooned.  Some of these losses are driven by market distortion but a majority of them are real.  And, yes, those fat profits of late 2007 will be remembered, longed for, but not repeated for a long time. 

By favoring the largest companies in the index (Siegel’s suggestion) you will always over report the index’s earnings.  Higher earnings will drive valuations (market cap) higher and will result in higher weights in the index–earnings number will matter more.  At the same time, companies that suffer losses will be punished by the market and thus their market cap weight will be lower and (negative) contribution to overall earnings will be less.  This is exactly what happened to Citigroup, Bank of America, GE and many other losers.   

There is a good reason why S&P doesn’t weight earnings by market cap.  Siegel’s suggestion makes as much sense as a university, for instance, calculating an average GPA score for the school by attributing higher weight to cum laude and summa cum laude students.    

Market capitalization weighting makes no sense.  Ironically, Mr. Siegel starts his article explaining how bizarre market weighted calculations are (S&P computes S&P 500 performance based on market cap, but computes earnings by adding all earnings for companies in the index, not by market cap).  He explains that the performance of mega cap companies like Exxon completely overshadows the rest of the index where performance of smaller companies becomes irrelevant.  I agree.  Stock market indexes that are constructed based on market capitalization don’t represent a reality of actual portfolio construction.   I have yet to meet a money manager who determines his portfolio weights based on the market capitalization of companies in his portfolio.  

What makes his message intellectually discordant is that Mr. Siegel has been promoting an index fund company (and I believe he is on the company’s board too)–WisdomTree.  WisdomTree’s sole purpose is the creation of index funds not based on market capitalization but on fundamentals (i.e. price to dividends and price to earnings).   

Mr. Siegel in his op-ed said that a disproportionate amount of losses come from companies that represent a very small market capitalization in the index.  He is right, but their capitalization is small now, it was not small a year and a half ago.  These companies used to be enormous.   They are small because of their losses.   If you were to recalculate S&P earnings based on the weights of the index in September 2007, you will likely get an earnings number that is far below Siegel’s suggested $71.10. 

Also, Siegel’s claim that a small company taking huge losses distorts results of the index lacks intellectual rigor.  An original small (I mean not one of the ones that just dropped in price tremendously because of high losses) company usually has low sales and lower profits, thus it is much harder for it to generate large dollar losses as well.   In other words, my mother-in-law’s barber shop or Jones Apparel (the smallest company in S&P index) for that matter will never have enough losses to overshadow mega large caps in S&P.  

Problems with Siegel’s suggested method don’t end there.  Our understanding of historical valuations is based on S&P 500 P/E data going back to the early1900s which is computed based on the current “flawed” (according to Siegel) way.  Siegel’s P/E based on market cap weighting loses comparative reference to the past and thus loses its meaning as we start comparing apples (his computation) and oranges (aggregate, S&P’s computation).   For a reasonable comparison with historical valuation levels Mr. Siegel would need to apply his capitalization weighted method to past periods.  At 12 times, based on Sigel’s earnings market, may or may not be cheap as past P/Es are computed differently. 

We know that $28 in estimated 2008 earnings doesn’t represent the true earnings power of the S&P 500, nor does $70.  Of course, charge-offs tremendously distort reported earnings numbers, and no rational person looks at the 2008 $28 as a base case.  But let’s be honest with ourselves, 2007 earnings of $84 are only real to us today if we think that the global bubbles of 2007 will reoccur in the very near future.  

Siegel may manipulate earnings until they conform to this thesis as much as he likes, but the true number lies somewhere well south of $71, and thus while some stocks are cheap today, the S&P 500 is not.  

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

P.S. Jeremy Siegel’s book, “Stocks For The Long Run,” is well written and provides a very good overview of the performance of different asset classes over last two centuries. But the book needs a different title, maybe something like “Stocks for the Really, Really, Really, Long Run.” This way, it would not lure investors into a false sense of security when it comes to stocks. It preaches that stocks are always a buy, no matter what valuations as they do better than other asset classes in the long-run, and that a 7% real rate of return is a birthright for stock investors no matter if the stock market is extremely cheap or ridiculously expensive. 

This is very true if your time horizon is 30 years or you plan to live forever. It is also true if you can tolerate seeing your portfolio go nowhere for a decade or longer. Unfortunately, most of us don’t have this time horizon. We need to send kids to school, pay for weddings, boats, and other stuff. I don’t know anyone who has the patience to see their portfolio of stocks do nothing for decades. 

Despite stocks being a great investment for the really, really long-run, they have periods when their returns are unspectacular.  I call them range-bound markets and they take place after secular bull markets.  The buy and hold (forget to sell approach) that Siegel’s book lures to believe fails to produce acceptable returns during these type of markets as the last decade proved so far. 

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I am applauding this deal because typically these are done at the top of the market, but BAC found a restraint to wait till things went to hell. Yes, it was early with its first purchase, but picking bottoms is not easy, even for almighty BAC.

Unfortunately it takes years not months for all problem loans to surface from the balance sheet to the income statement. For example, in late 1980s CIti found itself in the center of a Latin American default crisis. It took close to four years for the company to work through the troubled loans.

This is not just another investment from a sovereign foreign entity that should “shore up investor confidence in Citi,” as PR would spin the deal. At 11% interest rate this loan is an act of desperation. Remember, the bank is in the business of making a spread between its borrowing and lending rates.

Unless Citi will be lending at a rate in excess of 11% – a highly unlikely scenario – the purpose of this loan was to fund its dividend for next three quarters. Citi’s management saw what happened to Freddie Mac’s ( FRE) stock – it took a dive – when it announced a 50% dividend cut and decided to take the expensive route instead.

The fallout in financial stocks will create a lot of buying opportunities as lot of great regional banks that were not smart enough to do dumb things are getting lumped in the same bad apple basket as Citi and the like.

Why would somebody ever give a loan or buy airline bonds of any country?  I can understand buying distressed bonds or maybe a stock as a trade. Not my kind of thing, but I can respect that. But a buyer (an investor) of fully priced (at par or close) airline bonds usually intends to hold them to their maturity, or for a long time. It is well documented that the airline industry as a whole has lost money over its cumulative existence. Thus, uneconomical, low fares that consumers have been enjoying over the years were subsidized by bond and equity investors. This is great for consumers, not so good for providers of capital. I almost want to say “Fly, don’t buy.”

One could argue, “but wait, Southwest (LUV) and Virgin have done well.” And maybe this is where the answer is, at least in part. We look at these very rare success stories and think that this time is different and the industry can reinvent itself and start making money. It’s rarely different.

Or maybe the answer lies in our forgetfulness? We forget that the deck (the industry structure) is stacked against us, that for every Southwest and Virgin there are dozen airlines that went through several bankruptcies, at least once. We look at glamorous, sophisticated, electronics-laden airplanes and forget that this is a very cyclical, capital intensive (planes cost hundreds of millions of dollars), low return on capital, highly unionized, debt burdened industry that is exposed to the gyrations of commodity prices. And to top it all, the industry has marginal pricing power and surprisingly low barriers to entry (i.e. new entrants compete with major airlines on one route at a time, it is similar to a death by one thousand cuts. Virgin Air was started with just couple million dollars and leased planes).

Russian airlines are even worse as they are forced to compete with a semi-government and thus not-for-economic-profit entity – Aeroflot. Also, the Russian government is predictably unpredictable. One day it may decide that it wants to control the airline industry and suddenly we’ll discover that airlines were ruining the environment, not paying taxes, scratching runways or whatever else it’ll need to say to justify ripping off equity and bond holders. It did this with many BP PLC (BP) and Royal Dutch Shell (RDS-A) holders a few months ago, so why would this time would be any different?

I suggest the rating agencies rethink their rating scale to accomodate for airline bonds: (A) – High Quality, (B) – Investment Grade, (C) – Junk, (FBJ) – Far Below Junk – domestic airline bonds, and finally in the Nuclear Waste (NW) category – Russian Airline bonds.

Why are banks not seeing this and what happened to risk (credit) spreads? My cousin mentioned that several large Russian oil companies just received loans from American and western banks (i.e. Citigroup (C), Goldman Sachs (GS), Barclays (BCS)) at or around Libor plus 25-50 basic points. Let me put it into perspective, this about 1% premium to risk (default) free US Treasury bills. In other words banks are thinking that Russian oil companies are just a bit riskier (1%) than the US Government – the entity that can print money, raise taxes and has nuclear weapons. Is this another case of selective amnesia, similar to sub-prime lending? Will they think it’s not a problem until suddenly (it is always sudden for them) it becomes one? Did banks forget about Russia’s near death experience of the late 90s or the Yukos debacle from 2004?

Lending at a slight premium to a risk free rate made very little economic sense. Any rational entity would have been better off taking the money and buying higher yielding (much higher quality), AAA rated U.S. corporate bonds. But see, big (money center) banks are in the business of making loans. To be more precise, they are in the business of making dumb loans. When the global economy is roaring, all loans are good loans, the risk is a four-letter word that only a few can spell.

As a man with a hammer is looking for a nail, a banker armed with cheap funds is looking to make loans and generate fees. Every time a recession shows its ugly face, the “dumb” loans float to the surface and huge write offs are taken, shareholder equity is lost. During the last recession of 2001, big banks were writing off billions in loans made to South America. In the next recession it will be Russian loans.

Again, why would western banks give loans to Russian airlines that never generated positive cash flows (and probably never will) or Russian oil companies at an almost risk free rate? The answers are very simple: global liquidity and syndication.

An abundance of global liquidity coupled with low interest rates has compressed spreads between investments of various risks. Investors hungry for any yield are garbling up bonds of any risk just to increase the yield of the portfolio. Also, more and more large loans are syndicated among dozen of banks, the risk is assumed to be diversified away. Syndication sounds great in theory, but it increases the system risk as it breeds indifference and a lot of bad loans – just wait a year or two.

This article was originally published on Minyanville.com

By Vitaliy Katsenelson, CFA

Investing in the stock market is a never-ending learning experience. That’s what makes it so appealing and intellectually stimulating. And I inadvertently had one of those live-and-learn experiences just the other day.

In my piece on Lloyds TSB(NYSE: LYG), I wrote that banks usually trade at lower price-to-earnings ratios to the market because they are considered riskier investments as a result of their high use of debt. That line caught the eye of Foolish financial editor Joey Khattab, who asked writers Stephen Simpson and Nate Parmelee whether they agreed with my logic. Both disagreed. They argued that larger banks have lower P/Es generally because they are perceived to have a slower or more limited growth potential.

At first, I thought there might be a conspiracy of Fools at work against me! So I asked several investment professionals for their opinion. And to my amazement, they all agreed with the Fools.

So I looked at some larger banks to see whether they had been slozw growers in the past, and I couldn’t reach that conclusion. Many of these banks, in fact, had achieved very respectable earnings growth and paid above-average dividends in the process. I then looked at expectations for future earnings growth, and they appeared not to be below average, either. With the exception of Fifth Third(Nasdaq: FITB), which Wall Street once loved to love and now loves to hate, the rest of the pack was trading at a substantial discount to the market and still are.

(to see table please click here)

The answer must be more complex than just the growth rates. I believe the answer to banks’ lower P/Es lies in the following four factors.

1. Cyclicality The banking business is closely tied to the health of the economy. As the economy expands, demand for loans increases and bad debt declines — a combination that improves banks’ profitability. In a contracting economy, of course, the reverse takes place.

Because investors pay up for predictability, they rarely pay a full market multiple for the volatility that comes with cyclical companies. Cyclical heavy-industrial companies like Caterpillar and Ingersoll Rand, for example, usually trade below the market P/E just as a many banks do.

2. Financial leverage We have not had a bank crisis in the U.S. for a while, so most investors have forgotten just how risky banks can be. But as Warren Buffett has said, by the time you find out a bank has a problem, it will be too late. The equity at most banks stands at meager 6%-10% of total assets, so when a bank does make a mistake, its high leverage amplifies the problem.

3. Interest rate volatility Banks are subject to the risks that come with changing interest rates. They prosper when the difference between long-term and short-term rates — in other words, the interest rate spread — is high. However, when that spread narrows, it becomes increasingly difficult for banks to make any money. Many banks have addressed the problem by boosting their fee businesses. For example, fees account for a full 46% of U.S. Bancorp’s income, thereby making the company less susceptible to swings in interest rates.

4. Complexity of financials I could teach my 4-year-old son to analyze retailers’ financials in about 20 minutes, if I could get him to sit and concentrate for that long. OK, maybe I’ll have to wait a couple of years. But the point is, retailers’ financials are very easy to understand. A quick look at the income statement and a glance at the balance sheet (especially the part that focuses on inventories) will very quickly tell you what happened during a retailer’s quarter.

Banks and insurance companies, on the other hand, are very different animals. Where analyzing a retailer is like playing checkers, analyzing a bank is akin playing two-dimensional chess. (I’ll save the 3-D chess analogy for insurance companies; their financials are even more complex than banks’ are.) Investors need to look at financial statements and at dozens of other sources to assess a bank’s true performance. And that’s a problem, since investors tend to embrace simplicity and shy away from complexity.

To make things even worse, banks’ financials are riddled with assumptions. Although all companies have to make some amount of assumptions in their financials, the complexity and magnitude of those assumptions increase exponentially with banks. Consider, for example, that it’s not uncommon for a high-growth bank to have its expected credit losses understated because of the immaturity of its portfolio (in other words, new loans have not matured yet). However, as growth decelerates and large portion of the loans matures, credit losses may skyrocket beyond the estimated provisions.

The quality of growth The very size of large banks often gets in the way of their ability to continue producing high-percentage growth. Instead, the bulk of growth for large banks comes from acquisitions. An acquirer is able to fold most of the acquired bank’s operations into its existing infrastructure, which, in turn, results in huge cost savings and, of course, higher earnings.

That sounds great on paper. However, acquisitions come with risks, including integration challenges. Bank One (now part of JP Morgan Chase) learned about that problem firsthand when it acquired First USA. Soon after the acquisition, Bank One ran into huge problems with the incompatibility of the combined companies’ computer systems, and the stock tumbled as a result. Regions Financial had similar integration problems after making successful acquisitions for a long time. To sustain its growth, it eventually had to start marking larger and larger acquisitions, and that’s when the problems began.

In addition to the integration risks, bank executives’ egos and their attendant desires to manage bigger and bigger (though not necessarily better) empires often get in the way of common sense. Ultimately, the acquirer overpays for the acquired.

 Still, despite all of the potential pitfalls, acquisitions have been the main source of EPS growth for most large banks. In fact, I can’t think of a large bank that became large by way of organic growth. Not one!

Bottom line Growth by acquisition is much riskier and usually more expensive than organic growth is. Investors recognize that risk, and thus they put a lot less value on large banks’ growth. So, to a large degree, Joey, Stephen, and Nate were right: Slow organic growth is, in part, responsible for banks’ below-market valuations. However, I believe that higher risk caused by cyclicality, high financial leverage, and the complexity of financials contributes to the lower P/E as well.