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The Daily Reckoning | Tuesday, January 15, 2013 One article in the mainstream press we proudly recommend reading... The unique advantage of having more ideas than money... Plus, Chris Mayer on finding refuge in a market you might not expect, and plenty more... ------------------------------------------------------ There could be blood in the streets if CNN, FOX and other news networks air this video But talk about an investment windfall! A technology has been revealed that could change human existence... change civilization... the way the light bulb, the telephone and the automobile changed civilization at the beginning of the last century. And it could be more profitable to investors than the invention of the personal computer, the Internet and all the multi-billion-dollar empires they gave rise to combined. Indeed, it’s far more groundbreaking in scope and monumental in effect than America placing a man on the moon. But religious fundamentalists might be outraged. Their loss. Your gain. Watch the video here. Quote of the Day... “The object of life is not to be on the side of the majority, but to escape finding oneself in the ranks of the insane.” — Marcus Aurelius Joel Bowman, reckoning today from Punta del Este, Uruguay... “Today is already the tomorrow which the bad economist of yesterday urged us to ignore.” So wrote the literary-critic-turned-financial-journalist, Henry Hazlitt...more than half a century ago. But if then was the “tomorrow” to which Mr. Hazlitt referred, where (or rather “when”) are we now? One shudders to think about it... During the 55 years since the author of the indispensable Economics in One Lesson penned his final “Business Tides” column for Newsweek magazine, a sky-high mound of intellectual claptrap has been heaped on feckless minds around the world. Hazlitt’s wit and erudition have since disappeared from the Journal...H.L. Mencken’s turns of phrase have fallen from the pages of the Baltimore Sun. Likewise have Garet Garrett’s biting criticisms of the New Deal vanished from The New York Times. And we are all the worse without their insights and wisdom. Of course, nothing is black and white...not even when it’s wrapped in newspaper. Over the weekend, long time Daily Reckoning favorite, Chris Mayer, appeared on the front page of the Washington Post’s business section. And the message he brought was clear, concise...and, for some, counterintuitive. Go Chris! “Here’s a bit of advice to begin 2013,” offered the man behind the Capital & Crisis and Mayer’s Special Situations newsletters, “Ignore economic forecasts when it comes to investing in the stock market.” Chris then went on to highlight a few examples in which markets have delivered handsome returns to investors...even as the broader economies languished in sub-mediocrity (and sometimes even in sub- sub-mediocrity). “Take Greece,” wrote Chris. “In 2012, the Greek market was among the best-performing in the world — up 33 percent. Yes, that Greece. The one you saw on TV with protesters in the streets with the Molotov cocktails and tear gas. The country with unemployment north of 25 percent, a shrinking economy and crushing debts. Yet Greek stocks more than doubled the return of US stocks last year. Meanwhile, the Greek economic crisis is ongoing.” There are plenty of other examples, too. Chris cited an observation by not-penniless investor, Warren Buffett: “He once looked at gross domestic product, a commonly used measure of economic growth, and pointed out that from 1964 to 1982, the US stock market went nowhere even though GDP quintupled. But from 1982 to 1998, the stock market rose 20-fold while GDP barely tripled.” So if economic conditions fail as reliable predictors of stock market performance, what should you be looking at? “In a word,” wrote Chris, “price.” As faithful readers of these pages well know, Chris has a rewarding habit of sniffing around for attractively-priced investments in all sorts of strange and counterintuitive places...even places as strange and counterintuitive as the United States of America. In his Post post, Chris identified certain sectors of the US real estate market as potential money makers. In addition, he pointed readers to the subject of today’s Daily Reckoning column: bank stocks. Intrepid contrarians are cordially invited to read on below... External Advertisement Think of the Damage Obama Could Do in 2013... When the current president took office, the US national debt stood at $10.6 trillion. It’s ballooned to $16.3 trillion today. That’s 54% debt accumulation in four years. The next four years could be even worse... and not just for the national balance sheet. This out- of-control borrowing wreaks havoc on your own savings account, too. Click here for the details you need now. The Daily Reckoning Presents A Surprising Refuge in a Dangerous Market By Chris Mayer “We Have More Ideas Than Money.” That’s what John Palmer and Rich Lashley titled their most recent presentation. You don’t hear that much today. Most of us have more money than ideas. We live in a market where a potential crisis of one sort or another makes every idea look like a straw house in Hurricane Alley. But Palmer and Lashley of PL Capital have a specialty that offers safety without sacrificing market-beating profits in the years ahead. Palmer and Lashley invest in stocks of small banks. They are often activist investors, which means that they buy enough stock to have some clout to make things happen. And they are darn good at doing this. You probably know bank stocks have had a bad decade. But you wouldn’t know that by looking at Palmer’s and Lashley’s Financial Edge Fund. It’s beaten not only bank stock indexes, but also the overall market...and by a wide margin. If they can beat the main bank index by a factor of 2½ with the wind in their faces, what can they do with the wind at their backs? I spoke with John Palmer hoping some of this magic might rub off on me and that he would share some of his thoughts on investing in banks. I don’t know about the magic yet, but on the latter he did not disappoint. We began by talking about all the challenges banks have to deal with. This leads to one inevitable conclusion — and a clear path to profit from the changes. First, those challenges. Today’s low interest rates squeeze bank profits. “The bigger banks can handle lower rates and make a profit,” John said. “At the community bank level, we’re going to feel pain in our margins. I don’t think it is a lot of pain. Loans have been priced down again and again. I am not sure they are going to price down further.” The bigger issue is loan growth. The regulatory environment makes that tough. “If you are going out there trying to grow your loan book, the regulators are second- guessing every loan you put on the books,” John said. “I can’t tell you how many times I’ve had a CEO tell me, ‘Well, we didn’t want to make this loan because we know as soon as we make it we’re going to get criticized by the regulators.’” The regulators are making it expensive to be a bank. “They are looking for layers and layers and layers of risk protection, which is expensive,” John says. Besides this, the economy is lousy. So there isn’t much loan growth. What’s happening instead is that loans move around from one bank to another. The only way to grow is to eat someone else’s lunch. Even the big banks, like JP Morgan and Citi, are starting to push their way to tables usually reserved for community banks. “Three to four years ago, you might have seen them come into our area on a $10-15 million loan,” John says. “They would try to undercut on pricing and try to take it away. I will tell you that now we’re seeing $500,000 loans migrate from our community banks to the big banks.” That’s crazy. John said that what is crazier is the pricing. “We’re seeing pricing at 150-200 basis points over costs. So how do community banks compete with that? It’s impossible. Their cost to service a loan will probably run 200 basis points.” (Note: 100 basis points equal 1%.) What to Expect in 2013... Between 2004-2007, Bill Bonner and Addison Wiggin did their best to alert their loyal readers to the dangers of the housing bubble well before the mainstream said anything about it. Well, today, they see something even worse looming just over the horizon. It’s not often our Reckoner-in-Chief agrees to appear on-screen, but this was just too important. Click here (or the image below) to see what they’re talking about now... So what happens next? (Here we get to our inevitable conclusion). The smaller banks will consolidate into bigger banks. This way, they can spread those costs over a bigger asset base. As John says: If you can’t grow your business, if you can’t grow profitability, then you are going to be forced into consolidation. The banking industry is so fragmented; it needs to be consolidated. There are 7,500 institutions out there. Think about it. Tell me another business where I go to make a loan to somebody and potentially within my market have over 200 competitors that are going to bid on that loan. All 200, obviously, won’t bid, but five or six or seven will definitely bid on that loan. That can’t exist forever. Somehow, we have to get pricing power back in place. And the only way to get there is to reduce the number of potential bidders on loans. I agree with John that consolidation is a certainty in the banking sector. The best chart I’ve seen on this is from John’s PL Capital, which shows the number of takeover deals in the banking sector, and the price at which they happened. We sit near cyclical bottoms on both counts. (Price-to-tangible book is a widely used valuation measure. Low numbers imply cheapness.) The turn is at hand. Now what to do? I say buy the smaller banks. As John explained it, “The larger the bank, the better they tend to trade off of book value.” Typically, a $3 billion bank will have a higher trading multiple than a $1 billion bank. And a $1 billion bank will have a higher trading multiple than a $500 million bank. So by moving up the food chain, you can actually increase your trading value based on your asset size. “That’s why these companies are looking to buy other banks and get bigger,” John said. “If they can move from $1.5 billion to $3 billion and get some cost savings out of it, they are going to get a higher trading value. If they can go from $3 billion to $5 billion, they are going to get a higher trading value again.” This is why, as an individual investor, you want to start with a smaller bank. As John explained, “Not only do you get a premium in a deal, but potentially you also get appreciation from the acquirer’s stock moving up to a higher level.” Bigger banks are typically more efficient. They can spread their costs out over a bigger asset base. In turn, they earn a higher return on equity, or ROE. A higher ROE drives a higher price to book. “It’s all linked,” John says. So market forces will dictate that we’ll have fewer banks. The survivors will be a lot bigger. For now, you can get pretty good little banks for less than tangible book value per share. As they move up the food chain, your little bank stock could trade for 2 or 3 times book down the road as part of a much bigger entity. In just the last 15 months through July, the Financial Edge Fund has seen 11 positions bought out. The premiums on these deals fall in the range of 120-150% of tangible book value. This is not unique to John’s fund. If you look at the 20 largest bank deals in 2012 so far, you get a similar picture. A few deals went off at over 200% of book value. Small bank investing is a safe strategy too because banks have had five years to fix their problems and are in better shape today. Don’t let the ghosts of 2008 frighten you away from this opportunity. As John says: I think there has been a hiatus in consolidation because people are concerned about credit quality. But as time goes on, that will change. We’ve been through five years of taking write-offs and building loan loss reserves... The level of confidence about what’s on the balance sheet continues to improve. To wrap it up: I am bullish on small bank stocks. Regards, Chris Mayer for The Daily Reckoning Editor’s Note: Despite the myriad dangers in today’s markets, Chris is surprisingly bullish on several sectors you might not know about. But that’s because he sees the world differently than most people... Where others see only crisis, Chris often sees opportunity. And it’s this opportunistic approach to investing that has made serious gains for his Capital & Crisis subscribers. In fact, right now, his subscribers could be banking consistent 42% gains, year after year, in one of the toughest markets in memory. If that sounds like something you’re interested in, you owe it to yourself to check out his most recent report. ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com Additional articles and commentary from The Daily Reckoning on: Twitter Facebook DR iPhone APP The Daily Reckoning is committed to protecting and respecting your privacy. We do not rent or share your email address. To end your Daily Reckoning e-mail subscription and associated external offers sent from Daily Reckoning, feel free to cancel your free subscription here. By submitting your email address, you consent to Agora Financial delivering daily email issues and advertisements. Please read our Privacy Statement. For any further comments or concerns please email us at dr@dailyreckoning.com. 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