Sunday, November 10, 2013

Investment Principle: Diversification Is Kind Of Good (The Banks We Didn't Buy)

We've posted about investment decisions made, highlighting good ones, and reporting on the process. Here is more.

Investing successfully is not only about making good buy and sell decisions; it's also about knowing when to walk away. We view investing not so much as a series of events as an ongoing sifting and winnowing process. When becoming aware of an opportunity, whether that be a particular stock or a specific sector, we put it on our radar screen, track it, study it and review it. We may buy immediately, in a week, in a month or in a year or more, or not at all. We may start small and work up or start big and work down. Be attentive and flexible.  

We always look to diversify. Diversification is a good thing but it is not the only thing or even the primary thing for building long run returns, far from it.  Let me illustrate.

Prior to the 2008 financial meltdown I knew this left wing bloke who was an active investor. Good I thought, here is someone with a different perspective who I can throw ideas at and learn from -- and vice versa. We talked and began to share notes. He loaned me a book that was his investment bible so to speak, lauding the value of diversification and re-balancing (selling portions of an investment portfolio that increase in value and using the proceeds to buy parts of the portfolio that had decreased in value). The book was chock full of formulas, mathematical models and historical calculations. 

The book peddled what many certified financial planners and advisers sell. It was an anti-stock picker screed, claiming that that no one could predict or beat the market. My friend said the book showed the only way to get strong and consistently positive returns was to use index funds to diversify across sectors, asset classes and risk levels, then re-balance the portfolio on a regular schedule. Nothing else would do. In other words, he was insistent on universally applying a few generally sound principles beyond reason, while ignoring information on financial and economic realities -- sounded an awful lot like liberal politics. It seemed like he wasn't really trying to share information so much as to recruit me into a way of thinking.

I thanked my liberal friend and returned his book saying I didn't agree with its recommendations. I was familiar with the theory and practice of diversification. But, I said, the keys to successful stock investing are knowing a firm and its management, understanding its micro and macro markets, exploring the impact of financial system machinations on stock prices and filtering out the real (as opposed to the intended) financial and economic impacts of government interventions. I wanted to delve into those issues. He said no, that market analysis stuff is all hogwash, you can't beat the stock market, it's scientifically proven, just look at the numbers in the book. He was a scientist, a chemistry teacher, who believed in quantitative analysis (as if quantitative analysis didn't shed light on the issues I raised), the more detailed and complex, it seemed, the better. 

I said, if you look at the work documented in your book it actually shows that managed mutual funds as a whole have under performed the market. Assuming that is true, I said, that does not apply to me or you as individual investors, because we (or I at least) don't manage portfolios like a mutual fund. I mentioned I could, for example, cash in all my equities on a moment's notice, or I could shift from long to short positions -- mutual funds did not do things like that. What if there is a recession I asked? Diversification is a good management tool to reduce risk, but it does nothing for systemic risk, like what will happen someday when the real estate bubble bursts. 

My scientist friend scoffed. His book had models and calculations. Whereas I had no proof. Whatever success I might have had previously as an individual investor that was pure luck (our home addition was random variation in his terms). In his view, there was no way little old me could outperform the pros who managed mutual funds. I could see there would be no learning here after all. We went our separate ways. He took a bath in the financial meltdown. We sold essentially all our equities prior to and did not.

One needs to be careful to not use diversification as an excuse to avoid homework. This can be seen by looking at how we got back into stocks after the meltdown. During 2009, bank stocks were high risk investments -- potentially high return (because prices had been severely beaten down) but also potentially a total loss as the financial sector shakedown continued. In all, 333, banks failed in 2009. The churn made a classically strong case for diversification -- don't buy one bank stock, buy many.  

Banks booked huge losses in 2008 and into 2009 that reduced or eliminated capital cushions; loan portfolios continued to unravel as recessionary impacts grew and spread. It was unclear if, when or how TARP would be unwound. Picking and choosing among the winners and losers would not be simple. Bank financial reporting depended more than ever on insider judgments about the quality of outstanding loans, judgments that are not necessarily impartial and, even if objective, judgments not easily made.  

Over a period of a year of so, I had identified as good investment prospects 5 regional and community banks, good because they had solid long term track records (literally decades). These banks were of various sizes in different parts of the country, reducing correlation of risks, thus making them good candidates for within sector diversification. It would have been easy to forge ahead in that time of great uncertainty, and, in the name of diversification, allocate our reinvestment into the banking sector among those five stocks. Fortunately, we did not.

We've addressed the two bank stock we ultimately bought (GBCI and WTBA). They were clear winners. The other three banks on list were First National Bank (FNB) in Pittsburgh, PA, Wilmington Trust (WL) in Wilmington, DE and Colonial Bancorp (CNB) in Montgomery, AL. Don't look them up by their ticker symbols -- two of the three can no longer be found. We bought a small number of shares in each but turned around and sold the positions in a matter of days or weeks as we continued our research and learned more.

We liked FNB initially because it operated in a rust belt market that had turned the corner and was forging ahead into the new economy. Wilmington Trust was originally a creature of the DuPonts -- it had a button down, old money, conservative, solid performer reputation and had been recommended to me as "very well managed" by a golfing buddy who worked for the American Bankers Association. Colonial Bancorp was a go get 'em sun belt bank operating on an arc extending along the Gulf coast from Texas, through Mississippi and Alabama and into Georgia and down in Florida.

As I watched the national economy and the Fed's financial market machinations, tracked stock price movements, reviewed financial reports and read conference call transcripts, and reviewed investor presentations and press releases, I noticed a couple of patterns. The first was that when the market for bank stocks popped overall, these individual stocks did not seem to follow, a sign that other, better informed investors, were using the pops to divest holdings.  I also noted that while these firms reported frequently and lavishly on their long term track records (trust us now because you could have trusted us before) their current performance reporting was brief and perfunctory. I picked up reports suggesting CNB was overexposed
We decided not.
in Florida markets that were among the hardest hit in the real estate meltdown. CNB had been warehousing Florida mortgages ala Freddie/Fanie. I learned that Wilmington Trust had significant exposures to commercial and residential developments which were in danger of going belly up. Maybe the banks would fail. No doubt I picked up some other negative vibes which have since faded from memory. I decided to take a pass on the final three.

What happened?  

My concerns about FNB were misplaced. Its stock price has bounced back by a factor of 2 to 3 times its 2009 prices and it is paying a substantial dividend. Wilmington Trust didn't die so much as fade away. In 2010, a struggling WL was forced by FDIC to sell out to M&T Bank at a stock price that was almost 90 percent below its 2009 high.  

Colonial's demise was a doozy, the 6th largest bank failure in U.S. history. State banking agents showed up at CNB's offices in August 2009, locked the doors and seized its files. FDIC took over, assuming a $2.8 billion loss in selling the CNB's assets and accounts to regional giant BB&T. The Florida mortgages were not merely problematic -- they were worthless. A Senior Vice President of CNB who conspired with an associate at a related mortgage placement firm, pleaded guilty to fraud for engaging in transactions that sold at least $400 million of nonexistent mortgages to CNB. 
Court documents state that in early 2002, TBW began running overdrafts in its master bank account at Colonial Bank because of TBW’s inability to meet its operating expenses, which included payroll, servicing payments owed to third-party purchasers of loans and/or mortgage-backed securities and other obligations.  Kissick and her co-conspirators engaged in a series of fraudulent actions to cover up the overdrafts, first by sweeping overnight money from one TBW account with excess funds into another, and later through the fictitious “sales” of mortgage loans to Colonial Bank, a fraud scheme the conspirators dubbed “Plan B.”  The conspirators accomplished this by sending mortgage data to Colonial Bank for loans that did not exist or that TBW had already committed or sold to other third-party investors.   Kissick admitted that she knew and understood she and her co-conspirators had caused Colonial Bank to pay TBW for assets that were worthless to the bank.  
According to court documents, Kissick and her conspirators also caused TBW to engage in sales to Colonial Bank of fictitious trades that had no collateral backing them and had no value.  Kissick or another co-conspirator at Colonial Bank were the points of contact for conspirators at TBW when the mortgage company needed an advance from the bank, and Kissick would generally discuss new advances with Farkas before releasing the funds to TBW. Conspirators at TBW would wire a request that included false documentation purporting to represent the sale of the trades to Colonial Bank to support the release of the funds.   Kissick and others caused the false information to be entered into Colonial Bank’s books and records, giving the appearance that Colonial Bank owned a 99 percent interest in legitimate securities, when in fact the securities had no value and could not be sold.
They are doing hard time (don't let anyone tell you no one was ever convicted of mortgage fraud after the meltdown).  Needless to say, CNB's stock became worthless.  All of which proves the point.
Wide diversification is only required when investors do not understand what they are doing . — Warren Buffett
It pays to understand.

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