Chris Mayer

In an email to my Capital & Crisis readers on March 22, I shared a great speech by Dean Williams, then a senior vice president at Batterymarch Financial. (Delivered in 1981, it was called Trying Too Hard.) The speech was full of great advice, including the following:

“There are two ways we can try to gain an edge over the market. The one most of us choose is to try to generate superior information, to know more than anyone else. The other choice is to be better at measuring value than others and not to care very much about what other investors think they know. To hold cheaper securities by today’s standards and let the future speak for itself.”

My path is the latter. Of course, this begs the question: What’s objectively cheap by today’s standards?

I have a few answers.

Gold stocks are cheap.

One way to see this fact comes from John Doody, editor of The Gold Stock Analyst. Doody compares the price of gold per ounce in the average gold stock as a percentage of the gold price. (Technically, he compares the market cap per ounce of proven and probable reserves against the gold price.) It yields a, shall we say, highly suggestive result.

Doody finds that gold stocks currently trade for just 13% of the current price of gold. Put another way, you can buy an ounce of gold by owning a gold stock and pay just $207 an ounce. From 2002-07, the market valued the gold of gold stocks at 38% of the price of gold. Ever since 2007, the percentage has been dropping. And it currently sits at just 13% — the lowest since at least 2001.

As Doody notes, to get to 38% from here, gold stocks would have to triple. We own a pair of gold stocks, both down. Doody, a masterful gold stock picker with a track record better than anyone I know of in this sector, has a portfolio full of losers. It’s a tough time for gold stock investors, which is a sign in itself.

Bank stocks are also cheap.

One way to see their low valuations is to look at price-to-tangible book value per share. I’m not saying price to book holds all the answers. But it is a pretty good, objective proxy for cheapness, much like Doody’s percentage measure on gold stocks. It’s also wonderfully simple.

Let’s break down banks into three buckets by asset size. Those with less than $1 billion in assets go in bucket one. Those with $1-10 billion in assets go in bucket two. And bucket three is for the banks with assets above $10 billion. The median multiples for each bucket compared with its 20-year average look like this:

A Different Kind of Bucket List

Put another way, these stocks trade for 71%, 74% and 64%, respectively, of their long-term averages. Skeptics would say there are good reasons why bank stocks are cheap. Look at earnings, they’d say. Median price-earnings ratios are around 95% of the 20-year average.

“Yes, but,” says I “profits move in cycles. They will rebound.” When it happens is anybody’s guess. As an investor, you focus on what you know today. And what we know today is bank multiples sit well below their 20-year averages.

According to Jeff Davis: “Historically, when bank multiples rose above the 20-year average, returns tended to be poor over the ensuing one- to two-year period and vice versa.” We’re in the “vice versa” scenario now.

Davis, by the way, is the managing director of Mercer Capital’s financial institutions group. He writes a good blog for SNL Financial. Mercer has spent “30 years studying equity market returns” and what goes into the mixing bowl that makes them. I got my figures above from him.

Importantly, bank acquisitions are still going off at 1.2 times book and greater. These takeovers make tremendous sense, as the buyer can lower costs and improve the economics of the bank. Larger banks, too, enjoy better valuations.

The odds of placing winning bets are extremely high in bank stocks, if you’ve got anything more than the patience of a gnat.

What else is objectively cheap?

Insurance stocks.

I add insurance stocks for much the same reason as banks. It is easy to find insurance stocks selling below book value, at the lower end of valuations ratios going back 10 and 20 years.

Here is a chart of EMC Insurance (NASDAQ:EMCI) going back 10 years. It shows the price-to-book ratio steadily falling over time.

EMCI: One of Many Such Fish in the Sea

There are plenty of good insurers for which I could draw similar charts. Many of the same criticisms leveled at banks apply to insurers. The profitability of these businesses is also at cyclical lows.

As an investor, the cheap sectors I have highlighted are exactly the kinds of situations that ought to attract your attention… and capital. Nothing exciting needs to happen to make a good return. You just need to see a return to average — a reversion to the mean.

Eventually, these things work themselves out, and investors make lots of money when they do. At bottom, that’s the basis of Dean’s sage advice.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. Sometimes a stock is cheap because it’s worthless. But other times, as we point out above, a stock may be cheap because investors are simply unable (or unwilling) to see the bigger picture. Readers of The Daily Reckoning email edition receive regular opportunities to discover for themselves just these types of scenarios. If you’re not already a subscriber, you’re missing out. Sign up for free, right here.

You May Also Like:


Phony Growth From Higher Debt

Addison Wiggin

The problem of debt through cheaper credit hasn’t disappeared; it’s grown faster. Each round of QE has purchased larger amounts of securities than the previous one. They went a step further now and made it open-ended -- “QEfinity” as it’s affectionately called.

Chris Mayer

Chris Mayer is managing editor of the Capital and Crisis and Mayer's Special Situations newsletters. Graduating magna cum laude with a degree in finance and an MBA from the University of Maryland, he began his business career as a corporate banker. Mayer left the banking industry after ten years and signed on with Agora Financial. His book, Invest Like a Dealmaker, Secrets of a Former Banking Insider, documents his ability to analyze macro issues and micro investment opportunities to produce an exceptional long-term track record of winning ideas. In April 2012, Chris released his newest book World Right Side Up: Investing Across Six Continents

Recent Articles

Don’t Blame Obama (He Has No Power)

Chris Campbell

The Americans who voted for Obama were expecting some big changes. But, six years later, the government he acquired has only spied harder, the drones have flown lower, and the weapons have gotten bigger. But don’t blame Obama. Read on…


Your Personal Gold Standard

James Rickards

All paper currency has a shelf life. It could be 5 years or 500 years, but at some point, the value of any paper currency eventually reaches zero. That's why, for centuries, people have turned to one shiny metal to safeguard their personal store of wealth. And, as Jim Rickards explains, you still have that option. Read on...


October Plays Another Dirty Trick – Here’s What You Do Now

Greg Guenthner

Bad things have a funny way of happening in October. Remember October 1929? It raised the curtain on the Great Depression. Or maybe you recall the infamous Black Monday crash in 1987. The Dow tumbled 22%— the largest single day loss ever. Guess what? That was in October, too. The 19th to be exact. Notice a trend here? Fast forward to this October... You know what happened this month. And if all that wild market action kneeds you in the gut, here’s what you should do now. Greg Guenthner explains…


In the Downdraft of Hormegeddon

Bill Bonner

The economist Milton Friedman didn’t go far enough when he said, “Concentrated power is not rendered harmless by the good intentions of those who create it.” Oftentimes, that power is rendered more harmful -- to the point of Hormegeddon -- the better the intentions behind it. In today's essay, Bill Bonner highlights the conditions necessary for popular delusions and the disasters they lead to. Read on...


Addison Wiggin
Health Care Costs: Still the Pig in the Federal Python

Addison Wiggin

Right now, health care makes up about 25% of the federal budget. A scary statistic to be sure... But here's an even scarier one: health care's portion of the federal budget doubles roughly every 20 years. Yikes! Addison Wiggin explains why this is and what needs to change to prevent health care from taking up half the federal budget. Read on...