Jason Zweig, who writes a column about value investing ("The Intelligent Investor") for the Wall Street Journal, poses an interesting question: Would Benjamin Graham - considered by many to be the father of value investing - be tempted by today's financial stocks? After all, the Dow Jones Wilshire Financials index is down nearly 50% from one year earlier, making many financial stocks look cheap on a relative valuation basis. In addition, many bank stocks are trading for barely more than book value.

Pointing to Graham's analysis of bank stocks decades ago, Zweig sounds a cautious note about today's beaten-up financial stocks, hinting that they may be a "value trap" for over-eager investors:

"I'm not saying there's no money to be made on financials in the next couple of years. But the potential for further losses is at least as great as the odds of big gains. When bankers themselves have no clue what their own assets are worth, there's no way most outsiders can determine which stocks are undervalued and which cannot be valued.

Graham warned that speculation is most dangerous when you delude yourself into thinking you are investing, take it seriously and risk more money than you can afford to lose. Many people who stampeded into financials over the past few days may end up wishing they had heeded Graham's advice. For many banks, the nightmare has only begun."

What do you think: Is it worth bottom-fishing in financial stocks?

NOTE: Please keep in mind that TradeKing does not specifically endorse any of the securities or trading strategies mentioned. Depending on your risk-reward profile, this trade may or may not be suitable for your portfolio. The stocks mentioned are for educational purposes only.

[video: Jason Zweig of the Wall Street Journal]

Financial stocks - which are unfortunately lumped together so broadly at present - are really an incredibly diverse bunch. There are enormous differences between a credit card company like American Express (ticker: AXP), a bank like Wells Fargo (WFC) or US Bancorp (USB), a credit derivatives company like Primus Guaranty (PRS), etc.

What it really comes down to is your ability to run a realistic stress test for losses, and work the valuation question back from there. You have a company like American Express that is making the reserves, and where the value is mainly intangible, and thus the equity has a positive worth even if there isn't much on the balance sheet to back it up. Then you have something like USB, where you need to figure out if the capital ratios are adequate, etc. - I think they're more than good, because USB didn't get involved with structured products and all that junk. Then you have something like Primus, which insures investment grade debt for fixed quarterly premiums - my model for that says that INVESTMENT GRADE credit losses would need to be about 3x the peak rate experienced during the last recession, and hold that level for two full years, for the common to be worth under $5/share... a real black swan situation, if you will. I think the odds are most out-of-whack with a reasonable forecast of reality in the last case, thus I recently bought the Primus common in addition to some of the senior debt from the holding company at around a 24% yield.
If you read Graham, and Zweig, the definition of an investment is something like "promises adequate return after safety of principle" - and I think Primus fulfills those. Certainly the exception, rather than the rule, in financials.

On the flip side, WaMu's underwriting standards were bad enough, and their loan portfolio large enough, that there isn't a way to establish what kind of capital raising will need to be done - and on top of that, you're likely to have management working against the common holders by diluting them should the stock begin to rally. That's speculative, which Graham defined as anything not meeting the above.
This isn't to say there's anything wrong with speculating, as long as you admit to yourself you are "speculating" in WaMu and not "investing" in WaMu.

Great analysis of the financials, JCullen! As you suggest, it's too easy to lump a lot of similar names together and assume that they will all perform the same. Investors with the right mix of patience and skill will be able to pick through the rubble and find the stocks that were unfairly punished by the market.

- The TradeKing Blog