PSU Banks: A Goldmine or a Death Trap for Investors?

Mar 20, 2018

Rahul Shah, Editor, Profit Hunter

Buying what looks tantalizingly cheap can backfire sometimes.

Just ask Bill Miller.

Before the financial crisis of 2008, Miller was a hero, a rockstar amongst fund managers: It is not every day that a fund manager beats the benchmark index 15 years in a row!

The odds of that happening are one in a million... You have a better chance of being crushed by a meteorite than achieving the same feat as Miller.

And then Miller fell from grace.

Not only did his long streak end, he racked up such huge losses that by the time the year 2009 ended, he was trailing the benchmark index. That's more than two decades of outperformance going up in smoke in a matter of months.

The carnage in financial stocks proved to be his undoing.

Instead of making a dash for the exits when the crisis first reared its head, Miller jumped right into the fire.

He loaded up on financial stocks, asserting that investors are being far too timid and when the dust will settle, he will walk away with handsome gains.

The dust did settle but not before completely obliterating Miller's portfolio.

As per Miller's own admission, he was completely blindsided by the statistical cheapness of financial stocks.

He thought they had already fallen a lot, how much lower can they go?

Well, some of them went all the way down to zero.

As the Wall Street Journal highlighted,

  • This meltdown has provided a lesson for Mr. Miller and other "value" investors: A stock may look tantalizingly cheap, but sometimes that's for good reason.
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Is this applicable to the PSU banking space in India?

The stocks do look tantalizingly cheap. In fact, they haven't been this cheap in years.

But is the low valuation justified in view of the risks it is facing? Or are investors being too pessimistic and someone with a contrarian bent of mind can really make a fortune over the long term?

In my Microcap Millionaires service, we do recommend out of favour, beaten down stocks. But we also keep in mind the following Charlie Munger dictum.

  • All I want to know is where I'm going to die so I'll never go there.

It is this rule that has stopped us from recommending any banking stock right since the inception of the service.

In its four-year history, we have never ever recommended a single banking stock in Microcap Millionaires.

I am going to tell you why.

The problem with buying an out-of-favour bank is that there's always a risk there's a Bill Miller-like situation around the corner.

Banks are leveraged entities and therefore buying them when they are out of favour is like playing with fire.

Any adverse development and you could well be staring at a complete wipe-out of their net worth.

The stocks could go all the way to zero, thus eliminating any possibility of making a comeback when business conditions improve.

Bill Miller learnt this the hard way.

This doesn't mean you should too. You are certainly not going to die every time you invest in a troubled bank. But why take the chance?

Even a long series of positive numbers, however impressive they may be, evaporates when multiplied by a single zero.

There are few stocks more capable of evaporating your returns than an out-of-favour, leveraged entity like a bank.

So, no matter how mouthwatering the prospect of raking in big returns from PSU banks, it is one space you may do well to avoid.

If you still want to take exposure, make sure it is not so large so as to run your portfolio into the ground.

Happy Investing,

Rahul Shah
Rahul Shah (Research Analyst)
Editor, Profit Hunter

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