ACE Limited ($60.6) and Expectations Investing

A little due diligence can go a long way in beating the professionals at their own game, given that a lack of context in Street published research seems as pervasive today as five years ago. One strategy we believe can go a long way to avoiding some irreparable harm (or outsized gains) to your portfolio is to spend more time trying to understand the "expectations" investment game a bit better (not just earnings estimates) for each specific Financial Institution subsector. In particular, the confluence of factors, including rising margins, expanding ROEs, and increasing sector and subsector valuations have resulted in substantial price gains for the property/casualty industry over the three and four year periods. We think the risk/reward today is substantial, given that two of these critical factors will be working against the industry going forward. The third factor, valuation support from lower average interest rates would now seem to have less positive momentum (and substantial more downside) given how far we have come.

We think it is interesting to look for clues that show contrasting sentiment between "analysts" and "owner/shareholders", by focusing on meaningful discrepancies between estimated price targets and buy/sell/hold ratings. A sample review of one property/casualty insurance stock provides a test case. There is a total absence of conviction in the ratings of Institutional teams providing detailed coverage of multibillion dollar insurer ACE Limited (ACE). Currently, the stock has 9 strong buys, 5 buys, 9 holds and 1 strong sell. Based on this bullish rating, you would think performance expectations would be substantially greater than the average 9% potential rise (target price $66, no time frame). The analysts providing coverage have their feet as close to the ground as possible, suggesting something is awry in the closed loop research process that predominates on Wall Street. Bias for ones own coverage can't fully explain the lack of proper assessment of risk and opportunity. In fact, a 9% expected return looks pretty meager for a stock that has averaged 25% to 30% average annual returns from the lows of 2003, and ought not be associated with buy or strong buy ratings. Our sense is that the "point in time" earnings estimates and price targets don't do an adequate job of providing context for ratings. While going out on the limb and calling for a "major industry cyclical decline" can be a career spoiler for analysts, an "if/then" style of scenario modelling can provide a comprehensive analytical framework for understanding sector (missed) opportunities

For ACE, consensus earnings estimates for 2006, 2007 2008 are essentially flat (in the $7 range). However, we sense little in the way of conviction in the estimates beyond the next few quarters, given how much margin expansion has been a fucntion of reserve releases. Operating ROE's are expected to drop modestly from the high teens level, though they will still be "above" average. One of the reasons that analysts can't square the circle is that they are constitutionally incapable of hypothesizing lower earnings for outer years despite the fact that they certainly know there is, at best, a one in five chance that peak industry margins and ROEs can be sustained even in 2007 without an even more notable decline in the quality of earnings.

We now believe there is greater than a 50% chance of a major cyclical decline in earnings within winking distance and single digit ROEs by late 2008/2009. And while things may be "different" this cycle, the differences are not likely to be sufficent to allow the sector to garner even average sector returns through 2009. As the bottom ranked group (time horizon two to three years) among the whole financial sector, we think one ought to sell before someone does it for you.

PHLY; A Gem In the Rough?

While calling a top in property/casualty insurance sector is proving to be a difficult task (my call this half of 2006) primarily because of liquidity-related demand for financial stocks, refuting the evidence supporting the long case for PHLY is rather easy. No significant company-specific or industry evidence is presented to bolster an already weak and tired case. According to the editors at Forbes in their "7 gems for 2007", PHLY makes the cut, though, like freshman basketball tryouts, you just have to show up. One must assume, that the stock screeners looked at the 5 year average annual advance in revenues (38%), and earnings (30%), as well as a 5-year uninterrupted advance in the stock price that resulted in a five bagger for investors. One must also assume that the quantitaive model (Quantex rating 100) must have spit this one out after a gangbuster Q3 with massive reserve releases which no one is his right mind would give "any" credit for at this stage of the insurance cycle (huh!!). One can also be fairly confident that assessing risk is not Forbes forte, since no mention of it appears. Resting the bullish case on the a reasonable valuation (14 x), while reiterating management's belief that the consensus can be beat seems about as poor an argument for buying a stock I've seen in a "respectable" journal. Given the top line growth (almost 25% in Q3) and absence of reserve growth (just about flat) from the Dec 2005 quarter through Sep 2006, and steep valuation (forget about p/e; its at over 3 times book) there is little room for error. The probability of sustaining 25% ROEs for the next six quarters is closer to zero than it is to 50%. The probability of growing premiums 25% annually and doing so in a flattish industry environment (premiums) without substantial risk approximates zero. The chance of sustaining the 3 x book valuation in the event the ROE starts to slip even modestly is quite high. We think you ought to sell before somebody else does it for you.

Case Studies in Bull Market; C and GE

The considerable number of “cautious” analysts covering GE and C will struggle through the New Year’s celebration trying to cope with the fact that these behemoth stocks got away from them. In fact, with virtually no change in earnings estimates or forward looking ROE's as a consequence of the last analyst meetings, the barely 3.5% yield today ( C ) , now looks less much interesting than the 4.4%-plus yield on offer a mere few weeks/months ago. (Both GE and C charts look rather similar as well; coincidence??). What does the “unexpected” move say about value added research which doesn’t provide context for price action? At least one thoughtful analyst (AG Edwards) did raise the “conviction level” of his buy, a reasonable attitude that contrasts with the intellectually inadequate revisionist research being spewed out of the brokerage house printing presses focusing on next quarters margins, NII, and revenue growth, as well as cost takeouts, with virtually no mention of market related valuation pickup. While that detailed discussion is good and well, the regular posturing for elbow room in the “bull” camp by analysts awakening from their slumber, whom now suggest that infinitesimal moves in margins are sufficient to kick start the largest financial service firm in the world is nothing short of comical. Any highly paid value-added research shouldn't rely unnecessarily on internal projections and tiny model adjustments to make a case for a stock (stocks) that are so representative of the economy. In fact, one can sympathize with the associates slamming away at their laptops, having to revise earlier model assumptions (input with apparently the greatest eagerness and conviction) every time old research pieces are cast aside because a bad trade in Greenwich sends ripples through the bond market. Readers will likely continue scratching their heads looking for explanations to the surprising stock price action, or be content with the fallacious arguments offered in the published research
We recently noted that the outperformance of C was coming courtesy of a switch from other big names in the sector (BAC, WFC; previous outperformers), in a rotational strategy that firmly underpins a still near-term bullish view of the sector as well as broader market. That said, I would be rather cautious on the FIG sectors with historically high margins and returns (p/c insurance and broker dealers) though somewhat more constructive on the secondary "mortgage sector". As far as C is concerned "the late buyers" of C at year end are bound to be disappointed (over twelve to eighteen months) given unusual near term outperformance.

Gauging Risk in Financial Stocks Using Price/Book

Thoughtful commentators are often questioning why some investors have a virtual total reliance on ROE and price/book for financials or stocks in closely related industries (insurance brokers, student lenders/facilitators). The reasoning is simple; it provides way of gauging risk otherwise virtually unavailable to buyers and sellers who have real limitations as to what they may really know about the market. While it won’t get you on board runaway stocks (and you might as well use charts for them anyways; fundamentalists never get them right), it will put realizable sector returns in context, especially over a relative modest time frame (usually a few years; sometimes more). Assessing the probabilitity of improving (or deteriorating) ROE can only be done using a real comparative knowledge advantage (there are a few sector strategists that certainly have that capability). And making the right call (or at least not getting the direction wrong) on a major move in interest rates is also somewhat crucial (as can be seen by the recent interest-rate driven sector and broader market move). But knowing what the odds are of attaining valuations far in excess of what is mathematically reasonable based on deliverable economic value, will go a long way to reducing risk and managing outsized gains obtained over a short time period

Financial Institutions; Risk versus Reward

While frothy may be a bit too hyperbolic, the excesses in some financial institution stock valuations begs the question of realistic risk-adjusted returns expected by investors from this sector going into 2007 and through 2008. We speak of stocks like GS, AXP, and others sporting cyclically high price/book valuations. These names have provided substantial relative outperformance over the broader Financial institutions group and their relevant sub-categories in recent quarters. One thing we do know is that most investors don't know much about how/where money is/will be made (case of GS). For one, the earnings surprise factor for GS is off the charts and the highest among all Financials. If Street analysts (at least one former Ibank CFO) with their ears as close to the action as possible can't estimate earnings reasonably, who can???? For AXP, the case is different, but the current valuation discounts unusually good things too far into the future (more on this in future dispatches).
If you strip out the added p/e or price/book premium (now firmly priced into the broader market) that investors have been convinced is merited based on the bond markets scorching rally from the high in yields, the potential alpha associated with incremental recurring earnings, cash flow, and/or ROE (for GS and AXP for example) is quite modest. By my estimation, its less than100 basis points (for GS) and even less for other financials. The stories of the "story" stocks don't provide sufficient explanatory power for future incremental ROE (the only justification for improving valuations) unless one takes the position of Bill Gross, and one puts a 3 handle on yields by early to mid 2007. Being rather agnostic on yields and more inthe camp (lower rates are coming at the expense of a weaker dollar), those still trumpeting the "bull market"in financials are being somewhat disingenuous since a considerable portion of incremental $ returns are are being erased in currency depreciation. Something has got to give.
Take institutional conviction on Citigroup. Just when everyone was bashing C for allowing BAC catch up (its market cap exceeded C not more than one month ago) while grossly underperforming the whole unicverse, the stock proceeds to launch itself almost 6 points in two weeks. It appears that some institutional investors are gaming the bond trade, using the most sensitive (and liquid) FIG stocks as proxies for the long end (of bonds), a game that can end badly for stocks companies dependent on "unusually tight spreads" for financing growth. Using the poker analogy, what are the odds of winning this hand by "calling" today versus just "folding"?

Can AFLAC regain its luster

The past three years have proven to be trying times even for the normally patient AFLAC loyalists, in the midst of a scorching environment for financials in general and life insurance stocks in particular. Will the next quarter bring more bad tidings and show the recent pattern of a sales shortfall and an immediate selloff to the stock? We don't know the answer to that one, but we do know that the same manic behavior benefiting the market in general has affected AFLAC, in the opposite way. Why should investors feel comfortable owning a stock like AFLAC (or buying on bad news) for the next ten years as opposed to a stock like AXP, which is making new highs every day, with considerable more intermediate term risk? Because the quality of the earnings stream virtually assures the company will report compounded growth in book value of 15% through 2012, while it is a virtual certainty that the payments/credit business will see a cyclical downturn (a decline in earnings and trough ROE) in the next three years
Granted the company will no longer assure the market of the 15% to 17% earnings growth investors have been accustomed, but there are several arrows in the quiver that could make this a lower risk alternative in a market for financials that now is priced for perfection. We've always thought the countercylcial nature of its earnings sources, and hedging and investment income flexibility (courtesy of AFLAC Japan) to be undervalued (we always thought being fully shareholder equity hedged to be too conservative a strategy in the Nineties). The risk with AFLAC is being out of the stock, as the yield curve in Japan shifts up wards (gradually) through 2010. In fact the parallel is with the rather gradual upwards shift in the US yield curve since the post 9/11 events. That gradual rise in reinvestment rates we expect in Japan will allow the company to incrementally boost margins offsetting some of the slowdown in sales that now seem adequately factored int othe stock price. The option is that Japan Inc. rises again as a regional powerhouse, with demand for financial and insurance products. The persistence of erratic sales is the primary reason for the steep drop in the absolute and relative valuation versus peers. At 2.8 book value, the stock now seems as "cheap" as it has been in years, given the higher probability (70%/30%) that yields will move up several hundred basis points by 2010. That should give the company some time to "fix" some sales issues as the CEO in training (young Amos) gets up to speed.

FMD Few More Thoughts on Trading vs Investing

It should be clear that in the process of assessing fair value, I am incorporating a "reasonable" multi-year scenario, and using unspectacular assumptions about loan volume, interest rates (yield curve), credit spreads, and securitization margins. In fact, currently assumptions consist of consensus numbers on volume and earnings in fiscal 2007 early 2008, a modestly bullish fattening yield curve (but much tighter spread between Fed Funds and 10 year Treasuries), and very modest widening of credit spreads (virtually guaranteed through 2008 as broader credit trends weaken). One can posit two different scenarios with potentially very different outcomes (one very bearish, one perhaps more neutralish than the original base-case scenario). The more neutralish scenario (for stock) is the one that has been unfolding for the most part since mid year; low absolute interest rates; goldilocks economy. That will probably stretch out the time frame for the bearish case to unfold more decisively. But lets be honest; those trading are playing a different game of mo-mo, not the same one that "investors" with a multi year horizon are. Those reading this are certainly aware that I'm making no great claim about what next two quarter's earnings reports will look like, and in fact I'm even recognizing the 1 in 3 chance of a final upwards burst of insanity. But accepting the fact that the ceiling on the valuation is within winking distance ought to go a long ways to preventing an accident to your portfolio.

More on First Marblehead (FMD)

I can’t help cleaving to the old models, and will continue to hammer away at the themes touched upon in earlier dispatches, patiently awaiting further enlightenment as to the obvious flaws of my analysis. As far as offering specious arguments, we’ll let the wider audience decide on that one, since no real alternative to valuing the stock using a method with any theoretical underpinnings has been provided. The feedback on First Marblehead (FMD) suggests the temperatures haven’t cooled at all. The “debate” is reminiscent of the feverish arguments over Freddie/Fannie in the late Nineties, when voices of skepticism were shouted down or ignored. Of course we all know how that ended. In the spirit of adding to the debate rather than engaging with those with an axe to grind, I’ll put my two cents as to why this stock is more expensive than the whole universe of 80+ financials that form part of the S&P financial sector. I will not (at least for now) delve into the detailed overview of GOS and securitization margins, residuals, (marginal issues at this juncture). Nor will I address the worrisome issues advanced as to potential growth in student loan demand.

One of the most bullish analysts on First Marblehead (FMD) does appear to be the Bankstocks.com team. I won’t bother with the “minutiae” (they’re words not mine), but will attempt to wrap my arms around the stock’s valuation and what is imputed from the current stock price. Unless convinced that a different valuation framework can be valid here, using price/book for assessing fair value for FMD (and all financials, broad as that term may be to even include servicers) seems like the only sensible thing to do. The bulls don’t really address the valuation matter directly, and the 2007 (split adjusted) estimate of some $3.50 (consensus) suggest approximately 50% growth in EPS (over 2006) is expected. But I would hazard that 50% per share earnings growth may be closer to what the “market” is discounting not just in fiscal 07 (ends June), but in 08, and 09 as well. But here is a big disconnect (between Street estimates and the “owners”). Consensus expectation in 08 and 09 is for low-teens growth, though it they seem like low conviction estimates with FMD being given very little credit, as of today’s date (chances are these are low balled numbers). To their credit, bankstocks.com report went to great lengths to detail the mechanics of FMD’s business model, but to a much lesser extent in my opinion, the economics of the model. So far, so good. There was plenty of detail, and even quite a bit of honest assessment that “it is a lending business after all”.

So what am I missing? The best lenders (bar none, except for AMEX, another short) generate low twenty ROEs. The top-tier underwriters/originators/servicers have sustained these numbers for ten years running in one of the most lucrative periods for credit businesses. But the burden of proof that FMD can sustain 40% to 50% ROEs is on them.

Investors buying into the story should look at history and the sector for perspective. The highest ROEs among all financial institution businesses (besides FMD of course), can be dug up in the footnotes of companies like CFC, WB, BSC, or GS. But a brief glance at parent company consolidated ROE's and valuations suggests 40%_plus ROE business lines (relative to these whole companies) are few and far between, and generally well hidden from competitors’ view. And for the most part even medium risk businesses with 20% ROEs would be very welcome additions to the portfolios of JPM, WFC, BAC. So does FMD’s “competitive advantage” shelter it properly? In my opinion, little risk is being priced in, while a lot of intangible value is being assigned to a business model with a relatively short track record, despite 20 years of student lending data (Come on guys; is that really worth much? COF’s army of analysts could slap something together in weeks looking for an angle here.) Perhaps excess returns (mid 40’s ROE average from 2004 thru 2006) will endure for a few more quarters or even a couple of years. By my estimation even with a decline in the ROE to 35%, it will take the company four years to earn its way into the current valuation SLM is also on the skids, with unusual relative underperformance over the last two years versus financials. Any suspicions as to why?

Is the Treasury "Bid" a Flight to Safety?

If it is (which is the camp we are in), one would need to be considerably more cautious about financial stocks as we head into earnings season. The disconnect is that spreads on financial bonds are still historically thin, a seemingly serious conflict with the weakening economy scenario. How will the stocks (and bank paper) respond with the slightest sign of weakness in credit quality. It's hard not to think a fairly quick reversal of the gains from the last few months/year in both bank and finance stocks as well as the widening of debt spreads even if Treasury rates continue to be bid. The level of conviction one must have to continue to stay long finance stocks and bonds (beyond benchmarks) needs to be high. Absent a view that a rather short term relative value play (versus non finance stock or bonds) is driving the strategy, one would be hard pressed to find "value" in these securities beyond a few quarters. We would expect insurance paper, and p/c stocks do be equally vulnerable to developments on the economic front as well as adjustments to earnings expectations as we move into 2007. You are not being paid to hold them. At least with some financial stocks, reasonable dividend yields offer a cushion, though an exit strategy ought to be in the thought processes on any rallies. The discrepancy between the performance of C and JPM, relative to BAC and WFC suggests some money is being taken off the table on the two stocks with larger gains over the last few quarters/years, especially if you take away the J Dimon premium, now being built in.

Insurance Stocks and Street Research

A fellow blogger on Seeekingalpha suggests several insurance stocks are cheap, though by the manner in which he went about addressing options strategies, it appears he meant that option premiums were rich, and covered options were a workable strategy. As far as any pure "buys", I would challenge the underlying assumption of most of the recommendations. For investors to make decisions based on consensus expectations of year ahead earnings and "valuations", I would say you're misleading those you are apparently trying to help. Its disingenuous to think that a stock with certain P/E and growth rate ranks better or worse than others with similar p/e and differing growth rates. By now, investors should be conversant enough with time tested DCF and ROE valuation models to stay away from P/E valuation metrics, given the inherent cyclicality of the insurance business. And when you are quoting Warren Buffett, it's even more important to show some consistency. I for one will attempt to canvas some of the Street reports in my research, examining some of the key assumptions and doing a more thorough exegesis of consensus opinion (earnings estimates, valuation and balance sheet risks, macro and interest rate assumptions ) especially when my philosophy clashes with II ranked analysts. I believe the timidity of Street analyst reports can be used to hedge fund and individual investors' advantage, if one has the conviction and maps out the the sectoral investment scenario a little more rigorously. A considerable portion of the short term movement in the financial sector stocks is tied to the perception of value associated with changes in interest rates, regardless of the impact on future earnings, though its rarely addressed by subsector analysts. The absence of a comprehensive total financial sector strategy (i.e. ranking subsectors according to their relative attractiveness within the whole S&P financial universe) is a defect in the provision of research by the I Banks. I think some refreshing and timely trading and investing ideas are readily available, for those with some patience and general sector knowledge.

Financials: Where The Risk Is

The virtual unanimity among investors that interest rates will either be low or really low (as reflected in the continued strength in bonds and financial stocks) suggest the best of the interest rate news (i.e. lower is better) is probably priced into interest-sensitive securities. So the question is; Is there a way to benefit from the earnings season given what the market seems to think about sectoral wide earnings? Which sectors seem most vulnerable to material "misses"?And what if the market is wrong about interest rates, which subsectors are the most vulnerable to a shift upward in the yield curve going into 2007? To the first question, it appears that the fourth quarter will prove uneventful (as far as gaming the reporting season) for investment banks (GS minting money again, though the stock was sold into the news) , commercial banks (JPM and C playing catchup with WFC, BAC; the latter two names showing relative weakness to the former two so far in December) , thrifts and secondary mortgage lenders (CFC, FRE, FNM) are no longer in the dog house . We're less convinced that property/casualty insurers can muster up 15% to 20% ROEs again, though another mild catastrophe season could make headline numbers look good. We think the stocks should be sold on strength.........and should also be sold on weakness. We view the mid cap p/c stocks as unusually vulnerable to any miss in 2007, given the extraordinary runup in stock prices since 2002/2003. Make no mistake, the earnings quality issue will come to haunt them. Just remember the debacles in the late Ninties with Fremont General, Reliance, Frontier, Gainsco, and many other high flying "growth stocks". As we get closer to reporting season, it will be interesting to watch how rotational trades affect some of the largest multiline, Life, and P/C insurers, all of which are trading at or near multi year highs, but primarily part of global liquidity bubble, which tends to lift all boats (kites, whatever) .

The bear case on First MarbleHead (FMD)

We've identified FMD as one of the most expensive stocks in the financial services sector, based on the implied ROE as suggested by the current price/book valuation of 7.3, the reported smoothed ROE, and the predictability (or lack of) in the earnings stream going forward. As usual, obtaining excess returns is feasible over a relatively short period of time, but by and large, there are no real barriers to entries in FMD's student loan advisory and securitization business model. And we would expect this to be recognized by market participants over the next few years. And even if we assume above average ROE's through 2008/2009, the stock would still appear to be 30% overvalued under current ideal interest rate conditions (i.e mid-, intermediate and long term rates below 5%) and economic conditions. Under less favorable conditions (say yield curve shifts upwards 50 basis points), another 20% to 25% could be clipped off the price/book valuation. For now, we assume the degradation in the ROE will be a more gradual process, with the returns falling from the 2004-2006 avaergae of approximately 45% to the mid to high twenties by 2008/2009 (versus 30% for consensus), and the price/book to closer to 3 times book.
How does Wall Street's view differ? To be honest, few are raging bulls (except for Think Equity Partners). But the others (Goldman, FBR, and JPM, Bear Stearns, UBS) though not bullish, can't seem to get a grip around why they the stock is so awfully expensive, and have limped in with neutral or hold ratings, despite expectations of a decline in the ROE to 30% by 2008. But they provide no explanation as to what the current valuation implies in terms of expectations of future earnings, returns on capital, margins, or for that matter the whole business model. This is a flat out sell, the sooner the better. Trading momentum stocks is one thing, buying on the basis of discounted earnings and cash flow is another. As a veteran watcher of financial stocks, this implosion of this stock is a "When" not "if". For those who may have been burned already by the run up, rest assured that it has less to do with company specifics, and more to do with demand for financial stocks; That firepower seems to show no signs of letting up, so a long short pair trade (say long FRE short FMD) may be the best way to play this thing until technically the stock finally breaks.

Long Yen denominated Financials/Short Euro based banks

The action in the big name financials, both US and European, continue to suggest a very liquid capital markets and equity environment. From C, BAC, GS, JPM and the insurers AIG, BRKA, MET, PRU to the European banks and insurers (such as AZ, AXA, ING and STD, RBS, Barclays, and DB; some takeover related). The exceptions are the Japanese financials (such as NMR, MTG, MTU), which may be dancing to different drummer, though their spectacular rise since the 2003 lows should be noted. But should they dance to different drummer given how earlyu in the tightening cycle they are relative to the US and Europe? While the 80's and Nineties exhibited little correlation between the US and Japanese markets (or Europe and Japan for that matter), things may be a bit different now given the freer capital movement, especially from Japan, and the correlated advance since 2003. While Japan has often been accused of lesser transparency, it seems to me the US financial conglomerates warrant some additional scrutiny, given recent history of the insurers, GSE's and stock option issues, and the magnitude of the unquantifiable hedge fund and derivative risks. One shouldn't get too get carried away with any bearish prognostications, though, its hard not to convey some caution. It's obvious that the latest broad based US market and sectoral advance, has come courtesy of a weaker dollar and is almost exclusively attributable to expected lower Fed Funds and a drop in long-term and intermediate term intermediate rates in the US. The only sensible way to play this is arbitraging between the US/EU and Japanese Financial institutions (favoring the latter). Now in fact, its the more extremely valued Euro and Pound based financials that warrant caution for unhedged investors.

PHLY short of the decade

As one of the most expensive property/casualty insurance stocks in the universe, investors can play this short of Philadelphia Consolidated Holdings myriad ways. If one is to buy into this idea as a pure short, you'll have to believe that the market expects near record margins and ROE's are likely through 2008 (at least 20% ROEs). If you agree with my contention that the p/c insurance cycle is at the tipping point and margins are likely to slip quite substantially by 2008/2009, than get on board (I think ROEs will fall to low double digits by late 2008). It could be fun on the way down. How steep this correction will be obviously depends on how the macro scenario unfolds, since lower interest rates are propping up valuations of all financial stocks. (There are some longer term ramifications to pricing because of this, but that is another discussion.) My sense is that the magnitude and duration of the correction could be rather severe and long, given the almost ten fold increase since 2000 of PHLY stock. A look at industry history shows few parallels in terms of uninterrupted stock advances and there is virtually no risk in taking some type of short position: be it long/short between financial subsectors, pure short, or even long short (large cap/mid cap p/c stocks). At three times book, it would only take one earnings miss to get the ball rolling, while potential for material misses rises as we go into 2007. One can envision the stock almost being cut in half in a worst case scenario (i.e ROE falling to low single digits) with the price/book falling to to 1.5X and interst rates backing up (now a less likely scenario in 2007). But the industry history is littered with rapidly growing companies with revenues advancing 20% plus, without growing reserves (flat since 12/31).

Lessons learned; Fannie Mae and Freddie Mac

Now that we are in the final innings of the "accounting restatements" with both Freddie and Fannie for the most part rehabilitated in the eyes of the Street, it would do investors well to reflect upon what actually transpired during this last two decades in the mortgage industry . This long period saw the most explosive growth in the mortgage industry this century, and investor sentiment swing from utter fascination with the two behemoths Freddie and Fannie in the late Nineties, to total disgust beginning in the earlier part of this decade, as investors saw the excess stock returns frittered away (first Freddie) by new revelations about management transgresssions and poor board and regulatory oversight.
Wall Street's obliviousness to relative risk and realizable long-term returns was never so obvious as here. The stocks galloped ahead in the late Nineties reaching a nose-bleed price/book valuation of more than six times book, despite the ceiling on its ROE. It was effectively capped as leverage reached 97%/98%. There was nowhere to go but down from here, and the forced shrinkage of the mortage book and additional capital retention imposed since the "scandal" erupted is testament to this. With both stocks now trading much closer to fair value, one might ask where is the opportunity. While these stocks are not "cheap" after the recent double digit runup, the relative play would probably continue to favor both these stocks over virtually all of the banking sector, given the annuity stream quality of the earnings, minimal credit risk, and comparable but more enduring ROEs. Thus a long/short paired trade through 2008 would allow investors to nimbly get through the coming turmoil in a weakening credit environment
with minimal exposure to a more severe downturn in the US economy.

Long COF/ Short AXP

The premium price/book valuation AXP holds relative to COF still isn't justified, regardless of the markets love affair with another Buffett favorite. The time horizon for obtaining your low risk alpha is probably 18 to 24 months for those entering into a a pair trade. But you can expect 15% to 20% on this trade over two years. Remember KO, another Buffett long-term holding, now in the doghouse for ten years running, while underperforming PEP by an ungodly amount. This one is easier, since COF has an unusually robust track record, generating an ROE over 20% annually since it was spunoff in the early Nineties, with the recent decline in ROE due to less profitable acquired companies. Those extended the "longevity" of the cash flow, and were accomplished because the credit book was intentioanlly shrink (smart in my opinion; ask J Dimon). AXP's premium looks even richer since the spinoff of Ameriprise Financial. The disposal of that unit seem to have been a lose-lose proposition, with the AXP name evaporating after so many years of investing in the brand.
The long/short of it is that COF is trading at 1.3 book while earning a mid-teens ROE. AXP is reporting peak earnings and ROE inthe 30% range. It disposed of the high capital business Ameriprise (formerly AMEX advisors) to make numbers look even juicier. In reality, though it makes the valuation even dicier. It may be a 30% ROE business at the peak, but more likely will be a 20% ROE (or substantially lower) at the trough. My money is on Richard Fairbanks and COF to catch up.

Broker Dealers- Balance Sheet Hyper Growth

A brief glance at the explosion in the size of the Broker Dealer (BDlr) balance sheets ought to give rise to pause when evaluating the merits in investing here. Themania for the stocks is also reminiscent of the fever for buyng the GSE's in the Nineties (FNM and FRE) when their mortgage portfolios were jumping by leaps and bounds, and of the speculation in Japan Inc (and the asset speculation of banks) during the Eighties. Too vague. Well so is what is on the balance sheet of GS. Does anybody really know? It can only be funded by adding debt (on balance sheet and off through securitizations and illiquid derivatives), a fact that accounts for the unusual facility of adding poorly disclosed assets. The unholy alliance between GS and "hedge funds" makes this that more interesting. The current valuation of GS now discounts an ROE in the low twenties practically for the next five years. While myself and many other have been incapable of getting our arms around the money making magic, be advised that GS would have to earn an average ROE of 20%+ through 2009, with declines from the 20%-plus to the mid teens beyond that time to justify the current price. Anything short of this continued spectacular showing would spell trouble.

Tale of two markets; Bonds and FIG equities

Fixed income markets are pricing in soft landing-Financial Institution equities are pricing in "no landing" as in, we''ll continue to fly as long as "they" let us with "they" referring to foreign creditors. The crucial element in the equation contnues to be the dollar, which holds the key to this "no landing" scenario. For now, it seems like every time we get closer to $1.30/Euro, the dollar buyers step in. In the event of a "run" on the dollar (say to below $1.35/Euro), all bets are off to this idealized scenario for financial institution stocks (and bonds). The stakes are rising for those who believe "it" can't happen, with "it" being a vote of "no confidence" for the dollar. Perhaps its a low probability scenario, but certainly not a "zero' probability, and in my view closer to 25% to 35% (say by late 2008/2009). A safe way to play domestic financials is with long/short hedged trades, capturing short-term mispricings among names in comparable sector (say it once again for the long COF/short AXP trade; more on this to come in future posts). Recent action of Japanese financials hint of something fishy is going on.

Property/casualty insurance stocks; The bear case

By "liquidity" design, investors continue to bid up insurance stock prices, reflecting minimal opportunity in the "pure credit area" among financial institution equities. We think the decline in long-term rates (and presumed forthcoming decline in short term rates) has put off the day of reckoning for this latter group, since liabilities are just moved further out on the term structure for credit underwriters. For p/c insurers, the valuation boost from the lower earnings discount rate gets an added kick due to the fact that most insurance portfolio investments are in corporate and treasury paper. This "portfolio manager's" framework masks the underlying deterioration in insurance earnings fundamentals. And while "intellectual capital" in the insurance industry has some value, insurance is still basically a commodity business, with long term returns (ROEs) likely to revert to the marginal cost of capital (if not lower). Who would have ever imagined insurance entities generating returns in the high teens/low twenties ROEs (as reported by ACE and XL)? Given that there are only two major components in the income stream, investors continue to believe that margin erosion will be minimal in the next two years. I would hazard a guess that margins peaked in 2006, and will fall 10 points (minimum on combined ratio) by 2008, and perhaps substantially more by 2009.

P/C Insurance stocks have peaked

The sub-sector with the greatest downside among the financial institutions (FIG) is the property/casualty (p/c) group. But, the best strategy for playing the FIG group is a long/short strategy, since the insatiable demand for stocks in this area seems unlikely to dissipate with all the liquidity sloshing around. Worldwide liquidity levele suggest a low rate environment is here to stay. In particular, the mid and small capitalization p/c stocks offer the most downside over the next few years (BER, PHLY), while select mortgage players such as CFC, FRE (yes mortgage stocks, though not credit oriented) still offer much more stable and predictable (on a relative basis) long-term earnings streams. These should be a hedge on the long side, for those unconvinced of the naked short case for property/casualty insurance. These two p/c insurance stocks are up five fold in the last five years in what everyone concedes is a commodity business. What gives? The ROE's (currently in the low twenties) are unsustainable and the decline (in ROE) could start to accelerate over the course of 2007 and through 2008; perhaps reaching breakeven levels by 2009/2010. Seems like a long time; But what is to be gained by owning them today? Those with short memories need to be reminded of Frontier Insurance, Gainsco, Fremont General, and Reliance, all of which liquidated in the late Nineties. Hartford's (HIG) Chairman suggested that profits likely peaked in 2007, and far be it for us to question his judgment. The market (based on current price/books) is still discounting mid teens ROE's through 2010, but the earnings quality has already started to show cracks in the way of reserve growth. Stay tuned.