Monday, November 20, 2006

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.