Thursday, December 14, 2006

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 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, 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?

Wednesday, December 13, 2006

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.

Tuesday, December 12, 2006

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.

Sunday, December 10, 2006

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).