Financials; Opportunistic Short Opportunities

The schizophrenic market participants (as opposed to the market) have shown moods that swing from exhibiting total despondency to semi-euphoria over the last several months, especially in the financial sector. For us, it indicates what we have long believed. Few investors have any real convictions about how to value financials and react to the news (or noise) in a herd fashion. While we firmly believe it is possible (and absolutely necessary) to trade when given the opportunity, one shouldn’t confuse that with investing based on traditional principals.

This is one of those moments where investing is becoming more difficult and trading somewhat easier, following the rate cut rally. It is more difficult to invest (or make the case to not invest) because two variables that have entered the equation loom rather large on assessing the quality and sustainability of earnings; interest rates and the dollar. The emphasis on US broader market gains without closer scrutiny of the longer-term implications of a virtual collapse in the currency seems short-sighted. We would add that the rather punk rally in large capitalization financial names; (in the US and in Europe and Japan), and continued backing up of Treasury and corporate yields, suggests serious concerns about the ability of most of the global banks to make money in credit. Shorting some of the small and mid capitalization names (FMT $5.28, FMD $38.44, BER $29.17, PHLY $38.20) as well as higher beta names that have rebounded (GS $205.95, AIG $66.97, AXA $42.89, ACE $59.70, XL $76.42) and are up against significant resistance seems the optimal trade as of today.

It’s virtually hopeless to try to measure with any precision the impact on future earnings from the change in the credit conditions. If estimating broker/dealer earnings was hard before the “crisis”, it is not likely to get any easier today. What has changed is the cost of being wrong; today, the cost of being wrong (for longs) has diminished given where we stand relative to the earlier year highs. And one shouldn’t give too much credence to the “theories” or “patterns” (related to Fed Rate cuts) suggesting the financial stocks will be much higher 3 to 6 quarters after the first cut.

The Long and Short of First Marblehead

It's interesting how the various constituent players are gaming this thing. After seeing the stock take a thrashing (off nearly 40% YTD) the "bull's are clearly in retreat, though one prominent well respected former analyst continues to "evangelize" on the merits of the company and stock (For the record, I have no position in the stock, but have recommended shorting since last December at around $50.) The quoting of "Bubba" (reputed to be a PM at a short hedge fund) for not making a convincing bear case (recently) plays right into the hands of the numerous shorts who are salivating at the opportunity to clip another 10% quickly by shorting the next rebound. The volatility in the financial institution sector, and likelihood that the credit squeeze carries on for a while, suggests they will get such a chance. The bullish commentator goes on to suggest the stock (FMD) offers lots of long-term value, and that not being a trader like Bubba, he will prevail once the market comes to its senses. He is undaunted by the risks of the securitization markets, competition, and other things, such as valuation (some 3 x book and high single digit P/E), purported highlights of Bubba's case. ( For the record, he quotes Bubba as saying "the bullish case is not made", as opposed to saying that Bubba thinks that "there is a bearish case at this price", a different matter altogether.) The author is a bit disingenuous to say that the bear case is not being made, especially considering the price action since year-end and his own recommendations even at the highs. (If he or others got in much below the current price prior to late 2006, congrats, but they should have sold. They won't get another chance at 50, not this decade.) My sense is that the bear case was made convincingly (unsustainable 40%-plus ROE's and peak price/book of 7x) and the decline reflects the even more subdued value creating ability of the enterprise that has emerged since mid year. The liquidity crisis was just the trigger. Certainly, the stock no longer carries the once deserved moniker of the most expensive stock in the Financial institution universe. In fact, if you shorted in the high forties (or $50), wouldn't you have covered? Nobody says the thing is worth Zero. But even if you thought it was worth 20 to 25, the stock feels so heavy, you would probably be waiting for technical rallies for entering new shorts, but you would have already proven your original argument (had you made it) about a ridiculously overvalued stock at $50. Period. By continued evangelizing, many new longs are getting all lathered up in the process, given their own ignorance, and the detailed scholarly quality lectures on securitization, residuals, gain on sale margins, eps growth, BBB tranches being provided by the most prominent FMD prophet. It is unlikely that this will prove to be one of "Peter Lynch"s gems, with bumps and bruises, but for the sake of owners, hope that the misunderstanding of the valuation of financials isn't fatal.

Broker-Dealers Price/Book ; Do They Suggest Cheapness

Much ink has been spilled on the matter in the last few weeks by pundits suggesting they provide unusual value. Maybe. But than maybe not. Few times in the last year were many skeptics willing to go on the limb to suggest the stocks were expensive at 2 to 2.5 x book value or more. Yet, the shorting opportunity presented itself with lightning speed, and any value investor worth his salt knew the ROE's were not only unsustainable, but also hard to imagine achievable without unusual and substantial risks. What can be imputed from the current valuation? Under normal circumstances, one would say that for a stock like BSC at BV, the market is assuming that the company can barely earn its cost of capital for the next few years; And for the years beyond that its easier to guess that the answer is a solid NO. But the current circumstances are far from normal. CDS spreads (at the recent peak) suggested the broker/dealer paper was being priced near junk, yet there was Bill Gross buying GS paper in the heat of the moment. The reality is, no one knows what the true cost of capital is, since it is (and will be for the foreseeable future) a moving target. No one knows how much of the liabilities are priced off of LIBOR, or Fed Funds, or Treasuries or anything else for that matter. Off balance sheet entities?? SIV's are the old SPV's, accounting creations that allow you to use even more leverage without telling anyone. Earnings power you say??? Even broker/dealer scholar Brad Hintz (Bernstein analyst covering broker/dealers and former CFO of Lehman) who ought to know more about the business than any analyst out only very infrequently get his earnings estimates within 20% of reported numbers. Why bother trying??? By all accounts, the stocks offer dead cat bounces, sold heavily on rallies 10% off the lows. At worst they are discounting a cyclical global decline in financial stocks that will lead to a multi-year de-leveraging, comparable to the GSEs, Japan Inc, mega cap US banks like C, JPM, and their hedge fund brothers.

First Marblehead; Why is everyone selling???

Perhaps the stock is still expensive. It is certainly closer to our price target (circa $20) set late 2006 and no longer carries the moniker (provided by us) of the most expensive stock in the financial sector. Meantime, that loud sucking sound called liquidity seems louder than the boo-yah of the cheer-leading section populated by the usual suspects. Perhaps they are selling and not telling, or perhaps the logic of the business model and valuation no longer seems so air tight. My sense is that the stock will see a 20 handle rather quickly, and selling into strength in the mid thirties is a virtual lock bet. We will revise our target price (probably lower) following the next liquidity crunch. Previously short listed short stocks that have regained their status after initial swoon are BER, PHLY, and CB.

Financial Stocks; It is Getting Very Late to Short Here

The second punitive phase in the financial sector is unfolding here, with too many johnny come late-lies trying to put on last minute shorts on banks and insurers they don't know how to value. Its likely to lead to unpleasant surprises for many piling on at the last moment. There were two significant opportunities to short; (1) earlier in the year, when the red light was flashing on credit and leverage, and the broker dealers like GS and LEH were discounting 25% to 30% ROE's as far as the eye could see and spreads were as tight as ever; and (2) a week or so ago, after vicious rally pushed up the group toward the first layer of resistance, that may hold for months to come. Is it too late to short during this swoon; Absolutely. With the broker dealer stocks down some 30%, bank stocks off some 10% to 15% and yielding 4.5% to 5%, and insurers now as close to book value as they have been in several years (with some down as much as 30% to 40% in mid cap space at their August lows), investors ought to find new profitable themes else where, and wait for possibly better short opportunities in late 2007 and 2008. The chance of a second major positive liquidity event is rising and will likely send the shorts scampering toward the same exit at the same time, attempting to cover ill advised positions . Given the relative under-performance of the sector over the last two months, even bad "market news" would likey make the group a relative outperformer for the next few months.

Sifting Through The Mortgage-Related Wreckage

Those seeking buying opportunities in mortgage-related securities or interest-sensitive assets will have plenty of opportunities (and a considerable amount of time) to dip in and go long again. Although this first phase of the liquidation process is almost over, the spillover from this meltdown seems likely to endure for years. And as long as it didn't come as a complete surprise, investors ought to step back and let the leveraged longs wreak some havoc with each others' portfolios as they crowd the exits. In a single-digit return world for stocks (and bonds), it will take some time to unwind the same positions that accounted for a good part of the extraordinary returns of the broker dealers, private equity honchos, and the rest of the masters of the universe on their way to ungodly prosperity and riches. Unfortunately greed isn't only the provenance of the chosen few who attended Harvard and Wharton. Those doubling down on real estate properties on the gold coast of NJ and elsehere will soon also see margin calls on their properties, as rental income falls just a bit short of making the grade. Any doubt, one should look at HOV, LEN and other homebuilders to see what is in store for property values. In the real world of investing for value, there are pockets of opportunities at modest risk which could provide 10% to 15% average annual returns over time (five years), absent a cataclysmic collapse in financial assets and the dollar. Contrary to conventional views, the GSEs (FNM, FRE)may offer the best all around return among financial stocks, a view I presented back in January.

Berkshire Hathaway Assesses LT Insurance Risk

While much ink is spilled about Warren Buffett and his current investment choices, very little energy is spent on assessing much more important decisions (or absence thereof). The buy/sell of KO one of his largest equity holdings comes to mind. (To whom would he sell said James Grant in 1998. ) Many of these, though virtually absent from public discussion have far greater import to the long-term profitability of his enterprise. Another such decision involves the virtual absence of growth (overall) in the insurance business. As per annual reports; 2006 premiums earned were $24.0 billion compared with 1999 premiums earned were of $19.3 bill. That corrsponds to less than 3% annual top line growth for 7 years. Absent the $7 billion (one time) premium gain in the first quarter, new risk would not have changed long-term growth rates materially. Compare this figure with your average Bermuda company (ACE) that showed a 5 year cumulative growth in premiums in the 13%/14% range. The master himself has suggested that returns will be down in 2007, perhaps sharply. What does his gimlet eye see that myopic investors fail to discern from the inflation/interest rate trends. While I admit to talking my position (short p/c stocks), one would have to give credit to the institutions (buyside, hedge funds) piling into the insurance stocks (life and p/c alike) with the hope that being long US US bonds (through holding US insurance assets) and a winning trade for years will continue to work, absent the foggiest notion about what is coming down the pike in this notorious cyclical industry. The industry is due for a long period of seriously declining margins and ROEs, and investors are likely to be as surprised of the outcome as they are of the impact on their portfolio of insurance stocks.

REITs and Financials

A very decisive pullback in the REIT sector ought to give caution to the bulls stampeding through the financial sector. While we've seen this rotation before, the size of the REIT sector
curently is much more significant than five or ten years back. In addition, the wave of property mergers, and the financial calculus (i.r. cash returns) of real estate now makes it clear that the margin of safety in real estate investments in general (and lending in general) that much thinner. Far be it for one observer like myself to call the top in financials (or at least encouraging investors to sell on strength ). But even loooking at the major banks suggests that the ROE's discounted by the current valuations need to continue to be in the high teens (and above range through 2010). What has changed to make the risk/reward so much more problematic as we approach mid year earnings season? For one, notwithstanding the multi-weeek strength in the dollar, it is still dangerously hovering at multiyear lows at a time when it is clear the European Central Bank is popping its own property bubble. The aggressiveness of the ECB and the changing complexity of international capital flows suggests favoring long term asset reallocation to non-dollar assets (albeit cautiously at these levels). Can one explain the feverish multiyear depreciation of the $ any other way? and why are $ equity markets so complacent? I for one would suggest that the burden of proof is on the guardians of $ stability, and that attempting to buy $ assets with the hope that they will appreciate faster than the $ is depreciating is a risky proposition. As the repository of most dollar denominated assets with substantial exposure to rising long-term interest rates (currency imposed), the banking system is de-facto losing its credit worthiness and the security of its long term profit stream. Mid-single digit intermediate term returns (five years) can be obtained much easier in the bond market, with less potential loss of capital

Trading student lenders SLM ($45.0) and FMD ($52.89)

With Morgan Stanley having tactically changed its recommendation to equal weight its target price to $53 (from $55) following the sharp heavy volume selloff and dramatic underperformance versus the sector, yours truly thought it worth revisiting the short call on SLM ( first made here on September 6th anonomously) given the fact that I consider him the most competent sector analyst out there. I came away unconvinced that my own target price of $35 should be altered uness we go push out the time horizon to 2010. Then, the price target would rise to the low forties. It's clear that the relative value versus the S&P financial sector is now somewhat enhanced by virtue of its own dismal performance. (Hence I believe his tactical call.) It's a twisted way of seeing opportunities through the lens of hedge fund investors, whom, for the most part, are happy to pick at an idea if it provides some relative performance through to the March quarter. And as investment opportunities go, this stock is as likely as any financial for a short-term rebound; bonds are a bit oversold; banks have given up substantial ground since late December, and the yield is now above 2% and competes with the S&P yield. What struck me was the analyst's conviction that the real story was the growth in "private loans" (30% potential and worth $30 of the $53 a share!!!!). In my humble opinion, giving credit to a stock trading at this unusually high premium/book on the basis of "growth" in private loans is tantamount to "credit suicide". Even under the base-case scenario for 2010 of a 29% ROE, the stock would deserve a price/book of closer to 2.5 to 3x (depending on yield curve shifts) and prospective ROE assumptions beyond 2010. In fact, I would hazard a guess that the p/e will fall to the single digits like FNM and FRE did after their mercurial rise in the Nineties (and subseqeunt fall out of favor) along with SLM'a unsustainable high ROE business model. So to sum, up, if you are going to go long this idea (SLM) for a trade this quarter, short FMD ($52.89) in the interim, a short opportunity of historic proportions (more on this in past and future posts)

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) .