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.