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"?