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.