Sunday, November 4, 2007

My Thoughts on Financial Companies

I have been in the car for many miles and hours driving and listening to music over the weekend as I traveled to Marble Falls for a buddy's bachelor parties. I typically enjoy these lonely road trips because it makes you do nothing forcing me just to think, and think I did. I have not taken the plunge and bought any financial stocks in all this financial turmoil. Since October 2006 I have shorted many names in the space including Bank United (BKUNA), Downey Financial (DSL), Thornburg Mortgage (TMA), Goldman Sachs (GS), Moody's (MCO), and MBIA(MBI). All of these I have made money on (except TMA which I covered at a loss before the huge stock drop, still bitter about that one, lol). Looking at the landscape currently there many names I find interesting to potentially buy and yet I haven't. So most of my ponderments were on why I haven't and if I needed to start moving into some names this week. Have I not because I am being ruled by the emotional fear that is gripping the rest of the market? Right now can I not be greedy when others are fearful? Is there an emotional aspect to all of this that I simply need to overcome? These thoughts and others I kind of rolled around in my brain and the answer I think I came to is no. I have bought (and so far lost money in) things related to the homebuilding space. Not homebuilders yet (found it interesting that Buffett said he thinks the whole space is still not interesting) but things related to homebuilders. Obviously there despite the danger and continued deterioration of prices I have been able to resist the urge to flee with others so what about the financial space?

I think it is different. Unless you are intimately connected, at least for me, I find it almost impossible to handicap various outcomes. I have said numerous times that hurricanes sink even the best of captains and I think no where is the danger higher of sinking great captains caught in hurricanes than in financial hurricanes. The reason is the nature of the business. Everything (unlike homebuilders or oil exploration companies) is based on confidence, trust. The world we live in is terribly dependent on credit, securitizations, derivatives, insurance, etc. If all of a sudden the trust falls apart, the system itself falls apart, it doesn't matter how good you are, you are sunk. A great example of this has been Delta Financial (DFC). I looked at this name numerous times. I read the majority of the annual report, almost bought it several times. It was cheap on every meaningful metric. If you are unfamiliar with them (very rough explanation) they originate, securitize and sell subprime loans but they originate virtually zero floating or adjustable rate mortgages. They are almost all fixed. Their management has been very conservative and stayed away from the froth nonsense of arms and teaser rates and all the other abuses that went with the bubble. They had a great management but in July into August when the hurricane hit, they still were sunk. It didn't matter, down went the ship. Why? Because the market didn't trust the system anymore. Had nothing to do with the management team or the company, the system was thrown out as untrustworthy. As a result financing was essentially cut off from them, their lifeblood, and a huge gaping hole emerged causing the ship to start sinking the stock price going from 12 to 4 in weeks. Maybe their is no permanent impairment of intrinsic value, (I think their is) but here was a great company that was very conservative with a great management team where all of a sudden the system lost all trust with all investors.

Compare this to a homebuilder like M.D.C. Holdings (MDC). I do not own it but here a is a homebuilder caught up in an equally if not bigger hurricane with equally conservative, superior management team but this company has virtually zero % chance of going bankrupt. They have tons of cash and it isn't like there won't be any homes built in America for 10 years. So here, though the price keeps drifting downward, I can handicap the downside much easier than a financial company.

It is impossible to predict "black swans" which is what makes them black swans but it seems to me in the financial system we have a greater probability than we have had in a long time of the financial system breaking down to the degree that even great companies with great management teams still are not cheap. A system wide deleveraging where you have a category 3 hurricane turn into a category catastrophic category 5 hurricane. Please understand I am not by anyway predicting this. I am just saying the probabilities are much higher than they have been in many years and I am having a terrible difficult time handicapping this when analyzing great financial companies selling at what seem to be potentially ludicrous prices. You have your $.50 (even $.20) dollars in quite a few places which appears to be very large margin of safety but like DFC that margin of safety can evaporate in mere weeks as the system completely breaks down. In my mind it is similar to technology. Very hard for guys like me to invest in technology companies because it is extremely hard to predict what the technological landscape will look like even 3 years out. Well it seems to be very difficult for me to predict what the financial system will look like even 3 weeks out right now.

Anyway, with all that said there are many opportunities and I have been thinking alot about how to reduce my risk while taking some exposure. I think I have come up with some fairly creative ways to do this and will probably work some trades in the next couple of days so will wait to talk about them until later. Just thought I would write about some of things that bounced around in my brain over and over as I put miles beneath my tires and the pavement.

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