Sunday, August 12, 2007

Fear, Corrections, and Regret- Crisis of Confidence

Corrections happen. They are painful, come up spontaneously and unexpectedly, frequently take your breath away and replace your confidence with fear. It is important , at least in my view, to remember at times like these, all of those factors that brought you into capital markets or your specific investment holdings in the first place. Don't let yourself be spellbound with fear.

The flurry of liquidation will subside as redemptions end, as valuations come to irresistible levels, and as anxiety diminishes. Though bargains, in my view do not yet abound, considerable valuation opportunity has opened in the last week. One day leaps of faith represent little indication of anything beyond traders' bravado. Risk adjustments are taking place fairly quickly in the corporate bond realm, and it is important to recognize that you as the owner of the equity have the bottom rung or the residual position.

The malaise of the junk bond market spills over into equity markets fairly easily. Spreads which had narrowed to silly levels of 60-70 basis points over Treasuries now find themselves in a more reasonable, but hardly generous 250-280 basis points over. Think of equities as being the lowest form of junk debt to put the proper perspective in place. Hence, risk premia in Discounted Cash Flow models must open up to reflect the fact that the bond guys are getting their pound of flesh, at long last.

Though the housing market has gone to hell in a handbasket, this is hardly news. There is no entitlement to home ownership for someone with bad credit or no dough...if you think otherwise, get real. If you are worried about your CDO holdings, despite having an "investment grade" tranche of BBB, get real. There is a reason that those who were yield hogs, got slaughtered and chances are, your going-in yield on the BBB tranche was some 200 basis points over where more "normal" credits traded. It ain't going to be pretty if you find yourself stuck in one of these situations. Liquidity dries up and the only enticement is offering your tainted merchandise with a lower price. The old investment adage "the first loss is the best loss" often applies. Being mesmerized by fear of taking a loss is a horrible trait that most of us (and especially men!) have.

Make an honest assessment of the quality of your investments. If it smells (i.e. cash flow from operations is negative, increased working capital is needed as a percentage of revenues as revenues grow, increased capital intensity, diminishing interest coverage, falling profitability) just sell it. If retained earnings is a negative number on the balance sheet, your company may be selling on hope rather than fundamentals. You probably shouldn't have been there in the first place. Take time to learn what the credit rating of the underlying bonds and debenture of your equity investments might be. Despite their poor timeliness and recently tainted reputation, the bond rating agencies can generally distinguish good interest coverage from bad. If your company is below investment grade in its debt ratings, you may be in for a rocky ride as the equity valuation adjusts to the increased yield on the debt.

There is little solace in this great Buffett quote, "You can't tell who is swimming naked until the tide goes out." Central banks around the world injected almost $300 billion in liquidity on Thursday and Friday of last week to try to fill in for where the tide had gone out. Fear is rampant out there, apparently even among central bankers. Don't let it mesmerize you!

Personally, this feels more like a panic than a crisis...more of a rough patch that may last weeks rather than a "drag your guts in the gravel" crisis. I have heard or read three warnings of the present market resembling a pre-crash 1987 scenario...I doubt it. Unless bond and money markets becomes so disabled that we need 150-200 basis points to clear merchandise, I don't sense more than another 5% of downside in aggregate averages. Who knows? Mr. Market seems quite despondent and may overshoot my objective.

Though many investors seem to want to see a Fed rate cut, its negative impact on the dollar could reverse the flow of foreign capital...I am not counting on such Fed action.

What to do? In my view, it is late to try to raise cash. In my view, you may regret not having taken sufficient risk in buying some equities in this weakness. What's on my shopping list?

Though it flies in the face of most strategists' advice, I like a number of financial services stocks. US Bancorp (USB) and Citi (C) are two of my choices among large domestic banks. I like Allied Irish (AIB) and Credit Suisse (CS) as well for international exposure. Even some community banks, which I have avoided for some time are starting to look more reasonable to me.

Some of the business services companies such as payment processors and tax preparation companies look interesting. Kartik Mehta of FTN Midwest Securities is interviewed in this week's Wall Street Transcript (subscription required.) These companies generate a significant amount of cash flow and a significant amount of recurring revenue and have low capex needs. Frequently, they tie into small business but also have some bank exposure. Companies like First Data (FDC) and Alliance Data (ADS) have already been chased down by private equity. By the way, I continue to believe that private equity deals will continue to be part of our investment scenario for at least the next year. In the business services I like Global Payments (GPN) and Total System Services (TSS)

Here is an interesting screen of companies that have bought back stock, every year for the last five years, in excess of stock issuance as well as pay better than a 2% yield, and that are down more than 10% in the last month. This is not a buy list, but an explore list. There are some companies hear that I would not touch!

Stick to your discipline and show some patience. Buy stocks that you feel comfortable with over a longer period of time. Buy into businesses that if Mr. Market continues in his anger, you will feel comfortable to step up to the plate again and adding to your positions at even better prices!

Ignore the histrionics and the hysteria. Like your batting coach told you in Little League, "You've got to keep swing ing the bat." There should be a fair number of fat pitches coming our way!

Disclaimer: I, my family, or clients have current positions in USB, C, AIB, CS, GPN, AZN, CMA, FII, and TOT.


At 1:02 PM, Blogger Dave said...

Thanks for the post - very insightful. I tried accessing your screen of buyback stocks but was blocked by Google spreadsheets. Could you please repost the link?

At 1:42 PM, Blogger Sal Darji said...

Your screen results on Google Spreadsheets doesn't seem to allow access to the public. Is there a way to do that?


At 8:56 PM, Blogger Nick said...

I am not able to access the google spreadsheet. Am I the only one with this issue?

At 10:03 PM, Blogger David Templeton, CFA said...


I enjoy reading the content on your blog. I did try to access the spreadsheet in this post but was unable to login.


At 1:52 AM, Blogger Jay Walker said...

Hi Rick,

It is interesting that we both like some of the larger financial stocks.

I recently did a podcast with Dennis Olson of and mentioned many of the same (the podcast interview occured on Aug 6th, but wasn't broadcast until Aug 15th.) (I also recommended your blog as a good read therein).

Anyway, keep up the good work - enjoy your blog as always -

Jay Walker
The Confused Capitalist

At 4:57 PM, Blogger Rick said...

Whoops! Sorry, the link has been freshened and corrected.



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