November 29, 2007

Value Ideas

Can we find value amongst this carnage in financials and the credit market?

As the market is filled with fear from losses and declining prices, this period can be rewarding for those who look at the big picture. In the angst of the stampeding and fleeing investors, there is got to be something of value. I can look in areas where I have some expertise in, those would be retail, real estate and banks. I am very sure there is value in other pockets of the market, may be in the Collateralized loans and Mortgage backed securities area, as Citdal fund have scooped $3 billion worth of paper for $800 million just today, but I do not have the expertise nor the information necessary to assess and understand their value.

The areas of potential value that I have researched, as I can asses it relatively well, are the following:

  • Bank of America (BAC): the bank has a large national branch network that have a solid competitive advantage compared to others. BAC has the economies of scale to be a low cost leader compared to other under capitalized, less represented geographically. It has minimal investment banking exposure, which is the source of all evil in this market. The problems of under capitalized lenders will drive business to BAC earnings, as BAC can withstand liquidity crunches due to its large capital base and size. The bank has an earning yield of 9% plus its dividend yield of 5.75% to equal an expected return of 15.6% superior to the industry and the S&P as in the schedule below. The bank also has a ratio of equity to to total assets of 8.77% that will be increased once its mark to market its holding of the China Construction Bank. The increase in value will be $19 billion which translate an equity to total assets of 10%. My analysis regarding BAC is forthcoming, but I have managed to take a position in the banks two days ago at a price I am happy with.

BACIndustryS&P 500
P/E Ratio (TTM)10.1710.8920.35
Price to Book (MRQ)1.471.614.43
Price to Tangible Book (MRQ)3.434.048.82
Price to Cash Flow (TTM)8.819.6114.77
Dividend Yield5.71%4.88%2.26%
Earring Yield9.83%9.18%4.91%
Expected Return15.54%14.06%7.17%

  • Lowes Home Improvement (LOW): LOW have a good predictable earning in the long term. I have already invested in LOW, see my analysis here. LOW will recover when the housing situation corrects, that will happen maybe in 1-2 years, all the same I am willing to wait that long.
  • Corporate bonds: Corporate bonds are cheap and a better investment than many stocks or government debt currently. Investors in investment grade corporate debt are demanding 180 basis points extra interest compared with similar-maturity government notes, up from 99 basis points in July, see chart below ( 10 yr spread of corporate bond to 10 yr Treasuries, source: yahoo and dow jones) . The investment grade bonds are good as treasuries as their credit quality profile has not changed significantly and will reprice higher once this crises behind us. The premium for high-risk, high-yield bonds has increased even more to 4.95 percentage points.

And the way I choose to monetize this idea is through closed end bond funds rather than individual bonds for two reasons:
  1. Closed end funds are selling at large discounts currently and those discounts widened significantly over the summer.
  2. Closed end funds offer a diversification form issuer's risk.
A good example is UBS's FDI fund. The discount has widened to 12.39% while its average year to date discount was 8.7%. The funds yields 5.65% which translate to a spread of 1.65% over 10 year treasuries, a very respectable return for a majority of investment grade portfolio.
FDI Premium/ Discount Profile
However, a bad example is the likes of BlackRock core bond trust (BHK). The fund is offering 6.58% yield, a little more than 2.5% over the 10 year treasury. The fund is currently is selling at 10.5% discount to it NAV (Net Asset Value. The discount has widened considerably since this summer, when its averaging close to 6%, see chart below. However I would stay away from such funds as they are filled with mortgage papers. You have to go through the individual holdings of these funds to realize if it holds any value.
BHK Premium/ Discount Profile
I would stay away also from High yield issues, although their discounts and yields offer very very attractive returns. High yield issues will have higher defaults during economic slow downs and their prices usually plummets. So if you think the economy is going to do well in the next few quarters, these funds will offer a very attractive opportunity.

Where I do not see any value is in investment banks and large money centre banks in general; I have written about banks previously and I always come to the an uncertain conclusion about their future. Banks face some unfavorable possibilities in the future that probabilities can't be assigned intelligently and even unknown outcomes. Assets quality and valuation are not easy to measure and understand. Earnings are extremely volatile and can't be assessed over the long run.

Here is an expert from an article from the today's financial times that convey my thinking about banks:

The last thing a buyer wants is to rush in and buy cheap-looking companies[banks] if the value of mortgage- backed instruments on their books could fall even further. Also, there is growing fear that the US economy could weaken significantly into next year. If that is the case, financial companies could suffer bigger loan losses and become even cheaper. Finally, they might prefer to raise pricey new capital to stabilise their businesses, rather than selling out completely at a price distressed enough to attract a buyer.

Getting the timing right is tough. Witness Bank of America. It injected $2bn into Countrywide in August. The mortgage lender’s shares have since slumped.There will be ample opportunities for canny investors willing to inject capital into US financial groups. But do not expect a run of mergers or acquisitions unless the uncertainty subsides.

It is going to be very interesting over the next few quarters.

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