April 7, 2008

Review of distressed sectors

If you followed my writing over the past few months, you would have noticed that I have been buying into three sectors: retail, real estate, and Banks. In this post I will review briefly each sector and my investment actions going forward.

The sector came under stress due to credit event mainly. My thesis for investing in Banks like US Bancorp and Bank of America is the decline of prices happened due to a credit event and once the event is resolved prices will be restored. However the credit event is unprecedented in its duration and complexity something I underestimated. Another factor is the market share that will be gained by Banks like BofA USB; they will grow at the expense of failed banks and contracting operations, rather than normal overall sector earnings growth. The earnings growth that powered big returns in financials in recent years now appears to have been driven by borrowing and moving certain assets off their balance sheets. It isn't likely to return soon.

I am not big on investment banks as I do not trust their earnings and liquidity as much as commercial banks. Most of their earnings come from trading earnings that is non recurring and should be valued less than banking fees. I have no desire to own any investment bank at any valuation. Most of these institutions have no real competitive advantage or if they have any it walks out of the door each evening; I am skeptical of the value in businesses like these.

Banks have a lot of challenges going forward: mainly searching for revenue growth and shedding non performing assets so their earning will be pressured for the next two years. More importantly the complexity of financial relationships and estimating the risks are becoming more paramount. One thing the credit event have reminded me is the lack of transparency in general on Wall Street, let alone banks. I will not add to any additional position in this sector and will only concentrate on UBS and BofA.

Real Estate:
I am talking about real estate operators rather than residential home builders. The group has recovered some what during the past quarter, actually the group has outperformed the S&P 500 on YTD basis. REITs have recovered somewhat when investors realized that they oversold the sector in reaction to the meltdown in the residential property market. Commercial property prices will come down a bit but with rising stock prices the discount of market price to REIT's Net Asset Value is closing slowly. I do not think that commercial properties will hold their price despite of the good fundamentals; there are simply too many headwind forces to overcome.

I still think there are opportunities to be had in this sector but you have to be selective. I am looking for unique assets in highly dense urban cities, where barriers to entry are so high that supply can not be easily generated.

Retail has also outperformed the S&P500 on a YTD basis. I still think there is a lot of undervalued businesses in the sector that can be well positioned to recover nicely once the economic environment improves. Some of the retailers are selling at levels that is ridiculously low; their P/E s are in the single digit. I am still evaluating some businesses in this space but I will be happy to add to my existing position in Lowe's and Sears Holdings.

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