BofA out Amex in

I am rolling my capital allocated to Bank of America into American Express (AXP).






I have been mulling getting out of BofA position for awhile. The buyout of Merill Lynch have changed my outlook on the bank. Mainly due to the integration risk and the diverse cultures of investment banking and retail. This merger would have been difficult to complete in normal circumstances but with the stress of bad economy and credit crises this could be impossible to pull off.

Also the financial landscape has changed a lot since my investment in BofA. BofA, as I reasoned when I made my investment, held a competitive advantage over its peers by being the largest retail bank with coast to coats network of branches, which ensured that it held a relative competitive advantage in its economies of scale to its peers. Now with the rapid continuing consolidation in banks, that is no longer the case. Other banks like JP Morgan and Wells Fargo achieved that position by buying Wachovia and Washington Mutual. So that relative competitive advantage disappeared, which can lead to margin compression over the long term.

Buffet also sold out of BofA so I get my confirmation to my thought process.

I am not saying BofA will perform badly, but there are more risks associated with the business. BofA management is still good and have a lot of experience with merger integration and the opportunistic acquisitions they made in the last 6 months can secure their position in the global banking industry. However the return is more speculative than say with AXP or JPM.

My cost basis for BofA is $42 per share I sold it at $18 for a loss of 57%. That hurts. But I will not dwell on it, as I need to find the best risk/reward proposition for my capital and at the moment BofA does not fit that bill. American Express, on the other hand, will offer me a better return, I think, once market settle down. I bought AXP at $20 per share.

AXP has several competitive advantages that makes it a unique investment.

• brand: BusinessWeek ranks it 15th out of 100 most valuable global brands.
  
• network that akin to toll bridge earning fees on transactions from retailers and interest and fees from users
• retailers have limited bargaining power in this industry. Credit card networks can increase fees with little of resistance from retailers.
• what will be good for BofA will be good for AXP, while the opposite is not true. BofA will have specific risks associated in its operations that can overwhelm its earnings.
• Buffet ownership gives a backstop for any permanent loss of capital in AXP, while with BofA government involvement present a risk for permanent loss of capital, think of AIG.
• With the sale of BofA i generate some tax loss amounts that will be used to offset some of my earlier capital gains in the year, something I think I will not discuss for awhile.
  

Here is a good case for AXP as undervalued investment by Vitaliy N. Katsenelson.

I think by redeploying capital from BofA into AXP I will be better served. I will sell my investments when I believe that I could redeploy the capital in investments that offer more attractive risk-reward profile. I will always be willing to sell an existing holding at a profit or a loss, if I can find a better use for the funds.

NorthStar business model re-evaluation

Any lending operation currently are re-evaluating their going concern and the future of their business model. Any financing operation without a stable deposit base is at risk and have a bleak future. That's why the investment bank have disappeared from wall Street. But this change will affect many other operations depending on leverage,like leasing companies, mezzanie funds, commercial real estate reits..etc. One of my holdings NorthStar realty is one of those affected as it is a commercial financing company.

The entire sector of REITs specializing in financing commercial-property transactions are facing headwinds. Companies like NRF, Gramercy, CBRE Realty Finance Inc. and Arbor Realty Trust Inc., have seen their access to capital severely reduced by the credit crunch. They are also suffering from a dearth of property transactions and rising defaults.

The business model of traditional commercial-mortgage REITs -- which act like leveraged bond funds, making money only if the yields on their investments exceed the cost of their borrowings -- has been rendered obsolete by the credit crisis. Early this year, Gramercy bought a REIT that owns real estate to help diversify its business.

from the Wall Street Journal:

The reason: These companies have depended heavily on the ability to sell securities stuffed with the loans they originated, called collateralized debt obligations, or CDOs, in order to lock in financing for a longer period of time to match their mortgage portfolios with long-term maturities.

Today, with the CDO market all but shuttered, there is a lack of long-term debt financing that they can rely on to fund the acquisitions of assets.

"While I expect further loan impairments, the real focus will be on liquidity and any potential violation of their credit facility and bond covenants,"

NorthStar already has diversified away from the mortgage reit model into operating commercial real estate business before the credit crises. NRF has diversified into Net-lease operations through two joint ventures, Wakefield Capital, LLC, owning medical facilities and another venture, LandCap partners, with Goldman Sachs to buy distressed land rom home builders.

They have just reported their earnings and I have to say the report looked really good. Here are some highlights:

• continue to buy back their own CDOs at 50% discount; mark-to-market works on both sides of the balance sheet.
• The have no non performing loans (NPL).
  
• Book value increased to $15 per share from $12 in Q2 2008
• Management owns better than 10% of the company
  and is managing for the long term.
• very good liquidity and cash position.
• reaffirmed their dividends.
  

Despite an excellent report this quarter, management did indicate some
potential problems:

• There are very uncertain loans on their watch list which very easily can become NPL; of especial significance is the WaMu tenant lease which brings over $5 million in revenue per year. JPM after taking over WaMu from the FDC has 90 days from acquisition to decide what to do with the leases.
  
• NRF is accumulating cash and not doing much loan origination, which will impact future earning
• also management said their earnings will be less if LIBOR continues to decrease which is what they expect, again hindering their net income and dividend.
  

I think at this point I will keep my investment in this business as the fundamentals and the reasoning that I bought NRF are still valid. NRF has a favorable chances of surviving this episode of the crises and emerging as a commercial real estate company. Yes the price have dropped significantly, and chances are it may drop further, from my cost basis but I think I will hold this one.

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test - WSJ.com

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test - WSJ.com

A great article about AIG reckless underwriting of credit default swaps. The article is a great illustration on the difference between risk and volatility. I have argued this difference in several posts and I still believe that a lot of investors, even professional, as illustrated by this article, confuse risk and volatility.

Several take away from the AIG case:

1. Models do not articulate risk, they articulate volatility.
2. Common sense and conservative policies go along way in protecting capital.
3. Historical data should not be relied on for investment decisions entirely; it can always be manipulated to show whatever case you want them to show.
4. Good and conservative management matter much more than assets and technology.

Value idea: Preferred Shares

The dislocation in the market has presented several opportunities not only in equities but more so in debt instruments. Here is one example the preferred shares of Brookfield Asset Management (BAM).

Brookfield Asset Management Inc. (Brookfield) is a global asset management company. The Company operate and manage assets in property, renewable power, infrastructure, specialty investment funds, and fixed income and real estate securities. The subsidiaries of the Company are Brookfield Homes Corporation, Brookfield Properties Corporation, BPO Properties Limited, Multiplex, Brookfield Power Inc., Great Lakes Hydro Income Fund, Brascan Brasil, S.A., Brascan Residential Properties, S.A. and Brookfield Investments Corporation.

Upside potential of the shares:

• The preferreds trade at Junk level valuation. Pref issues M and N trade on a perpetual basis at 11-12% discount rate. However, BAM is an investment grade rated firm; its rating was recently affirmed by DBRS.
• The preferred shares have a current yield of 9% for the two issues, at that yield you can double your money in about 10 years.
• Strong management team that have strong acquisition and valuation discipline
• Long term quality assets in place from power, infrastructure and property.
  

Downside risk for the preferred in particular:

• Interest rate risk: typically preferred shares go up when interest rates go down. This relationship have been broken lately due to negative sentiment and investors liquidating out of fear. The relationship will return to normal levels in due time. However the prospect of central banks raising rates in hurry after the credit crises subsides can hurt the preferred.
  
• Liquidity risk that can lead to withholding dividend payments.
  
• Leverage risk / adequate debt service provisions.
• Redemption risk as the company can redeem the issues at its option however the risk comes with a nice upside as it will be redeemed at par.
• Conversion risk to common by the company. Here the company can convert the issues to common but with a premium to the trading price of the common shares.
  
• Black swan: any event leading to company bankruptcy: book value of the company is $3.2 Billion ( total assets less intangibles less liabilities). If we assume a bankruptcy recovery rate between 55%-65%, reasonable rate as based junk bond historical recovery rates, we can see up to $2.5 billion to recover for equity and preferred shares. Off course preferred shares rank higher than common equity and should see full recovery of their book value; book value of all outstanding preferred is $870 million. And because we are buying those issues at deep discount we have almost 45% margin of safety.
  

Which issue to choose?
It depends on several things. you premium on liquidity as many issues have limited liquidity than others. Some issues have floating rate dividends while other have fixed rates. This requires more research on your part.

I am going to zero on issues B, M and N for selection.

Expert prediction: flipping a coin is better

Let me begin this post by two endearing quotes about economists:

An economist is expert who will know tomorrow why the things he predicted yesterday didn't happen today

Lawrence J. Peter

Economics is an extremely useful form of employment for economists

John Kenneth Galbraith

Media has reported on economists and investors who called the crises and profited from it. Some of those people are John Paulson the famed hedge fund manager who made multi billion dollar in 2007 betting against sub prime. Another is Prof. Roubini who "predicted" the crises and continue to give sound bites to the media.

I always enjoy reading about the newly minted expert of a crises or an episode of the economy. Before Paulson and Roubini there was Abby Joseph Cohen, the famed Goldman Sachs strategist, who called the S&P during its bull run in the 1990s and was hailed by media as the market genius. Internet companies had their prophets as well. There are a host of so called "experts" who came and gone. Those experts rode their once in a life time call on economic or market matters but disappeared into the sunset when they tried to do it again. I reckon that Roubini and Paulsn will face the same fate.

Lets look at these experts in another light. If there are 20,000 experts, why does only one guy have this figured out? What is special about them?

Walk into some big arena filled with 20,000 people each standing and holding a quarter. Ask them to flip it one time: heads you remain standing, tails you sit down. Repeat the trial 14 times among the people who remain standing only. A normal distribution of outcomes would say after fourteen trials you would reasonably expect one person to be standing up, actually 1.22 to be exact. Ladies and gentlemen, I give you Professor Nouriel Roubini, Andrew Lahde Capital, who saw his accomplishment for what it is and called it quits, andPaulson.

My point of the post is economists and the "expert" of the day had his/her lucky call, odds are stacked against his next call to be right. Do not chase expert and their performance as predictions are always harder when it is about the future!

Acman's value idea:Target Spin-off

One of Target (TGT) largest shareholders, Ackman, the hedge fund manager of Pershing Capital, have proposed a transaction to unlock value in TGT. You can view his presentation here. I have to say that I always enjoy Ackman's work; it is always detailed and a learning experience.

I have to say that the transaction does not make much sense to me. It is a lot of financial engineering that, most likely, will not create any value to shareholders.

The core of the transaction is to spin-off of the land that TGT's stores are build on, TGT keeps owning the buildings, into a REIT that will charge TGT rent and perform building maintenance and development of new stores. The REIT pays dividends to shareholder and because it is a REIT it does not pay any taxes. According to Ackman TGT will be $70 after the transaction and $83 in a year, somehow. What the transaction boils down to is : tax. That is it. The new structure eliminate some taxes, actually, redistribute it to you , the shareholder.

My problem with this is creating value by tax redistribution only is tax policies are outside management control. Tax policies can change therefore relying on a tax policy to create value can disappear very quickly. Management can create better sustainable value by using some of the levers it can actually control: revenue, expenses and cost of capital. The transaction is a lot of ado about nothing in my opinion.

A company value is the perpetual discounted present value of its free cash flow. Then, there are two way to create value for shareholders.

1. increase free cash flows, and that can come from two things:
1. increase revenues
2. increase operational efficiencies or decrease operating expenses and capex.
   
2. decrease the discount rate or the cost of capital, a company can accomplish this by:
1. decreasing borrowing costs,
2. optimize the company's capital structure.

None of Ackman financial wizardry do any of the above. TGT is an excellent retailer with good management but I do not think the transaction adds much to the pie.