Tuesday, February 26, 2008

i've said it before and will keep saying it: buy financials now! (and here's why)

it's tough, here in february of 2008, to go way against the crowd and advocate something most investors would consider foolish right now: buy financials. but please remember, the market is the ultimate discounting mechanism: once the information is known and also widely disseminated, it's almost always already in the shares. as shown thus far in 2008, let alone the latter part of 2007, it is not going to be a smooth ride; profitability has been impaired and the recovery will obviously not happen overnight.

my time frame is up to two years, roughly this time in 2010. here's why i've already bought financials, am going to buy more financials, and are hoping you'll seriously consider adding financials to your portfolio:

1) permanent capital is being replenished - while costly and dilutive to existing shareholders, the curative process is now well under way (though ignored by investors). sovereign wealth funds (Kuwait Investment Authority, Abu Dhabi Investment Authority, China Development Bank, Singapore's and Temasek Holdings all with Citigroup; and Government of Singapore Investment Corporation with ubs, private equity (warburg pincus with mbi), hedge funds, long-term institutional investors (Davis Selected Advisors with Merrill Lynch), domestic corporations (bac with cfc) and international corporations (Citic Securities with Bear Stearns) have recently infused much-needed capital to shore up financials' capital bases.

2) government policy will not be standing still - treasury secretary paulson's first pass at shoring up the mortgage market was dead at birth. nevertheless, more cogent policy is likely ahead (formulated by both parties). this might be especially true in an important election year.

3) the seized-up credit markets will not be a permanent condition - indeed, improving libor and ted spreads (recently ignored by the marketplace) are seemingly presaging a more nomal credit market. historically, this has been constructive for the financial sector.

4) credit writedowns will likely peak in the 4th quarter of 2007 - i believe that about 125 billion to 135 billion of writedowns will have been taken in the financial sector in 2007; that figure should drop to only $35 billion to $50 billion in 2008. if this is correct, financial sector profit growth could add several percentage points to the S&P's 2008 earnings.

the opaque disclosures of 2004 to 2007, bogus pricing and "marked to modeling" of earning assets (especially of a credit kind) have been replaced by vicious, monumental and historical writedowns. though this is difficult to quantify, it is possible that if the recession is relatively shallow, then the period of maximum pain is now behind most financial institutions.

5) many managements have been turned over - with more probably to come. the rotten apples have been replaced by more sober and experienced managers like thain at mer, schwartz at bsc and pandit at c. the credit mistakes of the past will not be repeated in the near term - at least not until the next cycle of overexuberance and folly in financial product offerings.

6) business franchises are intact - while principal activity will no doubt be curtailed, financial companies' agency businesses - including underwriting, merger and acquisitions, asset management, retail brokerage, etc. - are intact and will remain so as the cycle runs its course again. indeed, one can make the argument that the larger, more established and better-capitalized entities will gain market share at the expense of its competitors.

7) financials are statistically cheap vs. sustainable earnings - financial shares are attractive on a valuation basis.

8 ) financials have dramatically underperformed relative to the s and p 500 - while one trading day of course does not make a trend, it is interesting to note that the financials not only withstood the dramatic market weakness on a friday of last month, but many financial stocks actually rose by 1% to 2% - something that probably should not be ignored.

9) as i wrote yesterday, recent evidence suggests that some of the huge financial writeoffs and writedowns of a variety of credits at leading financial institutions might have been exaggerated. this could lead to financial WRITEUPS over the next one or two years.

if this supposition is correct, then there is a fortune just waiting to be made in the financial sector. levered loans are trading at about 88 cents on the dollar. by contrast, the market is expecting a 10% to 15% default rate, a level that has never been seen according to kdp advisors. in fact, says kdp, "the loan market is trading with a higher default rate than the junk bond market, very bizarre given that leveraged loans are secure debt and are senior to bonds in corporate capital structures." so, levered loans are trading well below fundamentals.

the same holds true for high-yield bonds, in which the current default rates stand at 1.5%, implied by spreads are 8% defaults, and expected by ratings agencies (like moody's) is only 5%.

the same holds true for commercial real estate loans, in which the current default rate is 0.3%, implied by cmbx is 8%, and the expected default rate, according to expert credit professionals, is expected at only 2%.

one could assume from the above data that there is a mistaken pricing of debt that is causing larger-than-necessary financial sector writeoffs, similar to when portfolio insurance kicked in and forced investors to sell stocks during the 10/87 market crash.

if my beliefs are correct, a mistaken pricing of debt is serving to constrain bank lending, slow the economy and has produced artificially low stock prices - especially of a financial sector-kind - as investors could be overreacting to the huge financial writedowns at some of the world's largest financial institutions.

buy 'em now, while they're cheap.

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