By Jon Markman | circa January 2008
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Smart money? Not so much. A review of the one-year results of value-focused funds with some of the best long-term records shows that a virus of total stupidity savaged their ranks as one after another bought into banks, credit card providers, home builders and retailers at bargain-basement prices that seemed too good to be true— and were.
In a year when the Nasdaq-100 Index ($NDX) rose 18% and the S&P 500 Index ($INX) went up 3.5%, the $4 billion-in-assets John Hancock Classic Value (PZFVX) fund defied its tremendous long-term record by plunging 19.7% in 2007. (The fund was No. 1 or No. 2 in its category in the bear years of 2000, 2001 and 2002.) Long-term standout Weitz Value (WVALX) sank 13%. Even Legg Mason Value Trust (LMVTX), led by venerated manager Bill Miller, lost 12.2%.
Going into 2008, none of these funds appears to have altered its approach to value investing one iota. All continue to be heavily invested in banks and brokerages despite their multibillion-dollar losses, management chaos and extreme legal exposure— at the onset of a recession. So the question naturally arises: Are these guys insane, or could they possibly come out ahead once the credit storm passes?
Would you touch financial stocks now?
My own research suggests a few of the big banks are technically bankrupt and shouldn't be approached until they trade in the single digits, if ever, as you know from my previous columns. We're barely into the start of the unwinding of a credit bubble of historic proportions that is murdering household wealth and consumer spending and is likely to send corporate earnings into a tailspin all year.
Yet I'm also cognizant that down cycles turn higher when you least expect it, so you at least have to listen to the successful value guys. Although they clearly erred by jumping into financials way too early, if the Federal Reserve wakes up and slashes interest rates [[they did! : normxxx]]— creating instant yield-curve profits for the banks— they might have the last laugh after all, bitter as it may be.
A Citi revival?
Early this year, I talked with Richard Pzena, one of the deans of the value camp. His company, Pzena Investment Management (PZN), which I've mentioned as a buy on big dips, runs $25.5 billion in value money for clients worldwide, including that once-sterling John Hancock fund that's now in the tank. He was defiant, contending that he expects to double his money on such road kill as Citigroup (C), Fannie Mae (FNM) and Freddie Mac (FRE) over the next three years. I think he's dreaming, but he does manage $25.49 billion more than I do, so perhaps you should lend him an ear. Pzena's main point is that though losses in subprime mortgages have generated the most headlines in the sector, few banks actually have much exposure to them. He sees Citigroup, for instance, as a global consumer-credit business that generates most of its money by issuing plastic overseas. The way he sees it, virtually every adult has a credit card while few have subprime loans, so what's the problem?
To be sure, Citigroup has had monumental write-downs on its mortgage portfolios and gotten stuck with illiquid structured investment vehicles on its books, and credit card defaults will lead to more losses. But before too much longer new management will have taken out the garbage, and the remainder of the company will have a chance to shine again. "We view it as a great global franchise that's inefficiently priced," Pzena says. "We don't think the real value of the firm has come down at all, even though it's lost over $125 billion in market cap."
Pzena says he doesn't know how long he will have to wait to be right— and if he did know, the stock wouldn't be cheap. His analyst team has torn the company's financials apart, stress-tested them to the most outrageous negative cases and sees its business getting back on track in every scenario.
Will the dollar rebound in 2008?
The US dollar could turn out to be the big comeback surprise of the year. One reason: As foreign investors put big money into US companies, those foreign countries are less likely to dump the dollar, MSN Money's Jim Jubak says. "The reason it's so depressed is that no one really knows how bad it will be, but we think that sometime in 2008 there will be clarity and we'll start to see buyers come back," he says. "Corporations, and especially the financials, might have to cut their dividends— which would not be so terrible— to shore up their capital base, but they're not going out of business. They will weather this storm."
Pzena says his analysts have put their money where their spreadsheets are— buying more Fannie, Freddie and Citi for their personal accounts than at any time in the past five years. "They believe they have properly analyzed these franchises and should buy even though they don't know when the turn is coming… There's no dissension about this position within the firm.Buying low is a strategy that has never failed to work."
No Competition Left For Fannie And Freddie
Catching falling knives is a strategy that has never failed to leave your hand in shreds, either. But Pzena insists he has history on his side. Financial stocks got extremely cheap in the year before the past five recessions, he says, then began to outperform the market about three months after the recessions' official start dates, as determined later by the National Bureau of Economic Research.
If the current recession began in the fourth quarter, as many independent experts believe, then it could be time for Citi, Fannie and Freddie to start bucking up. The idea is that when people fear the unknown, they sell. But in the reverso-world logic of Wall Street, once a recession becomes evident, investors begin anticipating a recovery. The worst companies to own during a recession are often growth and momentum plays that are the strongest in the pre-recession period, such as Research In Motion (RIMM) and Intel (INTC). That might account for the scorching 9.4% decline in the Nasdaq-100 this year. And if this plays out as it did in 2000, then we might look back and see that a hidden hand flipped a switch that sent investment dollars surging out of highflying Nasdaq stocks and into beaten-down value plays.
So if you fancy yourself a contrarian, put on an armored oven mitt and consider joining Pzena and his peers by grabbing Fannie and Freddie in free fall. The value manager says these two government-sponsored home lenders ought to be the biggest beneficiaries of the subprime meltdown because the breakdown of the asset-securitization market has left them virtually the only home lenders and mortgage insurers left standing.
10 Market Predictions For A Glum '08
It'll be a year of stock upheavals, especially in banking, but with great bargains along the way. And if I'm wrong about prognostication No. 10, I'll eat this column on a live webcast. For investors, the new year will be defined by a titanic struggle between governments' efforts to flood the world's faltering financial system with cash and banks' efforts to hoard it all for themselves. Commercial banks are stashing instead of using the cash infusions because leveraged mortgage bets gone bad are shrinking their capital bases faster than central banks and foreign investors can refill them.
So what are the prospects for investors in this unhealthy environment? Here are the surprises that I see lying ahead:
1. Bank Bankruptcy
Every financial crisis of the past 200 years has resulted in the bankruptcy, merging and closing of many banks. Sometimes even very large ones. This crisis will be no exception. Bankruptcy is an efficient means of clearing deadwood out of the forest, where it is purposelessly hogging resources, so that newer, stronger competitors can thrive. Expect at least one major bank to fail in 2008 as high-risk mortgage and business loans made in the mid-2000s by more than 2,500 U.S. financial institutions lead to lethal losses. Citibank (C), which may already be technically insolvent, is probably too large to be allowed to fail.
But smaller institutions such as Countrywide Financial (CFC) and Washington Mutual (WM) could certainly go under or be purchased for loose change by larger competitors. The nation has far more banks than it really needs, and these two institutions— and many others— could easily have their books of business absorbed by competitors.
2. Banking Bargains
Growing fears of bankruptcy will have devastating effect on all financial institutions regardless of their solvency and relative merits. Expect the bargains of a lifetime to develop in the stocks of certain financial companies as babies, plumbing, bathmats and floor tiles are thrown out with the bath water. A couple to consider are Leucadia National (LUK) and Pzena Investment Management (PZN). On any big down day or series of them, buy some shares, throw them in a drawer and don't look at them again for three years.
3. Food Rules
In 2008, grain will become recognized as the new gold, agriculture companies as the new tech stocks and the Mississippi basin as the new Silicon Valley. Many fertilizer and seed companies' shares did very well in 2007, yet you ain't seen nothin' yet. Farm-focused companies combine innovation with scarcity, and the result is strong growth that's unlikely to abate. Droughts in Australia, China and Ukraine have slashed crop yields this year, pushing wheat and soybean prices to record highs. Meanwhile, the demand for corn and sugar cane as feedstock for soaring U.S. and South American ethanol use is hitting a wall in the lack of cropland and water. Since ethanol use is mandated by government and has become an increasingly inexpensive alternative to crude oil, thinning supplies are being allocated by price.
Schroders asset manager Christopher Wyke told Bloomberg he believes "we are in the early stages of a rally that could last 20 years in agriculture" as prices "are historically cheap." Commodity experts say agriculture rallies typically last two to four years and push prices up as much as three times. My list of companies to take advantage of this trend hasn't changed since I first wrote about it last year. On dips only, consider Monsanto (MON), Mosaic (MOS), Potash of Saskatchewan (POT), Bunge (BG), CF Industries Holdings (CF), Terra Nitrogen (TNH), Deere (DE), CNH Global (CNH) and AGCO (AG).
4. Credit Crunch, The Sequel
We already know that mortgage-payment and home-equity-line-of-credit delinquencies are rising steeply along with home foreclosures. Starved of funds by banks, many strapped individuals turned to credit cards, and now delinquencies in these payments are also rising rapidly. Hedge funds, which heavily borrow to augment returns, are also feeling the effects of credit starvation, as are ordinary folks like dentists, attorneys and manufacturers who depend on easy access to loans to expand and fund their businesses.
Expect credit card companies such as Capital One Financial (COF) and American Express (AXP) to sink to new lows in the first half of the year as they write off losses from deadbeat customers and announce a shrinking of lending opportunities. While investors are still wondering how big the losses in the home-mortgage market will get, the problem is spreading to commercial mortgages, MSN Money’s Jim Jubak says. Meanwhile, expect to learn a new term for your growing credit lexicon this year:Pfandbrief is the term for a type of European asset-backed security that has long been considered the safest type of bond on the planet. Stresses are developing in its $2 trillion market, however, as home loans sour across the continent, so beware of major German banks, including Deutsche Bank (DB), that trade on U.S. exchanges.
5. Default Swap Snafu
A relatively new security called the credit default swap, or CDS, is the bond market's equivalent of homeowners insurance. If you own a corporate bond and worry that it might default, you buy CDS contracts to hedge your exposure. If the bond fails, an investor to whom you've been directly paying the equivalent of insurance premiums owes you, typically, $10 million per contract. Hedge funds have run the market for these puppies way past the $1 trillion range because they've also become a way of betting on the potential for bonds' default. Yet there's one teeny-tiny problem: CDS contracts are largely unregulated and have never been tested in a crisis. No one really knows if they are enforceable or what will happen if counterparties suffer bond losses so great that they're unable to make good on their CDS obligations.
If CDS contracts are not fulfilled, banks' exposure to losses might be much higher than anyone has anticipated. That's just another reason to continue to avoid the bank stocks this year or bet against all of the banks in the S&P 500 Index ($INX) by shorting Select Sector SPDR-Financial (XLF), an exchange-traded fund.
6. Alternative Lifestyles
Adding the word "alternative" to your business plan these days is the equivalent of adding "dot-com" a decade ago. Makes you sound like you're swingin' with the cool kids. Alternative energy, one of the biggest areas for faddish investor behavior, is likely to have its comeuppance before too long as outlandish claims for making material amounts of energy out of algae, ocean waves, sun, wind and animal droppings are laid to waste. [[Water-based, non-selenium (evaporation) process: normxxx]] solar is likely to be the only longtime solution, since it does the most efficient job of turning the energy of the sun directly into power, but valuations of companies in the sector are overheated. Expect a brief surge in alt-energy stocks at the start of the year followed by a long period of sideways action as proponents lose steam. To play it safe, buy ETFs such as Market Vectors Global Alternative Energy (GEX) rather than individual companies in the sector— but only on significant dips similar to the ones in August and November.
7. Equity Abyss
Even though earnings growth for major U.S. companies in aggregate came in at a lousy 2.3% in 2007, annualized growth estimates for 2008 are perched at 14%. That's setting up the market for a huge disappointment just as the virtual elimination of two key props of the market last year— corporate share buybacks and private-equity buyouts— are felt the most acutely. Expect stocks to surge on undue optimism at the start of the year [[boy, was he ever in for a surprise!: normxxx]] but then sink during at least the remainder of the first half as earnings growth continues to slide, the country slips into recession, energy costs remain stubbornly high and new threats to financial companies emerge. The key moment will come when the major market indexes approach their August lows and investors hold their breaths wondering whether central banks and major value-seeking buyers will ride in to save the market with the S&P at 1,400 and the Dow Jones industrials ($INDU) at 12,500. Those levels may hold for [[for some time: normxxx]], but the best opportunities to make money on the downside will come as those levels are breached and a great sucking sound takes the two indexes down to 1,250 and 11,500 or below.
8. Submerging Markets
One of the most optimistic views of world equities these days contends that the rise of the middle class in the emerging markets of China, South America, India and Eastern Europe has "decoupled" their markets from those of the developed world. This is absolute rubbish that will bring great pain to those who believe the suppliers of raw materials will not be affected if demand for finished goods wanes. The middle classes of these countries are definitely strengthening but are in no way capable yet of standing in for U.S. and West European customers. Derivatives expert Satyajit Das, who lives in Australia, calls the decoupling hypothesis a narrative fallacy in which a "convincing but meaningless story is shaped to fit unconnected facts." The exchange-traded fund Short MSCI Emerging Markets ProShares (EUM) delivers the inverse return of the main emerging-markets index, so consider it if you want to make a targeted speculation on this theory's demise.
9. Dow Bow
Top stocks in the Dow industrials this year are likely to be the least economically sensitive, so place your bets on Johnson & Johnson (JNJ), Altria (MO), Merck (MRK) and McDonald's (MCD), and possibly, as long shots due to their construction exposure, Honeywell International (HON), United Technologies (UTX)and 3M (MMM).
10. A Pledge
If Citigroup or JPMorgan Chase (JPM) beat any of the above-mentioned defensive stocks this year in a freakish turnaround, I will eat this column on a live webcast at noon Wednesday, Dec. 31, 2008.
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Fine Print
To learn more about Leucadia National, visit its Web site, which has to be the sparsest of any major U.S. company. . . . To learn more about Pzena Investment Management, visit its Web site. . . . To learn more about the ag companies, visit some of their Web sites here: Potash, Mosaic, Monsanto and Case IH. . . . Learn all about the wonders of anhydrous ammonia here. . . .
Van Eck has turned out some of the most interesting and tradable ETFs in important niches such as agriculture, hard assets and nuclear energy. Visit its Web site here. Its world agribusiness fund has the best ticker symbol of all time: MOO. Read about it here.
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Normxxx
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The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
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