I wrote earlier in the week about Richard Pzena who in the months leading up to the financial crisis was still calling Freddie Mac the “cheapest stock” that he had ever seen.
All investors make mistakes. Even the best. What we need to do as individual investors is try and learn from those mistakes so that we avoid them ourselves. That is one wonderful thing about the difficult game of investing….you can learn from others mistakes so you don’t make them yourself.
By 2006 Tom Brown of Second Curve Capital was pretty widely known as the premier analyst of financial stocks in the United States. Brown took a $130,000 contribution from his father in 1984 and by investing in virtually only financial stocks turned it into $18 million by the early 2000s. That is a two decade run compounding money at around 40% per year.
Brown also became one of the most respected Wall Street analysts of financial-services stocks in the 1980s and 1990s, working at Smith Barney, PaineWebber and Donaldson Lufkin & Jenrette. In 1998, he joined hedge-fund manager Julian Robertson, heading Tiger Management's North American financial-services group. In 2000, he formed Second Curve Capital, a $550-million-in-assets hedge fund that invests exclusively in financial-services stocks.
Two decades of market smashing returns. An incredible reputation built and a great investment record. And then….
I’d like to quote from a recent interview from Bruce Berkowitz on WealthTrack. Berkowitz was asked what frightens him. His answer was that what frightened him was that his next investment could be the one that he is remembered by. In other words if at the end of a successful run as a money manager you make one large mistake you can undue a 20 year run of wealth accumulation simply because the further you go into your run and the greater your investment funds the more money you are laying out per investment.
Tom Brown unfortunately is an example of this.
Consider this article from November 29, 2007 which was only a few weeks after the all time top in the stock market:
“Nov 29 (Reuters) - Second Curve Capital LLC, the financial stocks investment firm run by Thomas Brown, has lost nearly 50 percent of its value this year as top holdings like First Marblehead (FMD.N) and CompuCredit (CCRT.O) have slumped, Brown said on Thursday.
But he said he is expecting a rebound in financial stocks in the next year or so as companies write off losses from the subprime lending debacle and investors pile back into the once-robust sector.
"I think we're really close, if not at the bottom, for the financial services industry," Brown told hundreds of investors at the Value Investing Congress in New York. "There are many opportunities in the most battered sectors."
Brown, who said he manages about $400 million in three funds, has seen his fortunes rise and fall in recent years. His Second Curve Opportunity Fund International, for instance, was up over 50 percent last year, according to investors.
Despite this year's losses, he said that his investors appear to be mostly sticking by him. He declined to give exact performance figures in an interview after his speech.
Brown told Reuters that only 7 percent of his investors chose to put in redemption requests for year-end 2007. He said his investor base does not include hedge fund-of-funds, which are more likely to bail out of loss-making hedge funds.
Brown, who maintains a Web site called Bankstocks.com, said his top stock picks include First Marblehead Corp, which securitizes student loans for banks including JPMorgan Chase & Co and Bank of America, and CompuCredit, which provides credit and related financial services.”
It is hard to believe that the best bank analyst in the business who has spent a lifetime studying banks could not on the edge of the abyss see what was about to happen.
Fast forward another half year to mid 2008. Brown’s Second Curve Capital assets under management had already fallen from $852 million to $140 million. Here is a post from Brown on his Bankstocks.com website:
“One never knows until long after the fact, of course, when stock prices reach the exact top or bottom of a given cycle. And, besides, trying to pick precise tops and bottoms always turns out to be a pointless, unprofitable game. So don’t even try.
Have I hedged myself sufficiently? Good. For, as it happens, I believe July 15, 2008 will turn out to be as good a date as any to mark the end of the long, painful bear market financial stocks have endured for the past 18 months. And more to the point, it marks the beginning of the greatest financial stock bull market in our lifetime, one that will be much broader than the bull market that began in 1990.
I believe the current valuations of scores—even hundreds—of financial companies are wildly out of whack with the companies’ long-term earnings potential. The companies are extraordinarily undervalued, in my view. In the vast majority of cases, I can get comfortable with their potential future credit losses and (in the cases where they’re needed) the possibility of future, dilutive capital issuance.
With the gap between current market values and business values so wide, investors shouldn’t even worry too much whether July 15th was indeed rock bottom for the stocks. The margin for error today is so wide that any investor with at least a one-year horizon and a little analytical ability can pick huge winners. We wouldn’t buy across the board, but the vast majority of the depressed financial stocks will survive, recover, and deliver high investment returns from these levels.
Why July 15 was Capitulation Day
Financial services investors had a lot to deal with last week. Do you recall? On Monday, they grappled with news that regulators had closed IndyMac the previous Friday. It was the third-largest bank failure ever. Also over the weekend came word that the Treasury Department and Fed had drawn up plans to stabilize Fannie Mae and Freddie Mac.
It was momentous-sounding news—but, if you think about it, not necessarily negative. IndyMac’s failure couldn’t have been a surprise, thanks to Sen. Schumer. And the prospect of a stabilized Fannie and Freddie should have been seen as a positive, both for the economy and other financials. Even so, investor angst rose and, on Monday, the XLF, an index of large-cap financial stocks, dropped by 5%, closing on its low.
Why July 15, 2008 Will Be Remembered As the Bottom
Beyond the highly volatile, dramatic trading patterns that happened on the 15th, conditions for a turn seem to be in place that will be familiar to anyone who’s lived through a market extreme before.
4. Fears about dividend cuts and new, dilutive capital raised are excessive. Here’s a shocker: an investment bank specializing in the banking industry issues a report that predicts that . . . banks will have to raise a lot of new capital! KBW, the investment bank in question, is not famous for having an especially sturdy Chinese wall separating its research and corporate finance efforts. In any event, it says 180 banks need to raise $30 billion in equity, based on its own stressed-earningS scenario. Do you think the report was perhaps a little self-serving?
In fact, I think second quarter earnings results are providing encouraging signs that the credit problems won’t turn out to be as great as widely feared, that not as much dilutive capital will need to be raised, and that fewer companies will have to cut their dividends. For example, despite its strong recent bounce and better-than-expected second quarter earnings, Bank of America stock still yields 8.7%.
It is just fascinating to go back over these real time postings with what we know now about how much further financials in particular had to fall.
My message is “be humble”. As Seth Klarman advises “You don’t know what you don’t know” so invest accordingly. Brown’s great record was through a pretty long bull run for financial stocks and he did not seem to account for what happens to companies who rely on the kindness of strangers for funding when the entire world is in panic mode. Companies like First Marblehead don’t have viable business models in such a scenario. You, me and Tom Brown will all make more mistakes. Make sure they don't ruin the rest of your good work.