If you have been reading Guru commentaries, you would know that Robert Rodriguez has foreseen credit crisis coming years ago, and avoided financial stocks for the past 3 years. Did the decline of financial stocks created bargains for him, not yet!
GuruFocus just updated the portfolio of Robert Rodriguez as of March 31, 2008 . To our surprise, Robert Rodriguez did not trade any stocks during the first quarter. His equity holdings are exactly the same as those in Dec. 31, 2007 . The decline of financial stocks did not create any bargains for him. Are financials still too risky?
Before we discuss further, we like to review Robert Rodriguez’s performances. For the 12-month period ended on Feb. 29, 2008 , his fund lost 5.2%, while the S&P500 lost 3.6%. For the 5-year period, his fund average 15.73% annually, and S&P gained 11.64%; over the last 20 years, the fund averaged 15.53&, beating S&P500 by more than 5.5% per year.
How did Robert Rodriguez sensed the bubble in financial sector? We looked into his shareholder letters over the past years, here we like to review these letters and hopefully all of us can learn something from it and can avoid future bubbles.
Why Financials Were Risky?
We believe the use and complexity of these instruments has grown dramatically, and they are now far more pervasive than was the case in 1998. ( March 31, 2005 letter)
Robert Rodriguez: “We are in the third year of an economic recovery and, typically, economic growth and productivity generally slow. We are beginning to see this in some industrial companies. Financial-service companies’ record profit margins have benefited from the steepest yield curve in nearly 100 years. As the yield curve has flattened over the last ten months, this process has placed greater pressure on financial service companies to execute strategies that entail significantly more risk so as to maintain their current levels of profitability, let alone make them grow. We see them executing strategies that entail interest-rate risk, credit risk or both. We view this period as one of the more dangerous for investing in these types of companies. The problems of tomorrow are being created today as we write this letter. Furthermore, there are risks in the balance sheets that we cannot see. Companies such as Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG) are now showing financial strains from previous actions taken to enhance the look of their financial reports. We are also concerned that many of these companies have used financial derivatives that are totally unanalyzable by outsiders, since there is insufficient information disclosed in their financial statements for a risk assessment. Warren Buffett refers to these instruments as “financial weapons of mass destruction.” … A financial accident at Long Term Capital Management in 1998 nearly shook the international financial system because of their aggressive use. We believe the use and complexity of these instruments has grown dramatically, and they are now far more pervasive than was the case in 1998.”
Editor: Since March of 2005, stocks prices of Fannie Mae (FNM), Freddie Mac (FRE) have declined by more than 50%, and AIG share prices declined by more than 20%.
Financial service companies represent nearly 21% of the S&P 500’s market capitalization — a 33-year high ( March 31, 2005 letter)
Robert Rodriguez: “ Financial service companies represent nearly 21% of the S&P 500’s market capitalization — a 33-year high. They are among the largest components in other stock indexes as well. In terms of operating profits, they comprise almost 28% of the S&P 500, and this does not take into consideration the finance operations of GM, GE or Ford. Including these finance operations would push this number over 30%. Grant’s Interest Rate Observer estimates that the financial sector represents 38% of the national income accounts data. Our conclusion is that there is no other sector within the S&P 500 that could likely offset a decline in the profitability of the finance sector. For example, two areas that have had explosive earnings growth have been energy and materials. Energy accounts for only 7% of the S&P 500 while materials adds another 3%. Should there be any profit contractions in other sectors, it would be nearly impossible for the S&P 500’s earnings growth to be greater than nominal GDP. Even considering the international segments of all the constituent companies in the S&P 500, it would appear to be insufficient to offset a financial-services profit decline or stagnation.”
The rise in short term rates, in conjunction with all of the new “creative” mortgage loans, is creating an environment for credit disruptions ( Sept. 30, 2005 letter)
Robert Rodriguez: “ We remain very cautious because we believe there are pressures building in the financial system. These pressures entail credit risk, inflation and corporate operating margins. We discussed several of these in our March Shareholder Letter. Since then, the pressures have continued building. We do not believe that we are being sufficiently compensated, through low enough share prices, to accept these risks… the rise in adjustable mortgage rates will start to hit the consumer through higher monthly mortgage payments. The rise in short term rates, in conjunction with all of the new “creative” mortgage loans, is creating an environment for credit disruptions. We are of the opinion that we are beginning to see some cracks in the credit-quality foundations of several types of loans. These are starting to show up in sub-prime and Alternative-A mortgage loans. Should this become widespread, many financial institutions could experience credit-quality issues in the not too distant future.”
Financial service’s profitability is at risk ( March 31, 2007 letter)
Robert Rodriguez: “ Prior to this, financial institutions were able to offset the flat yield curve by going down in credit quality. It would appear that option is now closing. Financial service stocks represent nearly 22% of the S&P 500 and 28% of its earnings. If one adds in the financial subsidiaries of GE, GM and others, it is quite easy to get the financial share of the S&P 500’s earnings above 30%. This segment’s profitability is at risk.”
The potential of a breakdown in the rating agency models (March 2007 letter)
Robert Rodriguez: “ My associates and I wondered, how might a house price decline affect the models that rating agencies use in determining the credit rating of a mortgage-backed ABS? On a conference call with Fitch on March 22, Fitch presented its assessment of the sub-prime ABS market. During the question-and-answer period, my associate, Tom Atteberry, asked the question, “What are the key drivers in your credit rating model?” Fitch responded that it would be the FICO score along with the assumption that home price appreciation (HPA) of low- to mid-single digit would continue, as it has for the last fifty years. Tom then asked, “What would happen to your model if HPA were flat?” They responded that the model would start to break down. If HPA were a negative 1% or 2%, the model would completely breakdown. Thus, if forecasts of 10% to 20% declines in home prices were to occur over a ten year period rather than one or two, the model that Fitch uses would breakdown and various securitizations with credit ratings of AA or even AAA would experience considerable difficulty. This aspect of risk is not factored into the market today.”
“The potential of a breakdown in the rating agency models has serious implications for various types of financial institutions and debt origination structures. It could potentially strike at the confidence in the rating agencies themselves. My associate, Julian Mann, has been studying the area of sub-prime and rating agency involvement. He recently showed me a very garden variety Libor sub-prime floating rate security. The Standard & Poor’s pricing service valued this bond at par while on March 19, 2007 , Moody’s rated this bond A3. To affirm the accuracy of this bond’s pricing valuation, Julian went to two brokerage firms that traffic in this type of security and requested what might their bid be, if we were to request a bid. One responded that it would likely be in the $7 area. This does not mean 70% of par but 7% of par, a differential of nearly 93% between what the Standard & Poor’s pricing service indicated and what might occur in the actual market. The other firm declined to indicate a bid but did say that the 7% of par bid was probably the correct one. Julian is continuing to investigate this area to determine whether this is an isolated occurrence or whether this may be the tip of something even larger. It does raise a serious question in our minds .”
Securitization Contamination (Absence of Fear, CFA SOCIETY OF CHICAGO SPEECH – June 28, 2007)
Robert Rodriguez: “ The asset quality problems in sub-prime and Alt-A have the potential to affect other areas, such as the collateralized debt obligation (CDO) market, in ways that many of the holders of those securities have little idea of how exposed they might be to unexpected changes in the security’s credit rating. It is estimated that U.S. banks have invested as much as 10% of their assets in CDOs, and the Office of the Comptroller of the Currency (OCC) requires that all of those CDOs be investment grade, says Kathryn Dick, deputy comptroller for credit and market risk. She says, “We rely on the rating agencies to provide a rating.” 2 As Kevin Fry, chairman of the Invested Asset Working Group of the U.S. National Association of Insurance Commissioners says, “As regulators, we just have to trust that rating agencies are going to monitor CDOs and find the subprime.” 3 This statement really enhances my comfort level. ”
Disagree with Ben Bernanke (Absence of Fear, CFA SOCIETY OF CHICAGO SPEECH – June 28, 2007)
Robert Rodriguez: “We disagree with the opinion expressed by our esteemed Federal Reserve Chairman Bernanke, when he said in his speech of May 17, 2007 at Chicago’s 43rd annual conference on Bank Structures and Competition, “We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the sub-prime market to the rest of the economy or to the financial system.” We will see if this optimistic assessment proves to be the correct one.”
I placed a halt on all equity and high-yield buy orders (Credit Crisis, January 22, 2008)
Robert Rodriguez: “On December 14 (2007), I placed a halt on all equity and high-yield buy orders for the accounts and funds that I oversee. This was the direct outcome of a conference call… My conclusion from the December 14 conference call was that the Fed would likely cut the Fed funds rate dramatically if the issues cited unfolded in January and February. The conclusion was that the rate would be at 3.5% or lower by March or no later than the end of March. This expectation was not discounted in the futures market at that time. It is now. Given recent events and the current yield curve, it appears that the funds rate will likely be at 3% or less before the end of the year.”
“Since the initial cut in the funds rate, we have witnessed only one significant positive response in the capital markets… We will consider deploying capital both in equities and high yield when we are being more than sufficiently compensated for the potential risks we may be accepting. This process will take time, patience and discipline. These are attributes that we have demonstrated on many earlier occasions. “
The odds of recession have shifted to or are nearly at 100% (Credit Crisis, January 22, 2008)
Robert Rodriguez: “How does one provide an outlook in such a chaotic environment? Consensus earnings and economic growth expectations have been too optimistic for too long, and still are (this comment applies to Federal Reserve Chairman Bernanke as well). Their positions seem totally unbelievable and do not reflect the current environment. Since our December 14 conference call, it has been my opinion that the odds of recession have shifted to or are nearly at 100%. Don’t look to the economists for an accurate forecast since their consensus forecasts have never predicted a recession in the last 40 years. The general consensus is that the U.S. economy will experience a slowdown for two quarters and then it will begin recovering in the second half of 2008. The Federal Reserve rate cut today of 75 basis points may add to this expectation; however, we again consider this an overly optimistic viewpoint.”
“The genesis of this crisis came from the excesses in the housing market. The decline in home prices is unprecedented so we do not know how consumers will react. It is our opinion that the credit crisis will spread into credit cards, auto loans, leveraged loans and commercial loans, and should stretch into 2009. Unless the structured finance market reopens soon, we should continue to experience continued credit contraction. Even if Fannie Mae and Freddie Mac are given broader lending authority, the size of the problem dwarfs their capability.”
The Fed’s medication is likely to be ineffective in dealing with this economic fever. Misguided policies could make the situation better in the short run but worse in the long run. (Credit Crisis, January 22, 2008)
Robert Rodriguez: “The general hope is that the Fed, along with regulatory changes and fiscal policy stimulation, will be able to contain and soften this credit contraction. Given that this crisis was not a function of high interest rates or restrictive monetary policy, it seems like an optimistic view that lower rates and a few changes of regulatory policy, along with a potential $100-150 billion tax cut, will save the day. This crisis is a function of a credit bubble that financed an asset bubble that is now in the process of deflating. Until overpriced assets, as well as excess and unsound leverage, are allowed to clear the system, the recovery from this credit crisis should be delayed. As I wrote in the September FPA New Income Shareholder Letter, “future Fed policy actions may prove rather ineffective in dealing with these challenges.” The word “challenges” was referring not only to the credit contraction but also to high oil prices and a weak dollar. I also referred to Chairman Bernanke as “Greenspan Lite” because his initial rate cuts were examples of what an Alan Greenspan policy might have been. Again, this crisis is not about the level of interest rates but of excesses in lending and borrowing on inflated assets. The process of clearing these unsound practices is analogous to allowing a body fever to run its course, when appropriate medication is unavailable. The Fed’s medication is likely to be ineffective in dealing with this economic fever. Misguided policies could make the situation better in the short run but worse in the long run. This refers to short-term fiscal policy stimulation that was referred to in a recent Wall Street Journal opinion piece as “feel good economics.” Our problems and challenges that we are witnessing currently are the outgrowth of similar unsound monetary and fiscal policies of the past.”
We have “Crossed the Rubicon” into a new financial era (Crossed the Rubicon, March 30, 2008)
Robert Rodriguez: “In light of the above comments, the partners of FPA came to a unanimous conclusion that the recent Federal Reserve actions and the potential new Congressional policies under consideration are likely to lead to a significantly higher level of long-term inflation in the U.S. We are more than disappointed in the substandard decision making that has taken place within the Federal Reserve and other governmental entities these last several years. The misguided monetary policies of the former Chairman of the Federal Reserve, Alan Greenspan, created an era of “too big to fail” that has led to two major asset bubbles. With each successive bubble, the policy actions available to the Federal Reserve to reduce financial system risk have been systematically reduced. The extraordinary actions taken by the Bernanke Federal Reserve reflect acts of desperation rather than long-term policy solutions. The rapidly changing events within the capital markets are forcing the Fed to adopt policies that have the potential of long-term negative consequences. These recent events, and their fundamental changes to the U.S. financial system, are forcing the leaders of FPA’s product areas to reassess their present portfolio allocations. In essence, we believe we have “Crossed the Rubicon” into a new financial era.”
Perspective of Energy Stocks:
The period of low energy prices has ended, and a new one has begun with considerably higher prices on average ( Sept. 30, 2005 letter)
Robert Rodriguez: “ The rise in energy prices is also troubling us. As you know, we have been very optimistic about the outlook for energy stock prices for several years because of the likelihood of rising energy prices. We have to admit that this latest round of price increases did catch us by surprise. We were not expecting to see $70 per barrel oil or a $14 per million BTU natural gas price this year. These are at least 30% to 50% higher than what we would have expected. What this demonstrates is that the world energy supply system does not have a sufficiently large cushion to withstand any type of disruption. We are of the opinion that a fundamental change has occurred, whereby the period of low energy prices has ended, and a new one has begun with considerably higher prices on average.”
We prefer to be invested in energy rather than in financial services ( Sept. 30, 2006 letter)
Robert Rodriguez: “ Despite the price runup in energy stocks during the past five years, this sector represents barely 10% of the S&P 500. This is up from a low of approximately 5%, but it is down from the 1979 peak of over 30%. Notice that the energy sector topped out at a level that was very close to where the technology sector peaked in 2000. Though it has been a strong performer these past five years, its significance, as a percentage of the major averages, is still substantially less than other periods when a sector has become “the” sector to own. For example, the financial-services sector currently represents over 22% of the S&P 500. After nearly 25 years of interest-rate declines and the explosion in financial derivatives and questionable lending practices, we prefer to be invested in energy rather than in financial services.”
We Believe That Oil Prices Are Likely to Be Sustained at Higher Prices
Robert Rodriguez: Oil prices have recently declined from the recent high to $58. Is this the beginning of a major decline? Have prices overshot and have we, as investors, become part of the consensus crowd? In our opinion, NO! We believe that “investment” managers are as short-term as always. They worry that the economy might slowdown or be on the verge of recession and, therefore, oil prices will decline. This may not occur but it is more likely the terrorism oil risk premium is starting to decline. We do not know, nor do we care. We believe that oil prices are likely to be sustained at prices higher than what the consensus may be currently anticipating. In the final analysis, it will be the interplay between demand and supply that determines the outcome.
World Oil Production May Have Reached Its Peak
Robert Rodriguez: In the case of supply, within the next five years, three countries may reach a peak in oil production: Mexico , China and Russia . Several analysts estimated that Mexican oil production would likely peak around 3.4 million barrels per day and that this event would occur in 2004. Mexico ’s largest oilfield, Cantarell, appears to have peaked and if this is the case, so has Mexican oil production, since six of every ten barrels produced by Mexico comes from this one field. Earlier this year, a 3% decline rate was forecast for Cantarell’s production. This has proved incorrect since it is now estimated that the decline rate is 8%. Obviously, this is likely to be of some concern to Mexico . Should this forecast of peak oil production for these three countries be correct, an additional 35% of non-OPEC oil production will have peaked, and together with the 41% from eleven major countries and others that have experienced a peak in production rates, 76% of non-OPEC oil production might have peaked by 2012. If this occurs, it will give the middle-eastern countries even more clout in the setting of oil prices. This is not a pleasant thought.
As for the possibility of Saudi Arabia and OPEC riding to the rescue, there is a major debate occurring within energy circles as to whether they will be able meet rising oil demand. Saudi Arabia says that they will have no problem meeting incremental oil demand for years to come. They estimate that they have over 250 billion barrels of reserves. This estimate has not changed since 1988, despite their producing over 3 billion barrels per year for nearly twenty years. Saudi Aramco, the Saudi state oil company, has acknowledged that its gross depletion rate is now approaching eight percent. If true, Saudi Arabia needs to bring on 800,000 barrels per day of new oil production each year to offset declines in existing fields. Several OPEC nations appear to have already peaked in their production capabilities. We wonder whether the margin of safety is as great as what Saudi Arabia would have us believe. The last independent audit of their reserves was done nearly thirty years ago and at that time, their reserves were estimated to be 110 billion barrels. It does raise a question.
The Primary Reasons We Have Focused Our Investment on Oil Drilling Companies
Robert Rodriguez: It is impossible to know when a peak is reached until several years afterward. For example, depletion of the U.S. oil reserves was first signaled by the drop in yield to exploration in 1940, as measured by barrels per foot drilled. But with enhanced technology, oil production kept growing for another 30 years despite a deceleration in yields. But then the inevitable happened, production peaked in 1970, and it has declined ever since. Interestingly, 80% of the oil produced today flows from fields discovered before 1970, according to 13D Research, Inc. Even more alarming, the world industry is now producing approximately three times the volume of crude it is finding each year. In other words, at current levels of drilling for oil, we are using up and not replacing 67% of our oil consumption or about 55 million barrels per day. This last point is one of the primary reasons we have focused our investment on oil drilling companies because current levels of drilling will not sustain current production. Exploration and thereby drilling for oil must increase to keep production levels from declining over time.
The Change in Supply and Demand
Robert Rodriguez: Oil depletion is accelerating, as evidenced by existing field production declines. According to 13D Research, Inc., ExxonMobil estimated a few years ago that by 2015, because of depletion of existing fields and growth in demand, the petroleum industry needs to add 100 million barrels per day of production. This is about four times the current level of production being added. If correct, this should be a boom for the oil drilling industry. Even if we see little growth from current production levels, exploration activity will still need to increase substantially just to keep production constant. The leverage potential in the oil drilling business we’re invested in is very large. As demand for drilling rigs strengthens from already elevated levels, rig day-rates will likely rise and the incremental change will flow straight to the bottom line, with the growth in profits far above the growth in sales.
On the demand side, we are witnessing a major change, with the increasing demands from China and India . As of 2005, China ’s annual per capita consumption was estimated to be 1.8 barrels per person while India was at 0.9. By comparison, U.S. per capita consumption was 25.6 barrels. U.S. consumption has continued to increase despite the rise in oil prices. Even with the recent rise in gas prices above $3 per gallon, demand only flattened. In our opinion, for over thirty years, the U.S. has not had an energy policy, other than one of cheap oil. For example, the United Kingdom and Japan consume no more oil today than they did in 1973. After the North Sea oil fields were discovered, the UK continued a policy of high gasoline taxes so as to discourage consumption. Japan began an aggressive policy of diversifying away from its heavy dependence upon oil to one that included nuclear energy. It appears that it will likely take considerably higher oil prices to constrain U.S. oil demand.
The Energy Sector Will Remain a Strategic Investment Area for Us
As you can see, we have given this considerable thought and believe that energy will be a growing issue over the next several years; therefore, the energy sector will remain a strategic investment area for us, as it has been for several years. Should energy prices decline more than we expect and the share prices of several companies that we are monitoring decline appropriately, you will see us expand our energy holdings by a substantial degree. It would be remiss of me not to pay special acknowledgement to the book “Twilight in the Desert” by Matthew R. Simmons. This reinforced already strongly held opinions by both Rik and me.
Current Energy Holdings
On Rowan Companies, Inc (RDC)
Robert Rodriguez: We believe the offshore-drilling business environment is extremely attractive currently, and we expect this trend to continue for a very long time. The company has no net debt while selling at less than 10x this year’s earnings. With a shortage of jack-up rigs internationally along with a balance between demand and supply in the Gulf of Mexico , offshore drilling day rates are extremely attractive for Rowan.
On Patterson- UTI Energy (PTEN)
Robert Rodriguez: Patterson- UTI Energy (PTEN), one of the two largest U.S. land drillers, declined over 25% for this reporting period and nearly 16% in the third quarter, in response to weaker natural gas prices. We repurchased all of the stock previously sold and we are now increasing our exposure. Investors are fearful that land-drilling day rates will decline because exploration and development companies will begin to defer some of their drilling activities. At our recent purchase price, PTEN could experience a 50% decline in earnings and we would still be paying barely 10x earnings. The company has no short- or long-term debt and is currently repurchasing stock.
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