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Value Talk: Stranger than Fiction

November 26, 2008 | About:
Charles Mizrahi

Charles Mizrahi

19 followers
In a recent interview, former Federal Reserve Chairman Alan Greenspan stated that we are witnessing “once in a century events” in the financial markets. I would venture to say that he was understating the frequency of current events. Over the past year the financial markets have been going through events of biblical proportions. I’m quite confident that the most recent events that have been unfolding over the past six months will be the subject of case studies and academic papers for a long time to come.

Imagine that we were sharing a cup of coffee a bit more than a year ago and I told you that in a year a half dozen of the most well-established and well-known financial companies would be out of business or a fraction of their current size. I’m sure you would have been more than a tad skeptical. In fact, I’m sure you would have considered it outrageous given the strength of those companies at the time. To be quite honest, I would have found it hard to believe too, even if someone had given me today’s newspaper (via time machine) one year ago. But in this case fact is stranger than fiction.

On August 31, 2007, here is what the market capitalization was for three well-known investment brokers, two government sponsored enterprises (GSEs), the largest thrift bank in the U.S. and one of the world’s largest insurance companies.

Market Cap

Company

(in billions)

Industry

Year Founded

Bear Stearns

$16

Investment Brokerage

1923

Lehman Brothers

$37

Investment Brokerage

1845

Merrill Lynch

$71

Investment Brokerage

1914

Freddie Mac

$38

GSE

1970

Fannie Mae

$62

GSE

1938

Washington Mutual

$59

Savings & Loans

1889

American Int'l. Group

$160

Insurance

1919



Over the next 12 months the financial markets around the world were impacted by a credit crunch brought on by the deleveraging of the housing bubble. The five years prior witnessed a period of easy credit made possible by low interest rates. This in turn fueled a bubble in housing prices, as now anyone with a pulse could secure a mortgage, the presumption being that housing prices would forever continue climbing. Sometimes buyers were able to get a mortgage for more than the purchase price of the house they were buying! To keep the party going, Wall Street financially engineered securities that were collateralized by real estate with the assumption that mortgage holders would continue to pay their monthly payments. These securities were so complex that hardly anyone could value or understand them. No one even really had a clear idea what would happen if housing prices stopped going up and/or homeowners started defaulting on their mortgages.

Since they yielded a higher interest rate than money markets, in a low interest rate environment these securities were seen as manna from heaven by institutional investors. These “toxic” securities started to find their way into nearly every corner of the financial world, both here and abroad. As the economy slowed, homeowners started to default on their mortgages, housing prices begin to slide and foreclosures increased. All this was bad news for the holders of these securities, which started to drop in value. Many financial institutions that listed them as assets on their balance sheets began marking them down to reflect a more “fair value” based on current market conditions. Every markdown or impairment to these securities caused the balance sheets to weaken, which in turn caused the institutions to scramble for outside cash so they could replace the amount written off by the falling securities. Merrill Lynch wanted some of these securities off the books so badly that in July 2008 it sold $30.6 billion of super senior components of these securities, which carry the highest credit ratings and are supposed to be the least exposed to potential default, for 22¢ per dollar of face value. In addition, the company financed 75% of the sale, so at the end of the day the buyer just needed to put up about 5¢ per dollar of face value ($1.7 billion to buy $30.6 billion of these securities). If that is how Merrill Lynch valued the components with the highest credit ratings, can you imagine the value of the lower credit quality components?

Warren Buffett said, “You don’t know who’s swimming naked until the tide goes out.” In the past year the tide was rapidly going out, and it exposed a lot of naked swimmers. As the housing market started to worsen, its impact on the companies above was, in many cases, fatal. Several of those companies ceased to exist and others are a sliver of their former selves. On September 15, 2008, this is what the market capitalization looked like for these companies:

Company

Market Cap

Industry

Date

Bear Stearns

$0

Acquired by JPMorgan for $1.2 billion

3/17/2008

Freddie Mac

$259 million

Placed in a government conservatorship

9/7/2008

Fannie Mae

$642 million

Placed in a government conservatorship

9/7/2008

Merrill Lynch

$26 billion

Agreed to be acquired by Bank of America

9/14/2008

Lehman Brothers

$131 million

Filed Chapter 11

9/15/2008

Washington Mutual

$3 billion

Searching for cash infusion

-

American Int'l. Group

$13 billion

Searching for cash infusion

-



In a little over one year the total market cap of these seven companies went from $443 billion to $43 billion—a loss of 97%, or $400 billion in value.

Myth of Diversification

The impact of the credit crunch continued to find its way into other asset classes. Balance sheets underwent impairments resulting in over $500 billion in write-downs since August 2007. So far, 11 regional banks have failed and the FDIC watch list of troubled banks has grown to 117 banks representing $78 billion in assets. The mantra of diversifying assets among different markets also proved to be foolish. Correlations that investors held dear, namely that price movements in one global market would behave differently than price movements in another global market, became unglued. The past year has seen global markets move in lockstep with each other, providing investors no safe haven.

Investors couldn’t even hang their hats on diversification among different sectors. It is during periods of panic that all markets and sectors correlate in the same direction…down.

Investors both institutional and retail acted in a similar manner: they froze. They began to sell assets, many times without regard to the underlying value of the asset. In order to raise cash for redemptions, hedge funds sold what they could, not always what they wanted. Investors became sick to their stomachs as they watched their account balances sink lower each month, and sold stocks at any price. They were more than glad to earn less than 1% investing in a 2-year-Treasury bill than suffer the daily roller coaster of stock prices. When stock market participants focus on the short term, employ leverage and need to liquefy their holdings, the table is set for the value investor.

Rules for Thriving During a Panic

As I have been telling you for the past year, it is during times of panic that value investors plant the seeds of future market-beating returns. While most investors are caught like deer in headlights as great companies are offered at bargain prices, value investors act. Benjamin Graham, the father of security analysis, laid the framework for how to view investing in stocks. He said that you should view stocks as pieces of a business, take advantage of the stock market’s fluctuations and invest when you have a margin of safety.

Keep the following in mind and you will truly see that market sell-offs should be viewed as opportunities and not reasons to sulk.

1. We’ve seen this movie before.

Financial panics in the United States didn’t start in 1929 when the country sank into the Great Depression. Prior to the 1929 crash, there were 10 financial panics, beginning in 1792, that had a great impact on Americans, were dramatic and involved neglect by others. In the past two decades we’ve lived through Black Monday (stocks fell 22% in one day), the 1997 Asian Financial Crisis, the 1998 implosion of Long Term Capital, the dot-com crash of 2000 and now the subprime mortgage crisis. While each panic was different, it pays to keep in mind Mark Twain’s observation that “history doesn’t repeat itself—at best it sometimes rhymes.” In spite of close to 20 panics in the past 200 years, the standard of living and gross domestic product of the U.S. have continued to march higher.

2. Act short term but think long term.

When sellers are forced to sell stocks at prices that are below the underlying worth of the business, value investors should be smiling ear to ear. It’s not very often that great companies go on sale, and when they do you should be a buyer. While over the short term stock prices may fall even lower, eventually the stock price will most accurately reflect the intrinsic value of the business. Graham said that those who view the market as a voting machine—stock prices driven by popularity­—will be in a better position to take advantage of periods of stock market extremes.

3. It’s Wall Street, not Main Street.

Much of the gyration that stock prices exhibit over the short term have little to do with the fundamentals of the company. Falling prices, especially on a short-term basis, should be viewed in the context of the company’s fundamentals. Ask yourself what long-term effect will the credit crisis and what will be the long term effect on companies such as:

Jos. A. Bank (JOSB) (added to the Special Situation portfolio in August 2008), one of the nation’s leading retailers of men’s clothing, with over 425 stores in 42 states;

Quality Systems, Inc. (QSII) (added to the Special Situation portfolio in September 2007), a leader in computer-based practice management and medical records systems for doctors and dentists;

Mohawk Industries (MHK) (added to the Prime Time portfolio in June 2008), the second largest maker of commercial and residential carpets and rugs in the U.S. and one of the largest carpet makers in the world; and

Manpower, Inc. (added to the Prime Time portfolio in July 2008), the world’s second largest temporary employment agency.

Over the long term these companies will continue to increase the underlying value of their business in spite of headline-grabbing news events that cause stock prices to slide over the short term. Take advantage of financial panics and view them as opportunities to establish holdings in great companies at discounted prices. So long as investors freeze up during times of financial panics and sell their holdings at any price, value investing will continue to remain a rational and low-risk approach to successful long-term investing.

References:

1. Market capitalization: the current market price of a company (shares outstanding × stock price).

2. GSE: A federally chartered enterprise that performs specific credit functions and, generally, is privately owned.

3. Sobel, Robert. Panic on Wall Street: A History of America’s Financial Disasters. Collier Books, New York, 1968, p. 5.

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

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