CIT Group: My Favorite Klarman Idea
CIT Group was a victim of the financial crisis unable to borrow money to fund their business on the short-term basis it became accustomed as money flowed freely from lenders. Many victims exist from a policy of extremely low interest rates over the last decade, but CIT Group is at the top of the list as their equity holders were wiped out and losses were taken in their bonds. However, some investors like Mr. Klarman are benefiting from their court-ordered restructuring and now the company has an opportunity to create a positive impact for society and shareholders. Hopefully, the company will manage their finances appropriately and forgive excessive leverage for responsible lending practices. As Mr. Berkowitz recently said in an interview with Morningstar, “CIT Group is what this country needs.” Our country needs an effective lending system to small businesses without funding financial disasters, and CIT Group is at the center of this operation. CIT Group is dominant in their business categories of accounts receivable factoring, small business lending, and various other financing solutions.
A common refrain among value investors is they didn’t purchase securities related to banks and brokerages over the last 5 years because they either couldn’t understand their financial statements or weren’t sure about asset valuations. Many people consider the residential real-estate market as a bubble that’s popped and the commercial real-estate market the next shoe to drop. However, I think it’s the reverse with residential real estate to remain weak for years as supply overwhelms buyers and commercial real estate is more attractive on a relative and absolute basis. I’ve spent a lot of time researching residential real estate in Hennepin County, Minnesota and I believe people are underestimating the inefficient nature of the market. I still see a significant number of homes owned by banks; you can view the transactions via the Hennepin County Property Tax system. Commercial real estate is scarcer in Minnesota and despite new additions in the county rents will recover long before prices stabilize in residential markets. Of course predictions offer little value, but I wouldn’t place a single chip on a home at current valuations. When I look at a home I see dollar signs, but recurring expenses rather than capital gains. Homes are a burden and transactions costs are high, which should be a red flag to any market participant about the efficiency of the market. A market can be overvalued with low transaction costs, but I believe high transaction costs increase the probability the market leans toward inefficiency. One little fact that made John Paulson a billionaire is homes tend to appreciate at around 100 bps annually over inflation. Since homes outpaced this trend over a number of years, it’s going to take years with the high transaction costs and negative demographic trends for prices to normalize. Another disappointment is the first time homebuyer tax credit luring unsophisticated buyers into a dangerous transaction. If you purchase a home for $215,000 and it’s intrinsic value is $160,000, then $8,000 isn’t going to justify the purchase. Also, it’s a loss of revenue for the government and gain for the bank because many of the transactions involve foreclosed homes, which is de-risking the balance sheet of the banks and increasing balance sheet risk for the individual buyer. Buyers need to remember if banks thought keeping these homes was a good investment, they wouldn’t sell.
Back to the issue of whether CIT Group’s equity is a good investment at its current valuation of $7.29 billion is separate from a view on residential real estate. Many hedge funds and prominent investors purchased CIT bonds and retained an equity position as the company emerged from bankruptcy. Some sold their shares like Brandes Investment Partnership while others like Fairholme and Baupost seem like they are holding a significant stake in the new financial structure. Unfortunately, the emerged financial structure is fairly complicated and maintains 30 billion in debt with extended maturities. Several potential catalysts remain for CIT Group like additional bond sales; a major one was completed on Friday with an undetermined portion under the government’s TALF program and potential ratings upgrades for their debt as business conditions normalize. Also, John Thain is the new CEO and Chairman who despite widespread criticism obtained an excellent deal for Merrill Lynch shareholders considering what could’ve transpired.
Without question, tremendous uncertainty exists with CIT Group, but I prefer common shares in CIT to any zip code in Minnesota where people cling to faulty valuations. CIT Group’s competitive position is stronger because despite their funding challenges, they remain well positioned compared to other smaller competitors. Another way to look at current residential real estate valuations is like Internet stocks, just because an asset declines by 50% doesn’t mean it can’t decline by another 50% or go nowhere for 10+ years.
Author owns CIT shares