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Big Time Investors Who Made Big Time Mistakes Example #2 - Tom Brown Prominent Bank Stock Analyst of Second Curve Capital Calls the bottom of Financials in the Fall of 2007 !

September 03, 2010 | About:

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.

  1. Long-term company valuations are extremely depressed. Before trading began on July 15th, many financial services companies were trading at valuations wildly out of line with their long-term earnings prospects--simply because of excessive investor fear. The fear has come about from the very real credit problems that have developed over the last 18 months, and the unrealistic expectation that they will persist indefinitely into the future.

    With the banks stocks off by 50% in the last three months alone, investors seem to have been stunned into inaction, while bearish momentum investors have piled on their shorts. Rational analysis about companies’ long-term prospects has given way to the simplistic notion that chargeoffs must go higher, so stock prices must go lower. As a result, many financial stocks are significantly undervalued relative to their long-term earnings potential.
  2. Bearish analysts have devised new methodologies to justify current or lower stock prices. Just as tech analysts rolled out new valuation methodologies to justify sky-high stock prices at the peak of the tech bubble in 1998 and 1999, bearish financial services analysts have developed new “methods” to “value” financial stocks to avoid recommending them now.

    They are nothing if not resourceful. One analyst, for example, estimates a bank’s entire future losses, deducts that number from tangible book value, then assumes the bank raises additional capital at current (highly dilutive) prices. Then he assumes the stock should trade at or below that estimate of pro forma, adjusted tangible book value. Potential book value growth from future earnings? A return to normal valuation? That counts for nothing.

    Clearly all the analyst wants to do is come up with as low a number as he can, whether it makes sense or not, in order to justify his bearish position. This isn’t “conservative” analysis. It’s poor analysis.
  3. New investment gurus are worshiped, while previous ones are said to have lost their touch. Remember back during the tech boom, when great investors such as Warren Buffett, George Vanderheiden, and Julian Robertson were suddenly seen as dinosaurs because they refused to participate in the mania? It was a new era, and those old guys “didn’t get it.” Today Bill Miller, Marty Whitman, Wally Weitz, and others are being criticized not just for their refusal to short the financials, but for actually owning them. People say that “this time it’s different,” and that these erstwhile investment legends suddenly don’t know what they are doing. I’ll bet on the legends.

    So who are the new media darlings? One is Bill Ackman, a man with a mixed track record at best. To show how crazy the current environment is, he shorts Fannie and Freddie on Thursday and Friday and then calls CNBC to tell them he has a plan to “save” the companies, which (what a coincidence!) involves a complete wipeout of common shareholders. And CNBC takes him seriously! None of the financial journalists who interviewed him on July 15th questioned his true motivation.
Then there’s Meredith Whitney, who last year raced to become the most bearish bank analyst on Wall Street. She published her latest report last week and held a conference call with investors on July 15th. Her new angle: stay away from bank stocks because future credit losses will be much higher than they think. Why? Well, Meredith discovered that the home-price futures that trade on the Chicago Merc are forecasting greater price declines than the banks expect. The futures market on which Whitney hangs her entire report has an open interest of all of 435 contracts, with a notional value of—are you ready?—$17 million. Since when do equity analysts rely on new, illiquid market pricing to do their forecasting?

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%.

  1. Second quarter earnings reports are so far encouraging. While commercial banks have mostly been the ones to report earnings so far, their reports have been encouraging with respect to credit quality. I’m specifically referring to changes in delinquency rates, slowing inflow of new non-accruing loans, and the lack of meaningful increases in criticized assets.

    Even the accounting for credit problems is improving, as companies have tightened up on the classification of loans 90 days past due but not on non-accrual. Banks seem quick to take writedowns on non-accrual loans and are aggressively building reserves.

    It is by no means clear sailing from here. Even so, the stocks are significantly undervalued under all but the harshest economic scenario. The evidence from second quarter earnings to date is that that scenario won’t come close to happening. “

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.

About the author:


Rating: 4.2/5 (17 votes)


Clm10 - 7 years ago    Report SPAM
Thanks for this post.

Nothing personal against Mr. Brown but I remember the reverence that was paid to this guy from 2005-2007 in the financial media.

It is interesting that he was everywhere basking in praise during those days but nearly invisible now.

A true guru is humble during the good times and humble some more during the bad times.
Dealraker - 7 years ago    Report SPAM
As I told a friend in 2007, 90% of the investors followed on gurufocus will underperform the market in the next 10 years. I stand by that.

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