Variant Perceptions

Category: Berkowitz

Buffett on the imperfect turnaround

Can you think of an example of a retailer that was successfully turned around?

Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins.

It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

Warren Buffett, student visit 2005

Another addition to the turnaround toolbox so that I don’t forget the obvious and known even in tempting circumstances.

And these are tempting circumstances. There are two retailers that I like their owner operators and I like their prices. Is there a need to mention their names?

Running the risk of being repetitive, my opinion is that in comeback stories the balance sheet is better used to estimate the runway of a business rather than its value. Both of these retailers have decent runways but the problem is that neither is turning.

These were some thoughts from an old previous post on players facing external threats.

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.

A good financial position, like Dell’s or Yahoo’s,  can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.

I’m still curious about Dell and Yahoo. I’m still curious about these two retailers. Actually, at the moment there are dozens of interesting situations. However, my preferred style is to jump on businesses that are turning or have already turned at the risk of missing some… and there are some good ones out there.

Now, if they decide to liquidate abruptly or in willful steps … well, that’s not a turnaround.

Position: none.


A friend suggests me to read Mauboussin’s More Than You Know, Chapter 21 and I do. Retail and technology are not the best sectors to look for comebacks.

Exhibit 21.2 shows what happens to companies that realize a downturn. The sample includes almost 1,200 companies from the technology and retail sectors.

The data for the two industries are strikingly similar, and not particularly encouraging: Only about 30 percent of the sample companies were able to engineer a sustained recovery. (Credit Suisse defined a sustained recovery as three years of above-average returns following two years of below-cost-of- capital results.) Roughly one-quarter of the companies produced a nonsustained recovery. The balance—just under half the population—either saw no turnaround or disappeared. Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).

This analysis also shows how long companies experienced downturns. For both retailers and technology companies, roughly 27 percent of downturns lasted only two years, and for both sectors over 60 percent of downturns lasted for less than five years. In other words, the destiny of most firms that live through a downturn is determined rather quickly.

These mean-reversion and turnaround data underscore how strong and consistent competitive forces are. Most stocks that are cheap are cheap for a reason, and the likelihood that a business earning poor returns resumes a long-term, above-cost-of-capital profile is slim.


TARP warrants: let every eye negotiate for itself and trust no agent

A secret about the TARP warrants is starting to spread.

Most have heard of the adjustment to the strike price after dividends but there is more to the anti-dilution clauses than just the adjustment to the strike price. A few months ago I decided to cryptically suggest this insight in a visited message board, where many were buying TARP warrants, to see who else had caught it.

Actually, not many. One of the few, the author of today’s post.

Over the last few months we have discussed the anti-dilution clauses. He recently decided that it was time to confirm the major insights: discussed them with a few lawyers, that did not help much, and ran the math with one of the small banks that has TARP warrants. He finally put some of the insights, but not all, in a document. It starts with a great Mark Twain quote so how could I not like it. I am thankful that he accepted to share it in this blog.

Both Bruce Berkowitz and Francis Chou mention the secret in their most recent letters. It is mentioned so cryptically as if they did not want it to be known. In the same cryptic style, the author of this post asked to remain anonymous.

There is a lot more to the anti-dilution clauses than what is being discussed in the blogs, the press, and even this post. If you are interested, I suggest you separate several hours and READ the prospectuses fine print.  Also the numbers are from a few weeks back and not all warrants mentioned in the table are from TARP or even have the same fine print. There are no shortcuts in this investment, you have to read a lot.

For more information, I first mentioned the TARP warrants almost two years ago in the following post:

Disclosure, we both are long a few of the mentioned TARP warrants



I am frequently asked, “So what is XXXX’s edge?” I think it is possible that in some cases we eliminate 80% of the competition when we start by reading the annual report. It never ceases to amaze me, how frequently we find that an investor in a particular company did not bother to read the annual report, including professional investors.

Now get ready for some tedious reading! If you do not feel like chewing leather than you are well advised when I say you should skip the following two pages.

Recently, I realized again how few investors bother to read the primary documentation, when researching the TARP warrants of US banks. I expect analysts and investors in these warrants to be do more research than the average sophisticated investor in equities due to the offbeat nature of warrants. However, it quickly became clear to me that analysts, investors and the press clearly did not bother to read the prospectuses of the warrants. Samuel Clemens (a.k.a. Mark Twain) used to say that “A person who won’t read has no advantage over one who can’t read” and that certainly rings true here.

For the benefit of those that have not heard about TARP warrants;

  • TARP- Troubled Asset Relief Program
  • Warrant- The right to purchase an equity security for a certain period at a certain price.

TARP is one of the programs that the US government created to bail out the banks. For example it allowed the US Treasury to purchase newly issued preferred equity from various banks e.g. Bank of America. The US Treasury received warrants, called TARP warrants in this case, with these shares. In time the US Treasury either sold the warrants back to the respective companies or it sold it off into the market where lesser mortals like us can now buy them.

The warrants have some important features.

  1. They are long term; 10 year warrants expiring around 2018-2021
  2. They have various anti-dilution adjustments
  3. The exercise price when compared to current tangible book value is low.

Continuing with the BAC A warrants as an example,

You can learn this by simply reading the relevant prospectus.

Technically, in the case of BAC and others, it is not the prospectus that holds the important information, it is the supplement to the prospectus. When you read the anti-dilution adjustments you note that the exercise price is adjusted downwards in some cases (e.g. when a cash dividend is declared) AND the number of warrant shares (shares/warrant) is adjusted upwards.

You can learn this by simply reading the relevant prospectus.

Last year you could purchase the BAC warrants for as little as $2.00-$3.00 with an exercise price of $13.30. Today, BAC’s book value is $21 and tangible book value is $12. We are NOT advocating that paying $2.00- $3.00 for the right to buy BAC until 2018 for around current book value is a good deal, but it is worth investigating. Particularly if there is potential for the exercise price to be reduced AND the number of warrant shares to be increased every time a dividend is declared.

You can learn this by simply reading the relevant prospectus and looking up the price.

There seems to be a general misconception in the market that the anti-dilution adjustments only apply to AIG TARP warrants, mainly because Bruce Berkowitz spoon fed the market with a statement in the press about AIG. However, these adjustments are not exclusive to AIG TARP warrants; in fact the exact opposite is true.

You can learn this by simply reading the relevant prospectuses.

In the case of BAC it also pays to read the “prospectus” for the warrent, Warren Buffett negotiated for Berkshire Hathaway in Aug 2011. Warrent, Warren. Get it? Eh, ok, I will move on.

The warrent comes with a strike price of $7.14 and 700m warrent shares (6% of BAC outstanding shares) and has the same anti-dilution adjustments as the TARP warrants. It is quite plausible for the warrent shares to increase from 700m to 1Bn AND the exercise price of $7.14 to be reduced to $5.00 over the 9 years to 2021. What can we say? The Master strikes, yet again!

You can learn this by simply reading the relevant prospectus.

Those of you that stuck with me through the section on warrants either enjoyed it or must feel like the man that tried to commit suicide by drowning himself in a puddle of water, one inch deep. The good news is, it is almost over.

When you research the various warrants you should realize that all these warrants are not created equal and we have found the most significant differences are evident when

  1. you compare the relevant company’s current tangible book value with the warrant’s exercise price and
  2. the normalized dividend per share.

In the case of b) I mentioned that the warrant shares adjust upwards AND the exercise price downwards when a dividend is paid. Technically the relevant amount is the difference between the dividend per share paid and a threshold dividend per share. This threshold was set by the last dividend per share payment at the time the warrant was issued. Most of these warrants were issued in the depth of the financial crisis, which means that in most cases the “last” dividend that was paid was at a time of peak profitability and before very substantial share dilution. Therefore, it is prudent to adjust for this and when we do so we come up with the following comparison.

We reiterate, neither are we making a case for or against buying the warrants nor are we saying this is anything more than a simplistic analysis. As always you have to do our own homework! 

We are simply saying that the relationship between the exercise price and the current book value and the relationship between the historical dividend per share and the threshold for the dividend to give you the “kicker” are very different from company to company. Therefore the investor that has that knowledge most certainly has a huge competitive advantage and in the case of the TARP warrants we believe it is a minority that understands the differences. All it takes is for the investor to read the relevant prospectuses.

Thinking about investing in US banks? a short answer to David Merkel

In the comments section to the post Three Years After Lehman I got this deceptively simple question from David Merkel, the author of the classic The Aleph Blog,

I recommend that you try to talk with M3 Partners, Chris Whalen or Hovde – if they will talk to you. They know banks far better than I do, and I am pretty certain they are bearish.

I’m no expert on banks. I only have a few question marks:

  • Exposure to Europe
  • Exposure to repo lending/borrowing
  • Lack of clarity because of illiquid assets, and lack of mark-market accounting.
  • Home equity lending
  • Over-reliance of clipping pennies from the Fed, at a time when the front end of the yield curve has collapsed.

Basically, I don’t trust the accounting. Why should I buy bank stocks when I can buy safer insurers at similar or better discounts, where I know the accounting is mostly fair, and the liability structures are stronger?



My first thought was that it was nearly impossible to answer all David’s “few” question marks in the comment section but surely I could answer his insurance versus banking question. How wrong I was. When the short answer became two pages long it was fairly obvious that it was the stuff for a post. It probably needs editing but the short answer was already taking too much time:



I am sure others do not feel as comfortable as you with insurance accounting and underwriting standards. I certainly do not and you have been my man when I want corroboration on those issues (smile)

I imagine that when you mean investing in insurance companies, you are referring to insurance companies where you personally feel comfortable with their underwriting and their history. Besides basic rules of thumb to check reserves, the accounting will not help much predicting future losses.  Also I suppose that there are some sectors that you would not trust like life insurers with large guaranteed annuities portfolios or some mortgage insurers.

That reaches a central point of investing in financial firms: some leap of trust is almost always needed. For insurers you cannot know every single policy, for banks you cannot know every single loan. There are a couple of mREITs that I know all their loans but those are an exception.

There are several investment approaches to this “leap of trust” thing:

  1. Do not trust any financial firm ever: that has been the path taken by several good investors. They prefer to keep it outside their circle of competence and I will not try to convince them to change. You have to pick your spots. At the same time, there is a leap of trust in any type of investment (BP/security, NWSA/ethics, HPQ/acquisitions) even if you trust the accounting, that as we know it is not always the case. I personally have lost money investing in some simple businesses, in simple industries with lots of net cash, and instead made substantial returns in some complex distressed situations.
  2. Buy great companies with great teams: Because of some accident an investor may get to know in depth some financial sector (you insurance, me banking) and get comfortable with some teams. Good teams can avoid disasters for decades and the top of them can regularly achieve 12%+ average ROE and grow. That is a recipe for fantastic returns. I consider this approach risky. Historically many have had style drift like AIG and also be exposed to nationwide cataclysms. For example, Bank of Ireland was the best of Irish banks but that did not help much. Besides, it can nurture complacency and abdication on the part of the investor.
  3. Wait for the earthquake and look for survivors: that combined with signs of a new management team doing what is necessary (exiting marginal business, manage for capital and cash flow, reducing legacy assets significantly) can be a powerful combination. You are NOT trusting management, you are seeing it in action and following its progress.

As you have probably noticed this blog is mostly devoted to turnaround investing and that means point #3. It is a way of trying to avoid the pitfalls of #2 by waiting to see the order of magnitude of the cataclysm and watch management in action not just in words or reputation.

One key historical advantage of approach #3 for banks is that damaging credit bubbles are usually tied with real estate booms, deregulation, overvalued or even fixed exchange rates (for countries not indebted in own currency), and sustained current account deficits. Some recent examples are Latin America 82, Scandinavia 90, Mexico 94, Asia 96, Argentina 00, Subprime 08, Eastern Europe and PIGS 11. Bubbles driven by excess internal depository savings badly invested are much more rare and different in their consequences (Japan 1990s, maybe China today).  That provides several advantages to an informed investor:

  • Avoidable: Real Estate is a big proportion of banks’ balance sheet and usually with deregulation capital is lobbied to be thinned. Most crisis in other categories are usually sideshows: they are not big enough or risky enough. So by only following a couple of categories it is possible to avoid 90% of banking crisis.
  • Measurable: when the punctuation hits Real Estate, the other categories follow linear processes that can be measured and followed for a sign of a turn (with the exception of C&D, always one big if):
    1. Pricing and collateral of new loans are improved
    2. Regulators are tougher
    3. Bubble loans become a lower percentage of portfolio over time
    4. Cash and liquidity increases
  • Scope limited: wherever real estate goes (residential or commercial depending on the type of bubble) that is where the banks will go. If the government does not intervene, watch out (1932). If the government delays or avoid the devaluation of a fixed currency (Greece, Ireland, Spain today) watch out. Loans that are non-performing are difficult to hide. They will show in regulator reports, the cash flow statements or real estate industry reports.
  • Time limited: CRE and MBS from bubble times become a lower percentage of the total portfolio over time, while the new loans should be perfectly OK with the improved underwriting and pricing.
  • Hated or unloved: headlines do not help and many people were financially burned, so you can wait for confirmation before investing. People get trapped in the morality tale just when it is already in the past. Also it is not like buying the dip is a must, there may be several opportunities. The important part is to improve the probability of a hit because the upside is enormous anyway.
  • Replicable: learn one running play and play it ad infinitum. There is always a country suffering undeserved short term capital inflows, misusing them, and becoming the next candidate for a banking blow out  … with the following renaissance. Just look at Greece or Australia. There are twists here and there, like for example countries indebted in their own currency like the US, but isn’t it nice to have a perpetual compounding machine?

The funny thing is that at the moment there is not a single bank stock in my portfolio. It is circumstantial because I have had small and medium banks on and off over the last year and I think the banking sector today is fertile ground indeed.

In this blog I have tried to bounce and structure ideas on approach #3, the turnaround approach. It needs more work, pragmatism and flexibility than what is normally understood as value investing. Its success is tied to avoid investing in every single opportunity but only the high probabilities, and there must be several high probabilities in the banking sector today:

  • Good industry: there is a bank in every Western film. There is a bank branch or an ATM in every commercial location. That is how critical and entrenched are banks in a modern economy and even its history. It is oligopolistic at the local level, without technology obsolesce, and has high regulatory barriers to entry (just ask Walmart). Chris Whalen may not like the oligopolistic setup but I am not seeing many advocates of a utility model. And the alternative of too much dumb private competition was one primary reason of the mess we are in. A highly regulated and oligopolistic model has historically worked.
  • Pool of good businesses: retail banking is a local business where you want strong local market share (or a collection of strong local market shares like Bank of America and Wells Fargo). There are plenty of cheap banks with local dominance funded by long-term low-cost deposits with margin to absorb negative shocks. It is not like Bank of America is the only option, actually I think there are better risk-adjusted alternatives with similar upside.
  • Hidden downside protection: I am finding multiple cash flow positive banks that are most probably overcapitalized and over-reserved. There is some regulatory risk (pushed to dilute) but at the current prices the upside is big even with some dilution.
  • Emphasis in the core business: loose times, loose capital. Tight times, tight capital. The best example of all is Bank of America selling stakes in Canada, Europe and China (that also reduces Private Equity and Credit Card exposure) while redoubling their efforts in the good old USA. Heavy emphasis on the core business, even if it shrinks a company, is a sign of a management that gets it. It improves profitability in the long term and reduces risk.
  • The investor has time to close the loop: I usually prefer small and mediums firms because they are less followed and their turnarounds are easier. But hate can also provide time to confirm that all skeletons are out of the closet … and banking is the most hated sector today. There are still not many in the media realizing that most banks are improving. Even the smart Chris Whalen, that has been positive of medium banks, is probably missing the improvement in the Big 4 normal operations and capital ratios most probably because of too much attention to the off balance sheet putback liabilities (issue that would require a whole new post to give it justice).
  • First cash flow statement, then balance sheet, finally income statement: And the banks cash flow is at several years highs.You can distrust the balance sheet but it is much more difficult to lie with the cash flows statement. If these loans and operations are so bad, why they are so profitable? It is not like there has not been enough time for bad loans to explode.
  • Look for stable or improving earnings potential: In non-financial firms l prefer stable or growing revenues targeting a turnaround based on cost reductions. For banks I look for stable or growing assets and deposits with provisions reducing over time. Most banks’ franchises are still intact and legacy issues are getting reduced. For example, the much maligned Bank of America has been increasing total deposits and core deposits.

And as I argued in Three Years After Lehman, the sector turnaround seems to be going full speed ahead. At this speed that means most of the US banking sector legacy issues should be behind in a year or so.

Therefore, any criticism of the banks should be focused on things off-balance sheet like putbacks or new shocks like Europe. Measuring their order of magnitude should be a piece of cake but I am not seeing many doing that calculation and much less balancing it against the capital, reserves and profitability of each bank. That is the game.

I will not try to convince you David out of insurance companies especially when they are cheap and right in the middle of your circle of competence. Actually, I think it is an interesting sector to follow these days:

But if the American commercial banks are safe, they are a lot cheaper than the American insurance companies. For example, if Bank of America survives – and I am not saying it will – it generates close to $40B in pre-tax pre-provision earnings and is priced around $80B. I do not know of any such disparities in the insurance sector (maybe you do?)

Also the situation is a little different, closer to investing in insurance companies after asbestos … the shenanigans are out in the open! You are faced with the more simple task of evaluating the trustworthiness of the companies projections without short term time pressure.

That is one huge advantage. Some time has passed and you are seeing how some of those projections have performed. Actually some competitors have gone down the drain that is also good for the survivors enjoying improving interest spreads.

With insurance companies, I personally do not know the shenanigans in this soft pricing market. Some have said that AIG was an example of a company too aggressive on pricing backed by the government but from my novice point of view they are not doing so bad in this catastrophic year. Conclusion, I do not know where are the insurance sector hidden bombs and to go by reputation and a track record is not usually my style, a style that shuns complacency.

Hope this answers your question David. Maybe next time I will post the answer to the few question marks …it is already running three pages long.

Be greedy when others are fearful, Francis Chou edition

From his latest letter, Francis Chou seems keen on financials, retail and pharma equities, and for financials he discloses his thesis for stock warrants of large banks.

Medium banks were easier to understand and bound, so that is where I focused first, but TARP warrants was how I expected to buy large banks when things became more clear. And things are becoming clearer by the day.

Large banks are an opportunity that I have been procrastinating for quite a while, in particular Bank of America that looks very cheap at 0.5 BV and 3x PTPP earnings. Large banks are sound with strong balance sheets but it is difficult to pull the trigger when probably there are more surprises coming. Francis Chou conveniently lists some of these potential negative events.

This is not an original idea, everyone that has read You Can Be a Stock Market Genius will remember Joel Greenblatt’s discussion on the use of LEAPs (long dated call options) for situations with binomial outcomes like the Wells Fargo turnaround in the 1990s. Greenblatt liked very much Bruce Berkowitz’s WFC thesis but had similar concerns to Chou’s today on the transparency of the balance sheets. Greenblatt decided to buy LEAPs, because in case of a collapse both common stock and LEAPs were worth zero, but you can commit less capital with LEAP derivatives for a similar upside to the common stock so the payoff proposition was much better.

Chou’s decided instead to buy warrants and it might be an even safer bet. The expirations are much longer and they include some very interesting anti-dilution clauses negotiated by the federal government that the general investor can now enjoy. We should still remember though that the attractiveness of these instruments also depends on the price and upside expected for each specific bank.

This is the excerpt from Francis Chou’s letter:



In the 2006 annual report, we noted our alarm at the cavalier approach of financial institutions with regard to their lending standards, particularly to subprime borrowers. We also expressed concern with the widespread use of derivatives by financial institutions (…) Well, starting in 2007, financial institutions went through a cataclysm. Directly or indirectly, almost all of them had to be bailed out by the U.S. government. Looking back at the crisis, this is what we have observed:

  1. The U.S. government will not let major financial institutions fail.
  2. The financial institutions that survive will be the ultimate beneficiaries of any recovery in the economy.
  3. Interest rates will be kept at artificially low levels for the foreseeable future. The spreads between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. After being severely burned, they have tightened their lending criteria and have been extremely cautious with their lending practices. In general, the quality of loans now being made are quite high and for the first time in many years, banks are being paid handsomely according to the risks they are taking.
  4. Financial institutions in general are hoarding capital. This will provide them with ample cushion to absorb losses if a double dip recession were to occur.
  5. The books of financial institutions were carefully examined by all kinds of government agencies, including regulators, before the government allowed them to repay the U.S. Treasury under the Troubled Asset Relief Program (TARP).
  6. Most of the big banks are selling below 10 times their potential earning power in the future.

An Interesting Way to Invest in Banks

Please note: the investment described below is the view of the writer and should not be seen as a recommendation.

One of the more interesting ways to invest in the better capitalized banks is through the stock warrants that were issued to the U.S. Treasury by the banks when they received funds under TARP. The stock warrants give the holder the right to buy the bank’s stock at a specific price. When the banks repaid TARP funds to the U.S. Treasury, the U.S. Treasury either sold the stock warrants back to the banks or they auctioned them to the public.

So, what is so unique about these stock warrants?

  1. They are long dated, with most expiring in 2018 or 2019. This time frame of eight- plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
  2. The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, you don’t see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class ‘A’ warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
  3. Many of the banks have excess capital on their balance sheet. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
  4. The concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish we need sound financial institutions that can generate reasonable profits.
  5. Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company’s future prospects, its position in the industry and how well it will do in a future economy. Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk averse. Too bad we had to go through so much turmoil to get there.

Below, August 13, 2010 prices of some banks stock warrants.

Even so, everything is not hunky dory for the banks. Banks face many issues and challenges. I have listed a few here:

  1. We still do not fully understand or trust the numbers
  2. Financial regulatory reform may reduce earning power
  3. New Basel rules may require more capital and reduce profits
  4. There may be a double dip recession
  5. The unemployment rate may go higher and create more defaults
  6. Commercial real estate prices may fall dramatically
  7. Banks are still not marking loans in their books properly
  8. Residential real estate prices may fall further
  9. States and municipalities are in bad shape

Our investing horizon is long-term – eight years or more for these bank warrants. Over that period, we believe the odds are it will work out to be decent investment – more so for the better capitalized banks. We view it as the glass being more than half full rather than being more than half empty.

No position

Bruce Berkowitz on Financials

Bruce on WealthTrack?  No, I still find it too familiar to call him Bruce even though most bloggers do so. OK let’s try again: Mr Bruce Berkowitz manager of the decade on Wealthtrack? Nah, too formal. One more time: Bruce Berkowitz on WealthTrack

Coming back to his roots and sharing the lessons of the S&L crisis for today’s environment. His thesis for Wells Fargo in the 1990s is something to read time and again side by side with Peter Lynch’s account. Below the fold, an excerpt of his views on banks but all the interview is worth seeing.

Vodpod videos no longer available.

BRUCE BERKOWITZ: There are two parts to the investment equation. There’s sort of what you give and what you get. So we’ll start out with what you get. We’ve had this most extreme period in the financial history of the United States. Some say we came very close to another Depression. And the U.S. government and its agencies just did a great job of pulling us away from that cliff. And, for the last couple of years, companies have gone through tremendous stress, the financials. But today, their balance sheets are stronger than ever, their earnings power, their pre-tax, pre-provisioning power is stronger than ever. And, you have to think about loans and the life of loans. You know, most loans go for between two and five years, whether it’s an individual loan, commercial. So there’s been this two-year stress period of burning through all these bad loans. And at the same time, they’ve had these two years of good loans, because they’re in very stressful periods. That’s normally when they put on their best loans.

So, the financial system came to the brink. U.S. Treasury, New York Fed, Congress did amazing job. I mean, with hindsight, you know, you could criticize a little here and there. But they did an amazing job. Now it’s up to private enterprise to take it over from here. And traditionally, that’s going to be our banks and our brokers leading the way on this nascent recovery. And there are going to be fits, and there are going to be starts. But again, the balance sheets are strong; the potential earnings power is used. They’ve battled hard, and it’s a trite saying, but whatever doesn’t kill you makes you stronger is quite true. And for those financial institutions still standing, and the ones we’ve invested in, will get through this period and move on to a more normal earnings period.

CONSUELO MACK: So, what’s the biggest risk that you’re taking, in having this sort of a concentration in these companies that have been through the grinder?

BRUCE BERKOWITZ: Well, the biggest risk would be the correlation risk, that they all don’t do well. Which would mean, you know, a severe double dip in the entire financial system of the United States, totally melts down, malfunctions, no longer exists. So, it’s hard to see that.

But, on the other hand, when you take a look at our fund today, one-sixth of the fund now is cash equivalent. Another one-sixth of the fund is in fixed income securities. So, we’re only two-thirds invested. So we have billions of dollars of cash ready to take advantage of whatever further stresses may come our way. And, you know, we’re right. And then, as I was mentioning to you, the other part of the equation is what you give. And by “most hated,” I meant that the financial institutions are not very popular today, given what’s happened in the past couple of years, and their price reflects it. So, we’re paying a pessimistic price for institutions that are essential to the country, and that will lead us, as they usually do, out of the recession.

CONSUELO MACK: Some of your competitors, including Don Yachtman, of the Yachtman Funds, who has a terrific track record as well, you know, recently told me that he doesn’t understand what you’re doing because he feels that financials are black boxes. That, in fact, you can’t possibly know what Citigroup’s loan portfolio really looks like. And that, he feels that you’re taking a tremendous amount of risk that is kind of contrary to what your prior practices have been. You don’t think they’re black boxes? I mean, you actually think that you know what Citigroup owns and what its debts are?

BRUCE BERKOWITZ: It’s our belief that enough time has gone by now, as I’ve said, that you’ve had the vintages, the various loans for a given year. You start to see, you know, the bad parts, the delinquent loans. You get to see the cash yields on the bad debt. You know, one thing that’s nice about getting older is that you start to see certain cycles before, and this is very reminiscent of ’91, ’92, when people thought Wells Fargo was going to go under because of commercial real estate. Citigroup, again. And, it’s perverse psychology. You’ve had so much strain in the system, so many balance sheets; individuals have been hurt, that it’s just very hard to look at them in a positive way.

But, with time, you start to see the patterns and the recovery, and you also have to give credit to the regulators, to the auditors, to the executives, to the oversight committees of the Congress. I mean, these institutions have been studied in the last two years. They’re under a microscope. Every element has been studied. And when you’re in stress mode, and when your institutions are shrinking, it’s very difficult to hide bad news. Everything comes out in shrink mode. But the good news is, when you’re shrinking, cash flows build up. You’re able to pay off the bad debts, and you’re able to fight another day. And, you see it now with the institutions.

CONSUELO MACK: Bruce Berkowitz and the Fairholme Fund’s rule number one is don’t lose money. And then, rule number two and number three is pay attention to rule number one. So, given the current strategy that you’re following, in the Fairholme Fund, are you still adhering to the rule number one and two and three, of don’t lose money?

BRUCE BERKOWITZ: We believe we are. At the prices that we’re paying for securities, we just don’t see the downside. We don’t see death, we don’t see bankruptcy, we don’t see significant losses. In the case of the banks, we’ve been buying below book values. We’ve been buying single-digit earnings yields. I mean, at some point, the banks will start to have a more normal earnings period.

It’s amazing, when you think of a Bank of America and all of the organizations they have merged with over time, including Merrill Lynch and MBNA, it’s tremendous. The amount of value and wealth is just tremendous in a Bank of America and in fact, it’s essential to the rebuilding of the country’s balance sheet. And so is Morgan Stanley and Goldman Sachs, and Citigroup and Regions Financial and CIT. All the companies that we purchased during their stressful periods.

CONSUELO MACK: So, Bruce, what would convince you to sell? I mean, is it going to be a price decision with some of these companies?

BRUCE BERKOWITZ: It’s going to be a price decision.

CONSUELO MACK: It is a price decision.

BRUCE BERKOWITZ: It’s going to. It’s just so cheap, relative to what you’re getting. And eventually, if we’re right in our understanding and we don’t have that dreaded double dip, going back into the Great Depression, then there’ll be a more normalized earning period. And then, that’ll be a tough part to determine, at what point our investments start to equate to T-bill type returns.

CONSUELO MACK: And so, when you look at, you know, a Citigroup, for instance. Let’s just take them one at a time. I mean, it’s value now. Do you think that there’s still a lot of value left?

BRUCE BERKOWITZ: Yes. Citigroup has the ability to earn a dollar a share, which would put it at $10, let’s just say. And you compare it to where it’s trading today, four. Under four.

CONSUELO MACK: And Bank of America, again, same?

BRUCE BERKOWITZ: All the same.