Variant Perceptions

Category: Lynch

Holding banking doomsayers accountable

Third quarter 2010 earnings are out and with several banks revisiting one year lows you would think that the credit situation is getting worse. That is simply wrong.

The New York Times finally started following the story with its Friday’s article “Banks Start to Dig Out From Troubled Loans“. My only complain is the use of the word start, why journalists not only are late to stories but then downplay them. And do not take my word for it, the same New York Times printed a graph that shows troubled loans peaking almost a year ago.

Some will say that those numbers are still high but before you jump into conclusions let me make a couple of points.

First, the USA is not Japan

It took more than 10 years after the bubble burst for Japan non performing loans to peak at close to 10% of total loans and only then government pressures pushed banks to deal with the zombie keiretsu borrowers. In the US instead, non performing loans were recognized faster, peaking at  7% in less than 3 years. Not to mention that the Japanese real estate bubble was crazier with much higher loss severities. And even after all that, when the Japanese finally decided to deal with their issues the banking sector NPLs decreased rapidly and stock prices recovered.

The second point is that American banks are very well capitalized (equity plus reserves) to handle the non performing loans even at this high levels. For illustration purposes lets bring back our old tool the Texas Ratio courtesy of updated for Q3 2010 that keeps improving from already manageable levels.

So what is going on. My impression is this just is another installment of the Fear of the Dark, Fear of Death series. Human beings do not react well to uncertainty and banks are part black box so it is easy to say “there are many things to worry about banks”. I have no problem with that, everyone is in his right to invoke the not-in-my-circle-of-competence amendment. What disturbs me is that it usually comes with a litany of measurable and testable arguments that when proven wrong are just simply set aside to be replaced by the next litany that justifies the preconceptions.

For example, in this blog we have been very sceptic of the Commercial Real Estate is the next shoe to drop argument. Has anyone care to see its recent performance, well here it is. Already in the third quarter of 2009  CRE NPLs hit the second derivative and are stabilizing at less than 5% of total CRE loans well below the real issues: mortgages and construction NPLs.

Do you feel the fear? That is Elizabeth Warren probably around February 2010 when it was already clear that things were improving on the CRE front. Lucky for us she is more of a analytical doomsayer so she tried to support her points of view with a congressional oversight panel report. And surprisingly,  it is a very good report with very interesting data.

What made me skeptical of her conclusions was how easily she mixed and confused CRE construction and development loans, a real problem, with income producing CRE loans, a much smaller problem. Mixing both had the consequence of exaggerating the scale and scope of the problems.

This wrong thinking has been repeated again and again during the crisis. The confusion of resets with recasts was another one. Were not option ARMs and other recasts supposed to explode more than a year ago bringing down the banks with them? That must have been one of the most silent explosions I have ever heard.

As soon as one of the issues is proven wrong, the discussion moves to the new flavor of the month. Now the new issues are:

  • Europe: can somebody explain me the contagion mechanism, maybe not because there is no contagion mechanism this time.
  • Putbacks that even the worst loss estimate is less than one year of earnings
  • Foreclosure mess: that the banks badly mishandled. However, that has been usually the case in every real estate bubble in history and every time the banks managed to get their foreclosures.

Doomsayers sound smart and professorial but their ability to predict has been abysmal even for forecaster standards. Why? Partly because markets adapt, people adapt, and capitalist economies grow solving a lot of issues in the process. But hey, the bogeyman and hell are just around the corner.

I sometimes miss people like John Templeton  and Peter Lynch in 1989, right in the middle of the S&L crisis, sharing their optimistic long term perspective while grounded in the difficulties of investing. They were not just smart but wise. Instead we are now at the end of the beginning for banks and these celebrities keep playing on our fears without checking their thinking and numbers.

I am not going to say that some of these issues could not become real, even data driven people like myself are susceptible to over confidence. I prefer to be detached with an open mind since banks are still somewhat opaque and their issues in other situations are real, just look at Ireland or some specific American banks like Flagstar Bancorp that is going through their third capital injection.

However, when you see one hit wonder celebrities that have been all wrong since October 2008 jumping to the new thing that confirms their preconceptions -and I think you know who I am talking about – take a pen, a napkin, run some numbers, but specially check the logical steps. Even with the more professional and less self promotional, like the excellent and bearish Chris Whalen, you should do so because there is no substitute to thinking independently and thinking correctly.


A case for investing in small cap banks

Continuing with our most important theme lately, today in Bloomberg there is an interview with mutual fund manager David Ellison. It points out pretty well the case for investing in small banks while noticing other investors worries.

As usual, I do not like the specific recommendations.  It looks like most mutual fund managers share for public consumption only their most sanitized ideas. So as consequence the recommendations have little edge and are only slightly undervalued. Pretty understandable: little to gain, much to loose

On turnarounds

David Ellison learned a simple lesson from legendary mutual-fund manager Peter Lynch as a young bank analyst at Fidelity Investments in the 1980s: If things at a company are getting better, you want to own its stock.

On banks today

We’re in the process of going from ugly to OK in banking. If you ride the right horses, you will do all right

This is the best time to be making loans I have seen in my career

Bad loans across the industry will be paid or written off over time and replaced by newer and better ones. Banks are lending to creditworthy customers and earning higher profit margins after former competitors such as mortgage companies were wiped out in the financial crisis and housing- market decline

On survivors

The institutions that have survived to this point will rise from the ashes

Smaller banks have fewer moving parts. These guys are the basic American lenders. They will grind through it

A continuing shakeout will eliminate weak players and allow the surviving institutions to gain size and strength. Consolidation will provide greater benefits to small banks because some may be able to double or triple in size

On the new regulatory bill

Would have a limited impact on small banks because they don’t invest in hedge funds or engage in proprietary trading, activities the legislation is designed to restrict. The overhaul will create uncertainty for larger banks without crippling their profits

On management in turnarounds

Ellison recalled that he once hesitated to tell Lynch to keep a bank stock in the portfolio because he didn’t like the company’s management. Lynch listened to Ellison and replied, “But do you think the company is getting better?” When Ellison said yes, Lynch decided they should hang on to the stock. “I learned a lesson,” Ellison said. “People matter. Profits matter more.”

On the economy

An economy that expands 2 percent to 3 percent a year will be enough to support an improving credit climate

Charting Banking VIII: more on construction and development loans

Some interesting data collected by for banks under $2 billion in assets: construction and development (C&D)  non-performing loans percentage by state. Let’s start with the worst offenders.

Nevada, Washington, Hawaii, District of Columbia, Idaho, Puerto Rico, Georgia, Illinois and Oregon all even worse than Florida and California that have saturated the media. Sure, they are smaller economies but I would not underestimate the economic importance of Georgia, Illinois and Washington. And if you run screens, cheap banks from these states pop up all over the place.

The information is not perfect: some banks loaned cross states and does not disclose how large a percentage of total loans was C&D. What I can tell you though, is that almost every potentially cheap Nevada, Washington, Hawaii, District of Columbia, Idaho, Puerto Rico, Georgia, Illinois and Oregon bank that I have analyzed had some big non-performing loan issues triggered by C&D loans. To reiterate, and I am sure it will not be last time I say this, construction and development loans are bank killers.

It is not difficult to see why. If 20% of your loans are C&D and 20% of them are  non performing, right there you have 4% of your loans non performing with some of the worse potential severity.  If you add home mortgage, helocs, CRE, consumer credit loans… there is not margin of safety buying a bank with more than 6% of non performing loans whatever its capital ratios, but I would raise the bar even higher if the bank has a large C&D percentage.

And when C&D are pervasive in a whole  region, things get much worse. Think Ireland. Banks desperately trying to sell their real estate owned from foreclosures while their competitors are doing the same, driving real estate prices lower and lower well below the replacement cost that in theory should have been the long term equilibrium. But in the short and medium term capital ratios suffer so banks do not lend making things even worse … if government does not intervene. A depression.

What about the well behaved, any surprises there?

Texas and New England? Home to some of the worst offenses in the 80s? For those who think that this crisis is completely new just read Peter Lynch’s “Beating the Street” and how he makes fun of New England bankers and warns about buying banks just because they reached new lows (how low can it go!):

How many people lost substantial amounts of investment capital when they  bought on the bad news coming out of the Bank of New England after the stock had already dropped from $40 to $20, or from $20 to $10, or from $10 to $5, or from $5 to $1, only to see it sink to zero and wipe out 100 percent of their investment – Peter Lynch

It is almost as if they  learned their lesson twenty years ago but I would not bet on it. And this is a good introduction to the next part of Charting Banking because we are going to review an indicator invented from the difficulties of Texan banks in the 80s that is used to anticipate those troubles: the Texas Ratio.

Insurance Sector Price to Book

While reviewing the presentation of a new reinsurance company, I run across some interesting data on historic price to book multiples for insurance companies.

In the context of also low banking multiples, it seems like the financials is one interesting place to look for ideas. There are several P&C insurance companies with good track records below 1x book value. But before getting too excited let me remind you the warnings about investing in banking and in financials in general:

  1. Black Box: you will never be 100% sure of its balance sheet quality
  2. Leverage: no perfect margin of safety
  3. Thin margins: usually no competitive advantage and bad performance pays
  4. Macro matters: you just can not ignore it. Deflation, inflation and interest rates have an impact
  5. Leadership matters: more than in any other sector, good management is crucial to control risk and allocate capital. This is not Coca Cola that can survive a series of bad CEOs

Part of the reason for the low insurance valuations is the soft pricing environment discussed at length in several articles by the StreetCapitalist and RationalWalk. Insurance is a cyclical business, where commercial pressures drive uneconomic pricing, that destroys capital, leading no the next hard market. As Peter Lynch mentions in his books, one way to invest in the sector is to anticipate these waves. Not an easy thing to do if you are not a card carrying member.

Let me also remind you the critical questions when using book value multiples in financials:

  1. How conservative is that book value?
  2. Is it improving?
  3. How are capital ratios and the need for value destroying new capital or a reorganization?

An excellent blog to read for an inside view of the sector is the now classic David Merkel’s Aleph blog. He posted recently an excellent analysis of reserve practices of several insurance companies that is tightly related to question #1. Very recommended.

Turnaround Cases: Premier Exhibitions Part 1 ($PRXI)

A great investment opportunity occurs when a marvellous business encounters a one-time, but solvable problem. You just need to know the business to recognize this – Warren Buffet

So after reviewing some situations where a turnaround was threatened by tough issues that were not completely on management’s control, we now move to situations where the core business is healthy but the performance has been compromised by solvable issues. This is usually the result of bad luck (it sometimes happens), internal issues brought upon themselves by incompetent leadership or by management’s inability to rise to a solvable new challenge.

What is the point of having a blog and end discussing examples with a strong consensus. Instead I am going to propose a controversial case: Premier Exhibitions (PRXI). You probably never heard that name before but you probably heard the names of its two exhibitions: Titanic and Bodies. Both are hit shows not only in the US but around the world and both continue to attract crowds. Bodies shows cadavers treated with a technical process that makes them viable for exhibition and Titanic shows pieces recovered from the wreckage. Someone appropriately used the adjective macabre to describe the situation however that is not necessarily bad. As Peter Lynch once wrote

Something that makes people shrug, or turn away in disgust is ideal – One Up on Wall Street

If you agree with that statement then Premier may be your kind of stock. This is a company well known for value investors since Mark Sellers, a respected hedge fund manager, is its majority shareholder. There are several articles on Premier’s good economics and the potential value of its Titanic assets so I am just going to make the introductions. Dear reader, here is Premier Exhibitions:

Most of these articles were written before Premier hit an earnings bump. That bump’s cause, consequence, solution and opportunity are going to be the topic of several posts, but as an appetizer let me show you the historic stock price:

Wow, that is what I call a rise and fall. You just have to go through Yahoo’s board to retrace the story and is really something. You can read how early adopters bought the story of the unrecognized Titanic assets, were joined later by growth investors that valued the successful new Bodies exhibition, how pricing got out of hand with momentum investors pumping pie-in-the-sky projections and the sudden collapse. Now it had gone full circle becoming a value stock again: I recommend you to check the Complete Growth Investor podcast on Premier and get their free report. This is indeed the story of an Icarus growth stock.

The collapse has wrongly been attributed to the 20/20’s attempt on character assassination of Bodies –that I still recommend to watch, also here is Premier’s response – and the settled investigation of the bodies’ origin. To the contrary, both were short term attendance boosts because as we know there is no such thing as bad publicity.

The reason for the collapse was simpler: an outsized and undisciplined organization built by an entrepreneurial one man rule seeking growth on too many fronts without the needed processes to manage that growth. This is a story repeated time and again that has been the subject of some best sellers like “Inside the Tornado” and “Build to Last”. I do not offer these books necessarily as testaments of good research but as witnesses of the topicality of the challenge.

All investing is risky and growth stocks have their particular set of challenges. Their stocks multiples can collapse fast when earnings or growth disappoints. And the probability of disappointing is higher than people think: these are some Bain and Co. estimates of success for growth initiatives


If this is not material for a good series, I do not know what is. It certainly has drama. In the next part we are going to address the story of Premier’s collapse and discuss if it is solvable.


The science and art of turnarounds: a personal view

Turnarounds seldom turn – Warren Buffett

Do not kid yourself, all turnarounds are risky. And that risk is seldom bounded because any margin of safety based on liquidation value can quickly erode in the process. Turnarounds are the ultimate value trap. Peter Lynch, who had a history of successful turnaround investments, said it best:

Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11. These aren’t slow growers, these are no growers. These aren’t cyclicals that rebound; these are potential fatalities – Peter Lynch, One Up on Wall Street

So why even take a look at turnarounds. Well, they have also some positive characteristics which can help to balance a portfolio and, if you are good at it, give it an extra kick:

  • Performance is less related to the general market: specially interesting after a 50%+ bull run
  • They have asymmetric returns, so when successful they can make up lost ground very quickly

The clue is to have a process to filter a thousand frogs to get to a prince. It has some echoes of venture capital investing.

Even Warren Buffett has invested in them. Always the riddle, while he makes clear cut statements about the dangers of turnarounds he is more pragmatic when opportunity arrives. The GEICO purchase in 1975, a period where good alternatives abounded, was undoubtedly a turnaround and a complicated one to boot.

I looked again at GEICO and was startled by what I saw after a few rule-of-thumb calculations about loss reserves. It was clear in a sixty-second examination that the company was far underreserved and the situation was getting worse –Warren Buffet, The Snowball

If you know anything about insurance, you know this a complex situation, even for a motor insurer with short tail risk. Buffett’s decision seems with traces of uncharacteristic sentimentalism. Hey, this was “the security I like best”. At the same time, GEICO was one of Buffett’s most successful investments and of course it was more than just sentimentalism:

This is risky. It could go completely out of business. But in insurance it’s very hard to get an edge, and they have an edge. If they got the right person in to run it, I think he could turn it around – Warren Buffett, The Snowball

In that simple paragraph Buffett narrows down the key issues on turnaround investing:

  • The Science: We are not looking for survivors that recover somewhat out of a recession only to fall again in the next one. We are looking for outstanding winners like IBM in 1992, not unrepentant alcoholics like GM in 1982, or 1992, or 2002 or 2008.
  • The Art: surviving depends on leadership, a good plan, momentum and luck. If you feel you lack the ability to read management and its progress you should probably avoid turnarounds.

I have read a lot of books about value investing. Not many of them even touch the issue of turnarounds. Probably because it is not considered really value investing.

On several postsI will try to give my personal view on this issue. I am not even sure what their content will be but I felt it was time to put some personal unstructured ideas in writing. And if in the process I can get feedback on particular investment ideas even better.

Voice from the Past: Lynch on Fannie and Freddie ($FRE, $FNM)

After realizing that one of the potential outcomes of this Freddie Mac preferred case is the possible conversion of the preferreds to equity, I decided to investigate how good was the GSEs business. I understand that many are skeptical of the GSEs’ future but I argue that you do not need to bet on their success. You just have to make sure that the prefereds are grossly undervalued relative to the common and do a market neutral pair trade. Word of advice before you try this at home. This is my first one and waited for years for a no brainier and still, I am  using puts on the short side to avoid nasty surprises.

While doing my research, I stumbled upon Peter Lynch that wrote a whole chapter on Fannie Mae in his book “Beating the Street”. Most value investors have a world view based on Buffett, Klarman and Graham. They have shaped my way of thinking too. However my hero in the 90s was Lynch. Yes, he was a little of a momentum investor but how well he played the auto, retail and financial sectors and his books have plenty of excellent advice. Here are some quotes rearranged and classified. Just swap the references to Fannie Mae for Freddie Mac and enjoy.


  • Every year since 1986, I‘ve recommended Fannie Mae to the Barron’s panel.
  • It’s no accident that there’s a snapshot of Fannie Mae headquarters alongside the family photographs on the memento shelf in my office
  • Maxwell was determined to put a stop to Fannie Mae’s wild swings…This he hope to accomplish in two ways: by putting an end to borrow short – lend long, by imitating Freddie Mac
  • Freddie Mac has stumbled onto the newfangled idea of packaging mortgages
  • Before mortgage-backed securities (MBS) came along, banks and S&Ls were stuck with owning thousands of little mortgages. It was hard to keep track of them, and it was hard to sell them in a pinch
  • There were two different businesses here: packaging mortgages and selling them, and originating mortgages and holding on to them.

Competitive Advantages

  • It occurred to me that Fannie Mae was like a bank, but also had major advantages over a bank. Banks had 2-3 percent overhead. Fannie Mae could pay its expenses on a .2 percent overhead
  • Thanks to its status a quasigovernmental agency, Fannie Mae could borrow money more cheaply than any bank, more cheaply than IBM or GM or thousands of other companies.
  • No bank, S&L, or other financial company in America could make a profit on a 1 percent spread
  • As long as people were paying on their mortgages, Fannie Mae would be the most lucrative business left on the planet

Credit Risk

  • A new fear crept in: not interest rates, but Texas. Crazy S&Ls down there had been lending money in the oil-patch boom. People in Houston who’d gotten mortgages with 5 percent down were leaving the keys in the door and walking away from their houses and their mortgages. Fannie Mae owned a lot of these mortgages
  • While banks like Citicorp were making it easier to get mortgages with little documentation -no-doc mortgages, low-doc mortgages, call-the-doc mortgages- Fannie Mae was making it harder. Fannie Mae did not want to repeat the Texas mistake. In that state, it was promoting the no-way-Jose mortgage
  • With fewer competitors buying and selling mortgages, the profit margins on loans had widened. This would boost Fannie Mae’s earnings.
  • Thirty-eight Fannie Mae employees were working in Houston alone to get rid of these houses. The company had to spend millions on foreclosure actions, and million more to cut the grass and paint the stoops and otherwise maintain the abandoned houses until buyers could be found.
  • What was the worst that could happen to it? A recession that turned into a depression? In that situation, interest rates would drop, and Fannie Mae would benefit by refinancing its debt at lower short-term rates
  • Even if new houses weren’t selling, the mortgage business grows. Old people would move out of old houses and new people would buy the old houses, and new mortgages would have to be written
  • I couldn’t imagine a better place to be invested in the twilight of civilization that Fannie Mae

Interest Rate Risk

  • Borrow short and lend long….When interest rates went up, the cost of borrowing increased, and Fannie Mae lost a lot of money
  • You can’t get very far by borrowing at 18 to make 9 (In 1981)
  • This one of those rare periods when a homeowner could say: “My house is OK, but my mortgage is beautiful” (the complete opposite of today)
  • Fannie Mae had begun to “match” its borrowing to its lending. Instead of borrowing short-term money at the cheapest rates, it was offering 3-, 5-, and 19-year bonds at higher rates.
  • Management now talked about “the old portfolio” and the “new portfolio”
  • Fannie Mae was reducing its interest rate risk by issuing callable debt. Callable debt gave Fannie Mae the right to buy back its bonds when such a move would be favorable to the company, especially when interest rates fell and it could borrow more cheaply.

The Stock Performance

  • When a company can earn back the price of its stock in one year, you’ve found a good deal
  • Was Fannie Mae an obvious winner? In hindsight, yes, but a company does not tell you to buy it. There is always something to worry about.
  • For a stock to do better than expected, the company has to be wildly underestimated
  • You have to know the story better than they do, and have faith in what you know I was comforted by the fact that whereas Fannie Mae’s foreclosure rate was still rising, its 90-day delinquencies were falling. Since delinquencies lead to foreclosures, this fall in the delinquency rate suggested that Fannie Mae had already seen the worst (this is the indicator to follow!)
  • The stock rose from $16 to $42, a two-and-a-half-bagger in one year. As so often happens in the stock market, several years’ worth of patience was rewarded in one.
  • I’m submitting this result to the Guinness Book of World Records: most money ever made by one mutual-fund group on one stock in the history of finance