Street Capitalist: Event Driven Value Investments

Price is what you pay, value is what you get. Those words aren’t mine, they belong to Warren Buffett. For now though, they remain incredibly relevant to the type of investment environment we’re in. With the collapse of Bear Stearns, many commentators took it upon themselves to proclaim that we live in a turbulent period where value can disappear in just a weekend.

This statement is faulty. Value and stock price are not the same thing. If that was the case, value investing would not exist. When Bear Stearns dropped 80%, it was the company’s stock price, not value, which plunged. Stock prices are just what market actors perceive value to be. Value investing works on the basis that what the market actors are perceiving is actually incorrect. This kind of rationale leads many value investors to become major contrarians, where I feel some problems are arising.

I think that by nature, many contrarians utilize a backward looking view at companies. Some funds like to call this “opportunistic” investing. What this boils down to is a hope that a company’s stock price will revert to its mean. But it is precisely this backwards looking perspective which enables investors to make catastrophic missteps. Sometimes the mean is wrong. Sometimes the mean was built on bad levees.

These global investment banks are mostly behemoths with intertwined banking, trading, and private wealth management divisions. Ultimately, easy credit has helped many of these firms soar over the last six years or so. Without easy credit, the foundation for the mean ceases to exist. The banking divisions may have a tougher time underwriting mergers as activity dries up, some trading divisions will undoubtedly suffer from volatile markets or strains in liquidity, and as write downs mount – PWM clients may flee. This can be detrimental to future earnings. Furthermore, many banks are announcing their write downs – these write downs slash book value.

If you were a clever contrarian, thinking you were buying X Financial for 0.5x book, and suddenly the company’s book value is slashed in half because of a write down, you’ll be getting it for 1x book. So, some of the obvious metrics for looking at financials are wrong and should be ignored during your valuation process. There is so much uncertainty in valuing some of these assets that there is a high likelihood for you to be incorrect. So far many sovereign wealth funds, hedge funds, and private equity firms have been hit rather hard by early capital infusion investments in these companies. It might be too early to tell, but I feel like a number of these players bet on a reversion to the mean – without anticipating what kind of impact the credit crisis may have on the future operations of these companies.

Underwriting standards are said to have dwindled in 2005, leading to an excess of loans to be made which helped fuel our real estate bubble. We will see a significant change in these standards which should negatively impact business. The same goes for home equity lines of credit or HELOCs, these were made during a period of rapidly appreciating real estate assets – many homeowners obtained HELOCs with the intention of refinancing as their home climbed in value. If home prices decline (which they have), you should see a decrease in HELOCs as well. This reduced activity will hurt most banks because most banks piled into the mortgage business.

As the pain grows, most financial companies will go through write downs and will need some kind of capital infusion. Usually these capital infusions lead to dilutions in earnings which are detrimental to small stockholders. Just look at Ambac (ABK). If the capital infusions aren’t enough, a “run” on the bank can occur which is even worse. Neither of these cases are pleasant for small investors, yet they are high probability events that you face with financials in the current environment.

I think what has happened is a lot of investors have associated falling prices with cheapness. The two seem like they should go together, but that is not the case. It is really essential for investors take the time to study the level 3 assets held by many of these financial companies, or for them to understand the negative impact that the credit crisis will have on business activities. With complex mark-to-market accounting and poor liquidity, valuing some of these assets becomes just a guess. A probabilistic view on the future of these companies based on their illiquid assets and impacted operations needs to be taken because a backwards view will only make you believe in non-existant value. Things aren’t just going to go back to how they were in 2006.

Some of Michael Lewis’ writings have been questionable as of late, but I feel like this quote is particularly important:

….If the market got the value of Bear Stearns so wrong, how can it possibly believe it knows even the approximate value of any Wall Street firm? And if it doesn’t, how can any responsible investor buy shares in a big Wall Street firm? ….

That’s why I’m steering clear of anything that makes me go long financials right now. If you look, you’ll find better companies that are undervalued in safer sectors (KHD looks interesting, especially after their recent earnings), I’d set my sights on these – after all, you should keep the preservation of capital at the forefront of all your investing.