Four notes for the evening: first, on Lehman Brothers: Deal Journal wrote a piece earlier this week on Lehman potentially selling their subsidiary Neuberger & Berman. I generally agreed with the piece, and wrote the following response:
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Be wary when managements sell their best/safest assets to stay alive. It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.
Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times. Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.
So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.
The same applies to Merrill regarding their stakes in Blackrock and Bloomberg. Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market. I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort. Merrill Lynch has more running room, but even they could face the same fate.
Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits. It failed when loan underwriting ceased to be done in any prudent way. Alt-A lending will return, but it is less likely that Indymac will see the light of day again. Whether in insurance or lending, underwriting is the key to long-term profits. Foolish lenders/insurers economize on expenses at the cost of losses.
Third, we have a possible deal that the US government may buy a convertible preferred equity stake in Fannie and Freddie. This comes on the heels of news that no access would be granted to the discount window, but this deal would include discount window access. (Ugh. Is it going to take a Dollar crisis to make the Fed realize that only the highest quality assets should be on the balance sheet of the Fed?)
Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer. My question is whether $15 billion is enough. It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?
Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.
As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety. I write this not to sneer at those who have messed this up, because I have done it as well. Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion. (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)
I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability. Many value managers have been hurt from an overallocation to credit-sensitive financials. They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?
Well, I have made that bet. Maybe I should not have owned as many insurers, but they should be fine in the long run. There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here. Look at companies that can survive moderate-to-severe downturns. If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.
David
I believe one thing that would have helped Bill Miller and other value investors is a better sell discipline. Bill seems to have this crazy idea that he can’t be wrong on the fundamentals or on the true value of the stocks he owns. Therefore as the stocks decline they become more attractive and he buys more all the way down.
To me its a warning sign when a value investor’s discipline does not leave room for being wrong on the value — if your discipline is tied to cheap then when can you ever intellectually justify selling a declining stock?
I am curious how you think about sell discipline — there is a brief mention of it in your 8 rules of investing but for the most part your focus appears to be on choosing wisely in the first place. I agree that is critical but you can’t always be right. Admitting mistakes before the losses get big is also important (Buffett’s first rule about losing money, which he means in a permanent sense).
Kyle
To your point on Lehman…
In April, Lehman created a CLO called Freedom. They sold a good amount of debt to the CLO but retained a few hundred million of interest. This would appear to reduce the size of their balance sheet without necessarily reducing their risk. Their interest is likely to be the first to suffer losses, although their losses are now capped at their exposure. This seems like a crummy way of reducing the size of one’s balance sheet.
http://scurvon.blogspot.com/2008/04/lehman-and-that-clo-thingy-dated-post.html
In May, they created a CLO called Thalia seemingly along the same lines.
http://scurvon.blogspot.com/2008/05/lehmans-new-clo.html
Saudi Arabia has already boosted its production by 300,000 barrels a day, or about 3 percent, to 9.45 million barrels a day last month. But that has had little impact on soaring prices. Oil futures in New York have gained more than 40 percent this year. They rose 2 percent to $134.62 a barrel before the meeting on Friday.
W fuill the market crash further?
David, I wouldn’t be so sanguine about insurers in general. The insurers have so far been able to avoid the subprime mess, but a lot of them are heaviliy into commerical mortgage loans. If the bursting credit bubble is spreading its virulence, I see no reason how the insurers can avoid write-offs on the commercial mortgage loans.
The other aspect of the insurers’ credit exposure is BBB corporates. As I’m sure you know, insurers get quite a heavy haircut owning below-investment grade bonds (naic class 3 or >3). Insurers, as a result of competitive pressure, invest in quite a bit of BBB bonds. BBB iis the lowest grade that gest NAIC class 2 rating. As the contagion spreads, there’d be quite a bit of downgrades coming in the BBB space. What this means is increasing capital strains as the bonds are downgrades. If the insurers have to raise capital in the current environment, that’d mean heavy dilution