Sunday, June 24, 2007

*Updated- Unsinkable Junk

A new Economist article (free for everyone) gives another example of what I have been saying for some time- credit bubble. In housing, we've seen uneconomical loans being refinanced on the prayer that someone later down the road will do the same, which has had the effect of depressing the default rate. Corporations have also seen this, with debt being made to riskier companies. The result: "the default rate in 2006 was just 0.5%, the lowest since 1981; Mr Altman says the rate so far this year has been just 0.2%. That compares with a weighted average between 1971 and 2005 of 4.2%." The question isn't if the default rate will rise, but when and by how much.

I'm not the only one who is worried... Bill Gross seems to believe in this scenario as well.

Wednesday, June 20, 2007

Blog Performance Update

The following is an update on the performance of stocks I have closed out positions on. Current open positions are SFK Pulp, Bancinsurace, Fairfax Financial, The Brick Group, and Exchange Bank of Santa Rosa.

Closed-out positions:
1. AGIS (arbitrage opportunity)
Bought at .044 on 9/21/06
Sold at .0475 on 10/5/06
7.95% pre-tax return in 15 days.

2. Delta Financial
Bought at 10.89 on 1/27/07
Sold at 12.55 on 6/20/07
15.25% pre-tax return in 5 months.

Open Positions:
1. Bancinsurance
Bought at $5.80 on 9/17/2006
Today's price: $6.50
Return: 12.1%

2. SFK
Bought at $4.90 Can on 2/5/2007
Today's Price: 4.98 Can$
Dividends: $.20
Return: 5.7%

3. Fairfax Financial
Bought at $170.50 on 2/12/2007
Today's Price: $193.46
Return: 13.5%

4. Brick Group
Bought at $9.32 Can on 3/29/2007
Today's Price: $9.85 Can
Dividends: $.30 Can
Return: 8.9%

5. Exchange Bank of Santa Rosa
Bought at 135.00, today.
Return: ---

A Second Look at Delta Financial

I mentioned in the last article that I needed to take a second look at Delta Financial. After all, 5.1% of their loans were 90 days or more past due, while the allowance for loan losses was only .88%. From previous research, I had learned that in Delta recieved at best 50% of the principal balance back on foreclosed loans, which makes the current provision for losses seem low. So, I took a look at the delinquency history to put the situation in perspective.

90+ day delinquencies, from 1994 to present.

2.1%, 1.44, .99, .96, 1.62, 1.55, 2.11, ?, ?, ?, .85, 2.65, 5.1
Note: The ?'s are for data that is unavailable.

30+ day delinquencies, from 1994 to present.

11.44, 10.5, 8.4, 7.4, 8.5, 9.6, 12.6, ?, ?, ?, ?, ?, 10.5

We are able to see two important facts. One, the 90+ days delinquency rate today is double anything that has been seen over the last 12 years. Second, the 30+ delinquency numbers are in line with historic standards. I don't know exactly what to make of these, but I do find the former very disturbing. This is one reason I've kept Delta at such a small position. (<4%)>


Edit: As I'm looking through this on 8/12/07, I realized that a paragraph i wrote after this is not here, probably due to some error on my part. The paragraph describes my decision to sell, which is subsequently confirmed in the next post on the same date updating Blog performance. Regardless, im disappointed this final decision to sell had not shown up on this post, but this has been why Delta Financial has not continued to be shown on my Current Holdings list for this time. I apologize for any misunderstanding.

Sunday, June 17, 2007

A Comparison of Two Banks

I am going to show you some statistics for two different banks to demonstrate the importance of the criteria I have been talking about recently. The first is Wells Fargo, WFC. In a recent interview, Charlie Munger talked about "this company in an emerging market that was presented to Warren. His [Warren's] response was, 'I don't feel more comfortable buying that than I do of adding to Wells Fargo.' He was using that as his opportunity cost." What does Warren like so much about Wells Fargo?

89 billion checking deposits
134 billion cheap savings deposits (2.4%)
310 billion total deposits

20.7 billion non-interest expense
15.7 billion non-interest income
35 billion total revenue

1.12% nonaccrual loans (90+ days without payment) to total loans
1.24% allowance for loan losses

What makes Wells Fargo particularly phenomenal is that they earn so much of their revenue from non-interest income- mostly from asset management, credit cards, and insurance. These businesses have shown great growth and consistency. Meanwhile, the company still has a very solid deposit base, with 29% of deposits interest free and the rest very cheap. Finally, their asset quality is good and their allowance for loan losses is acceptable(not great).

The second company is Corus Bankshares, CORS. The numbers are much less exciting.

280 million checking deposits
8.3 billion high interest deposits (5.01%)

66 million non-interest expense
19 million non-interest income
760 million revenue

5.09% nonperforming loans to total loans
1.3% allowance for loan losses

Everything about Corus stands out as bad. They have a terrible deposit base with a very high cost. Non-interest income is an inconsequential part of total revenue. And their allowance for loan losses seems terribly weak.

There are a couple of important things to take from this demonstration. First is that Wells Fargo is much more than just a bank, and maybe conventional valuation will understate its many positive qualitative factors. Second, it appears Corus is in trouble. In a business where equity to assets is usually near 10%, any weakness in loan allowances can quickly wipe away equity, and at this point that scenario seems plausible. Finally, this exercise threw up a red flag for one of my own holdings, Delta Financial. Delta had 5.1% of their loans nonperforming last quarter, compared to an allowance of only .88%. Although most of these loans are securitized and have no recourse to Delta, the company can still be hit very hard by a large increase in defaults. Something to look into...

Monday, June 11, 2007

Analyzing Banks, Part II

The list of PICO holdings provided many examples of investments in banks. Through reverse-engineering, I was able to get a better understanding of their bank investing philosophy. In this article, we will focus on two PICO investments, Exchange bank of Santa Rosa (EXSR) and Farmers and Merchants Bank of Long Beach (FMBL). Between the two of them, we can see the important criteria in analyzing banks.

Deposit base
One of the first things that stands out in all of PICO's bank stocks is their high quality of deposits. EXSR has 400 million checking deposits out of its 1.38 billion total deposits. FMBL has 770 million checking out of 2 billion total deposits. Most banks can only dream of these deposit mixes. Checking deposits are non-interest bearing and less competitive- people have few reasons to switch checking accounts and it is usually not worth the hassle. Market share can be an important factor in attracting higher quality deposits; EXSR is currently number one in its county.

Asset Quality
EXSR earns 7.7% on its loans. Judging by non-performing loans, EXSR seems to have good asset quality. Non-performing loans over total loans were .29% last year. Going back to 2001(the earliest I can find), the figure was at .15%. This compares with their allowance for loan losses of 1.6%.

Expense Ratio
Companies that can keep their expenses low have an advantage in deposit competition. My measure of expense ratio is (non-interest expense - non-interest income) / net interest income. EXSR has a respectable 51%. FMBL has an exceptionally low 31.5%. I'm not positive this calculation is the best way to measure it, but the important thing to take away is that FMBL has been able to run its business much more efficiently than most banks today.

Generally. a well-capitalized bank has a ratio of equity to assets of 1:10. A lower ratio means undercapitalization, and a higher ratio means the company has excess capital. EXSR has 128 million in equity for 1.5 billion in assets- it is slightly undercapitalized. FMBL, on the other hand, has 650 million in equity for 3 billion in assets. This is highly overcapitalized, and makes the company's return on equity look weak. (This is why when screening for banks, you should focus on Return on Assets, with greater than 1.3% generally being a very well-run bank) The company can dividend out 350 million and still easily be considered well-capitalized.

PICO must have been foaming at the mouth when they bought FMBL shares at a market cap of 550 million. The company could dividend out 350 million and leave a security with an adjusted 17.5% yield on a best-of-breed bank. Trading at over 1 billion today, the valuation for FMBL is much less compelling.

EXSR does not have excess equity it could dividend out, but the company does currently trade at only 10x earnings. This is cheap for a high quality bank, especially when compared to the valuations of other banks. But is it cheap on an absolute basis?

Additional Write-Up on 8/9/07

Wednesday, June 06, 2007

A List of Research Ideas from PICO:

A list of holdings from a successful "deep Ben Graham" investor is always a good place to look for research ideas. Through some maneuvering, I was able to get the list of holdings for the insurance subsidiary of PICO Holdings, a value-focused public company (Thanks to the Cheap Stocks blog for the idea). I filtered through the holdings and made a list below of all the ideas that were trading near the purchase price at 12/31/06. These are all small companies. Finding shares in many of these companies is very difficult, and information is even more illusive. The ideas in bold are transparent and relatively liquid.

JG Boswell Company
Cloverleaf Kennel Club 'A'
Extra Space Storage
Hanover Foods Corporation
Laaco Ltd
Merchanges National Properties
Mortgage Oil Corporation
Sadlier (William H)
Stonecutter Mills Corp Class B
Western Areas Ltd.
Bank of Utica
Beverly Hills Bancorp
Exchange Bank of Santa Rosa
First of Long Island Corp
Mechanics Bank of Richmond

Tuesday, June 05, 2007

A Checklist for Investing in Banks:

Albert Einstein said to "make everything as simple as possible, but not simpler." When it comes to analyzing banks, simple as possible is definetely not easy. By all means, banking is a marginal business, but finding out replacement value is tricky. Relying on traditional metrics such as Price to Book and Price to Earnings can get you in a lot of trouble, as I found out the hard way early in my investing career. Using just these ratios would be oversimplifying.

All banks are not equal. There are many ways a bank can add value that are not readily identifiable on a balance sheet.

Source of Funds: Analyzing the source of funds for a bank is probably one of the most important things that you must do. There are a few things you should be looking for. The most important is the cost of funds- the lower, the better. But do not look just at the cost, but the source behind it as well. For example, in 2001, banks could borrow all they wanted at 1% from the Federal Reserve, but flash forward to today and that borrowing would now cost 5.5%. This just shows how some funding sources are more susceptible to interest rate changes. Money market accounts are also very competitive, and savings are usually as well. The golden egg of sources are checking accounts, because they cost no interest and will probably stay that way long into the future. You also want to look at deposit growth. Over a long period of time, has this company been able to grow its "good" deposits(checking, low savings, etc.)?

Assets and Quality: Analyzing assets is a mess. Some companies choose to only invest in government and state municipality bonds, which are essentially risk free but have a low interest rate. Most banks though originate their own loans in order to earn a higher interest. You must not be fooled into complacency however. Some banks may seem like they are squeezing out excess interest returns, but it is only after it is too late that you realize these loans might also be riskier (Think what might happen to most banks' incomes if house prices were to fall 10%). Analyzing non-performing loans and charge-offs over a long period of time is a good way to figure out whether a bank is actually adding value on the origination side of the business.

Non-Interest Income: Finally, there is non-interest income- the more of it, the better. It is usually less dependent on interest rates and the economy, and therefore adds stability to the business. Wells Fargo's non-interest income almost equals its non-interest expenses. But a majority of banks would be lucky to have even 10% of non-interest income to expense. Also, some of this business might have superior growth prospects or other competitive advantages that should be looked into. Read the VIC on Meta Financial for an example.

I am definetely no expert on analyzing banking institutions. But if I was considering investing in one, these checks would be the least I would do.

Sunday, June 03, 2007

FPA Capital Understands:

The title says it all. FPA Capital's 2006 annual report highlights many of the points this blog has been making for some time. The market is underpricing the risks of credit contraction and it's fallout on the economy and market valuations. As a result Mr. Rodriguez has 39% of his fund's assets sitting in cash. In addition, Rodriguez mentions one new investment holding in Atwood Oceanics (ATW). The thesis, which he spells out in the report, focuses on the fact that Atwood is trading at 70% of replacement value and 11 times earnings, making it a great example of true marginal company investing. I plan on analyzing more on FPA Capital and its holdings.

Friday, June 01, 2007

The Marginal Investing Framework Self-Test:

I wanted to do a quick overview to show how my portfolio holds up to my marginal company framework.

Fairfax Financial (FFH)
The Industry: Insurance. Barriers to Entry: Capital.
The Price: when I purchased Fairfax, the company was trading at approximately 70% of book value.
Qualitative Aspects: Fairfax has one of the most astute value investing teams around, with an amazing track record to match. In an industry where most participants break even at underwriting, the investment side of the business can be critical to success.

Bancinsurance (BCIS)
The Industry: Insurance. Barriers to Entry: Capital.
The Price: Bancinsurance is currently trading at 85% of book value.
Qualitative Aspects: Bancinsurance is a microcap company that serves a small niche market, and it has a history of generating very profitable underwriting income.

SFK Pulp Fund (SFK-UN.TO)
The Industry: Pulp. Barriers to Entry: Capital.
The Price: At an enterprise value of 600 million, SFK is trading below the replacement cost of their businesses, which i calculate to be 750 to 850 million.
Qualitative Aspects: A globally growing industry protected by the limited nature of softwood fibers. The company has one of the lowest manufacturing costs in the business and can benefit greatly from a rationalization of fibre prices in the Quebec region. Finally, the company has a very great management team and does not have to pay taxes until 2011.

Delta Financial (DFC)
The Industry: Subprime Mortgage Origination. Barriers to Entry: Capital.
The Price: The price paid for Delta was in excess of the 150 million in equity of the company. However, this understates the income the company expects to generate from its 7 billion securitized mortgage portfolio. When you look at the fair value of this portfolio, which should approximate the economic reality behind the present value of this portfolio, the "true" equity is approximately 350 million.
Qualitative Aspects: One of the only subprime originators that maintained its strict quality standards and avoided the loan volume frenzy of its peers.

I left out Brick because I have treated it as a quality company and hence I am valuing it based on earnings power instead of replacement cost. It is interesting to note however, that many of my most successful past holdings, such as Posco, Sino-Forest, and KHDH, were trading at "marginal investing" prices while still having some respectable qualitative aspects to them. Conversely, Most of my losing investments have occured when I overestimated the quality of a company and paid an exuberant price. So, I should probably look over my investment in Brick one more time to see if I am not making this mistake again. I think the message is that it is much more difficult to understand quality than value, and that the growth of a value investor involves a sharpened ability to assess the qualitative merits of a company. Until that ultimate stage is reached, it is best to look for companies trading at a "marginal investing" prices and to treat most qualitative aspects as just potential bonuses.