Tom Brown: Is it a Bottom in Financial Stocks?

One never knows until long after the fact, of course, when stock prices reach the exact top or bottom of a given cycle. And, besides, trying to pick precise tops and bottoms always turns out to be a pointless, unprofitable game. So don't even try.

Have I hedged myself sufficiently? Good. For, as it happens, I believe July 15, 2008 will turn out to be as good a date as any to mark the end of the long, painful bear market financial stocks have endured for the past 18 months. And more to the point, it marks the beginning of the greatest financial stock bull market in our lifetime, one that will be much broader than the bull market that began in 1990.

Caution! The observation above is offered to investors only. If you can't stand the idea of seeing another, say, 20% on the downside, please stop reading at once and head back to CNBC.com. If you measure your investment horizon in weeks or months, please, for your own good and sanity, leave this site pronto.

But if you understand what drives stock prices, and have an investment time horizon of at least one year, feel free to keep reading. And if you are a patient value investor, get out your highlighter and get ready to buy stocks.

I believe the current valuations of scores—even hundreds—of financial companies are wildly out of whack with the companies' long-term earnings potential. The companies are extraordinarily undervalued, in my view. In the vast majority of cases, I can get comfortable with their potential future credit losses and (in the cases where they're needed) the possibility of future, dilutive capital issuance.

With the gap between current market values and business values so wide, investors shouldn't even worry too much whether July 15th was indeed rock bottom for the stocks. The margin for error today is so wide that any investor with at least a one-year horizon and a little analytical ability can pick huge winners. We wouldn't buy across the board, but the vast majority of the depressed financial stocks will survive, recover, and deliver high investment returns from these levels.

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Tom Brown: Matt Snowling’s Latest Attack on First Marblehead

But first, a little background. The default-recovery process in private student lending is very, very different than it is in other types of consumer lending. The process can take years. In auto lending, by contrast, when the borrower defaults, the car gets repossessed, and the lender might sell it a few weeks later. The recovery proceeds are in hand before you know it. In mortgage lending, the process takes a bit longer, but isn’t likely to last much more than 18 months.

But student lending doesn’t work that way. In student lending (which is unsecured, don’t forget), experience shows that material recoveries take place over several years following the default. You probably don’t have trouble figuring out why, either. For starters, many delinquent borrowers will eventually apply for a mortgage—the first ones might just four or five years after they graduate--and will want to get that student loan derogatory off their credit files in order to get their loan. Or a borrower’s earnings power will eventually rise (over four or five years, say) to the point where he can service the loan without much financial strain. For whatever reason, recoveries take place over many years. Remember, the loans are not dischargeable in bankruptcy, so there’s never a time when it’s not worth the lender’s time and effort to keep dunning.

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Tom Brown: Thoughts on FMD

FRANCHISE PLAYER: For years, the bears’ big complaint about First Marblehead has been that that the company doesn’t contribute anything of material value the student-loan origination process. It doesn’t lend (the bank partners do); it doesn’t service (third-party servicers do); it doesn’t guarantee (TERI does), and on and on. Eventually, therefore, Marblehead will be disintermediated by its partners and its business will disappear. Simple! To back up this line of thinking, critics pointed in instructive contrast to Sallie Mae, which originates a substantial portion of its business directly, without involvement of partners, and thus has its own solid, standalone franchise.

I happen to think that objection is nonsense, of course. Marblehead has considerable underwriting and product development expertise its competitors and partners can’t duplicate. If the company weren’t part of the lending process, its partners wouldn’t be able to originate student loans nearly as profitably as they do.

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Tom Brown: A Bear’s View of First Marblehead

I was pleased that Bubba was forthright enough to e-mail me, but was struck by how weak his objections to the company are. If this is what the Marblehead bears are left with by now, they're on shakier ground than I thought. Let’s go through Bubba’s points one at a time, and you’ll see what I mean:

1. The securitization market is currently closed.

Actually, the securitization markets aren’t closed. Just last week, NelNet completed a $1.5 billion deal. And Phoenix-based NextStudent is set to come to market next week with a $1.4 billion offering. Yes, the market has been disrupted and is challenging. That happens from time to time. But the disruption won’t last forever. It never does. In fact, I expect Marblehead will come to market with a deal of its own any day.

But even if the market were frozen solid, as Bubba seems to think, I still wouldn’t be too concerned. Granted, Bubba’s and my investment time horizons are different. I am a long-term investor and can wait these things out, while Bubba’s fund has a demonstrated record of being quite short-term oriented. A frozen market could be a disaster for Bubba. But unless the freeze lasts for years, Marblehead won’t have to change its business model an iota. As long as the company keeps facilitating loan volume at its current rapid (like, 40%-plus) rate at attractive spread to Treasuries, the company is creating a huge amount of economic value.

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Tom Brown: Defending First Marblehead

Yes, Marblehead recently received a subpoena from the New York A.G.’s office. From what I can tell, every company that’s involved in the student lending business has received a subpoena from the New York A.G.’s office. I understand the A.G. is looking into Marblehead’s GATE lending, which is a tiny (like, 2% of originations), marginally profitable part of its business that the company is in the process of winding down. The subpoena is completely immaterial; the only reason the company even disclosed it is that people in the Attorney General’s office insist on blabbing to the New York Times.

I understand why reporters start researching stories with a set of preconceived notions about what they’re going to find. That’s what I do when I look at companies! But when the facts don’t fit my initial expectations, I change my mind.

Why can’t New York Times reporters manage that? Eric Dash apparently spent months researching this story. He talked to members of the board, to former employees, to competitors, to me—to anyone who had anything of interest to say about the company. He clearly did not find anything incriminating. Is it too much to expect that the tone of his article match that fact? Instead, Dash piles insinuation on baseless allegation, and unfairly smears a company that’s actually doing a lot of good for student borrowers.

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Tom Brown: 2nd Part Interview with Tom Brown

Below is the second part of that interview.

Emil Lee: Can you give me your bull case for Montpelier Re?

Tom Brown: Montpelier Re is a reinsurance company with an above-average exposure in the areas with the greatest losses in 2004 and 2005. The market is overreacting to these unusual years. Coming out of that, there were a number of changes -- rating-agency changes -- which forced catastrophe-loss modelers to change. A lot of companies are scared and have reduced exposures. Also, primary insurers are looking to increase reinsurance coverage. So it's a very good pricing environment [for reinsurance]. For example, coming out of the heavy hurricane season of 2005, let's [hypothetically] say pricing was up 20% on Jan. 1, [and] by July it was up 30%. The question is: Where is pricing going to be in 2007? It looks like it'll be down a little bit. Also, attachment points are up, so the risk of loss goes down.

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Tom Brown: An Interview with Tom Brown

Tom Brown is the founder of the $550 million hedge fund Second Curve Capital, which specializes in financial-services companies. I once worked at one of America's largest funds, and ever since, I've been obsessed with all things alternative. From my experience, Tom Brown may be the best financial services analyst on the planet, and I doubt I'm alone in that opinion.

About six months ago, I decided to read every article in the archive of the Second Curve-run website bankstocks.com. It was almost like getting an MBA in finance. I wanted the Fool's readers to learn about Second Curve's methodologies and some of the companies in which the fund is interested. I called Tom Brown up for a phone interview; the notes in italics are my own commentary.

Question: I read some statistics on how you turned some initial capital from your father into a large sum. Can you provide me with details?

Tom Brown: My father got a lump sum contribution in 1984 of $130,000, which subsequently became $18 million by the early 2000s by investing only in financial stocks.

Brown calculated the annual average rate of return at roughly 40%.

Question: Why do you stick solely to financial-services companies?

Tom Brown: Well, financial-services businesses are in my circle of competence. I can try to grow that circle, but I just don't know other industries as well.

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Tom Brown: Citigroup’s Breakup: How About Plan B?

I’ve been harping for so long by now that Citigroup needs to be broken up that regular readers can likely recite my argument, chapter and verse, better than I can. Anyway, it boils down to this:

1. Citi’s various businesses (its commercial bank, investment bank, wealth management unit, and global consumer finance operation) would almost certainly grow faster on their own than they’re growing now as part of a big clunky conglomerate. Reason: smaller, focused companies, which are what the Citi progeny would be, are more effective competitors than mammoth generalists like Citi. If nothing else, they’d be more successful recruiting top talent and be simpler to manage.
2. The capital allocation synergies that Citi apologists point to in defending the status quo are largely a myth. The company is so large and unwieldy that even a highly competent CEO/capital allocator would have trouble deploying the company’s capital optimally across all its business. Citi’s management team is no one’s idea of a competent capital allocator, and is hopelessly inadequate to the task.
3. Citi’s current growth strategy, which involves such bright ideas as opening new retail branches in Boston and Philadelphia and buying a bank in Germany, is doomed to fail. The company has virtually no discernible sustainable competitive advantage in any area that it says it plans to expand.

Why not do partial IPOs of Citi’s various businesses?

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Tom Brown: First Marblehead, Not the Disaster Everyone Seems to Assume

Oh, and the company’s stock is lately trading at 9.7 times earnings for the year that ends in three weeks. That’s a 9.7 earnings multiple for a company that is expected to be growing at 31% annually for the next five years--without BofA and Chase. Also, don’t forget all the excess cash the company will be generating (both from earnings and as its residuals start to throw off cash) that can be used to pay dividends and buy back stock between now and 2012.

What was the problem, again?

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Tom Brown: Compucredit a Buy

From: Reuters.

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Tom Brown, who heads the $500 million hedge fund Second Curve Capital, said on that his best investment idea now is CompuCredit Corp., a subprime lender and credit card issuer.

Brown, who is an alumnus of Julian Richardson's Tiger Management hedge fund and who runs the Web site BankStocks.com, said CompuCredit is trading at six times estimates of 2008 earnings, and has $700 million of "excess liquidity" on its balance sheet, which it could use to make acquisitions or buy back stock.

Brown, who only invests in financial stocks, said Capital One Financial Corp. and First Marblehead Corp. are also among his top holdings. Brown said his holdings are giving his three funds "a great year," and added: "We're up over 40 percent in one of our funds."

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Tom Brown: Let the Wind Blow

Moral of story: despite widespread expectations to the contrary, the reinsurance industry seems set to earn very attractive returns in 2006 and beyond, under all but the most extreme scenarios. For an industry that’s under a death watch in certain quarters of Wall Street, that is very bullish news.

To read the complete article.

Excellent article by Tom Brown regarding reinsurers.

Happy learning,
Dah Hui Lau (David)