Buy or Short the Bond Insurers?

Editor's note: The original version of this article incorrectly stated that Marty Whitman expected not to lose money on his positions even if the bond insurers were to go into liquidation. We regret the error. 

It has all the makings of a title fight: "Coming out of the blue corner, at 41 years of age, this well-known activist investor manages more than $6 billion at Pershing Square Capital Management: Bill 'The Whiz Kid' Aaaaaackmannnnn!"

"And out of the red corner, an 83-year-old expert in distressed situations, and manager of the $12 billion Third Avenue Value Fund: Marty 'The Dean' Wwwwwwwhitmannnnn!"

The stakes? Hundreds of millions of dollars riding on positions (long and short) in bond insurers MBIA (NYSE: MBI  ) and AMBAC (NYSE: ABK  ) .

Here's the background
Speaking at the Value Investors Congress in New York last November, Ackman stated his belief that the insurers' holding companies could be insolvent by the second quarter of 2008, and announced that he's shorted shares of both companies. As part of the new generation of superinvestors, Ackman is known for his brash tactics; he bid on Rockefeller Center before his 30th birthday.

Meanwhile, the plain-spoken Marty Whitman, who's been in the business since before Ackman was born, has built significant ownership positions in these companies, including an 11% stake in MBIA.

Too leveraged or well-capitalized?
What are their reasons? Ackman says the bond insurers don't deserve their AAA rating, that their business model is flawed, and that they are way overleveraged. Whitman, on the other hand, thinks the bond insurance business is fundamentally attractive; even in the event that the companies cease writing any new business and go into run-off, he doesn't expect to lose money on his positions. Both men agree that MBIA's bond insurance subsidiary needs to maintain a AAA rating if it is to stay in business.

As far as I know, the only one of the two who has commented on the other is Whitman, who wasn't above a little trash talk. "[Mr. Ackman] doesn't know much about insurance," Whitman said, "and, certainly, he doesn't know anything about restructuring secured debt."

Who will come out on top? I don't know -- it's even conceivable that both could end up winners on their positions, depending on how things play out and the timing of their exit. However, I'm more interested in the lessons this situation illustrates.

1. Value investors aren't lemmings.
Professional value investors strive to be rigorously independent-minded, and they do their own research. They're not interested in someone else's half-baked opinion or "surefire" tip. Instead, they collect data from primary sources, and formulate their own opinions based on the facts.

2. A shared approach doesn't necessarily lead to shared opinions.
Both Ackman and Whitman have been following MBIA since at least 2002. Even smart, experienced investors that share a common value investing philosophy can come to different conclusions regarding a specific situation they know well -- particularly if it's characterized by high uncertainty.

3. High-uncertainty situations are attractive.
They're often grossly misunderstood, and consequently, they represent some of the best opportunities for outsized gains, whether as a long or a short. One way to identify these situations involves looking at stocks that are popular with short sellers -- and AMBAC and MBIA are very popular with those folks.

The following stocks are in the top decile of Russell 1000 stocks ranked by short interest as a percentage of shares available for trading. Two of them -- USG and Best Buy -- are Motley Fool Inside Value recommendations.

52-week Range

Short Interest As a % of Float

USG (NYSE: USG  )

$30.20-$58.74

22.6%

Lennar (NYSE: LEN  )

$13.00-$56.54

23.5%

Best Buy (NYSE: BBY  )

$41.90-$53.90

18.9%

Bear Stearns (NYSE: BSC  )

$70.10-$172.61

15.9%

Whole Foods Market (Nasdaq: WFMI  )

$34.40-$53.65

12.6%

Source: Standard & Poor's Capital IQ.

4. Risk management is crucial.
In situations in which some of the risks may not be knowable, prudent risk management is warranted. As of Oct. 31, 2007, Marty Whitman's Third Avenue Fund had less than 4% of fund assets allocated to bond insurers. By mid-December, these positions had increased, but I estimate the sector still represents less than 5% of the portfolio. Keep in mind that Whitman, one of the great investors of our time, said he was doing a "very, very big number" in this area. Size your positions appropriately.

Once the outcome for bond insurers is known -- and it could take a couple of years before that happens -- this will be a fantastic case study for investors. Meanwhile, my colleagues and I at Motley Fool Inside Value will continue to look for easily understandable businesses that may be tainted by excessive fear or uncertainty.

To find out more about our approach, and see all our recommendations, sign up for a 30-day free trial -- there's no obligation to buy.

Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. Best Buy and USG are Inside Value recommendations. Best Buy and Whole Foods are Stock Advisor picks. Third Avenue Value is a Champion Funds recommendation. The Motley Fool has a disclosure policy.


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