Be greedy when others are fearful. In hindsight, anyone who picked up financial stocks back at the March lows now looks like a genius with nerves of steel. That's just what CheckList34, one of the top investors from our Motley Fool CAPS community of more than 140,000 investors, did, and he has seen his March portfolio buys quadruple in the past five months. We asked him to describe his strategy and to evaluate whether he still sees opportunity in financials.
TMF: Describe the opportunity you saw with financial companies earlier this year.
CheckList34: My strategy consisted of betting on companies that were suffering from mark-to-market trauma (insurers, business development companies, and certain banks) despite having relatively healthy balance sheets. For example, XL Capital
As I noted in my blog back in March, I thought I saw a once-in-a-lifetime opportunity to invest in companies that had this kind of share price depreciation while having:
- No delinquent debt payments
- Positive cash flow exceeding their market cap
- Price/book of around 0.05
- Annual dividends that exceed the current share over the past 10 years or more
For these companies, some (though not all) of the dramatic losses of the past few years were not actual losses but a function of market movements in mortgage-backed securities, corporate bonds, and the like.
TMF: How have you done on these investments?
CheckList34: So far, so good. I'm roughly 4 times my money from the March bottom (with roughly half of my portfolio devoted to this strategy in real life). I think there is still a ways to run for most of these companies.
But some have not turned out as well as others. American Capital
TMF: What have you learned? What worked, and what didn't?
CheckList34: As I dug deeper, I realized that my market-to-market trauma strategy wasn't exactly a direct arbitrage opportunity. For example, an insurer like XL takes a GAAP earnings loss from the markdowns, but it doesn't make a GAAP profit from the markups. Thus, current accounting standards permanently lower earnings (if a bond drops from $100 to $70 on the market, the insurer takes a $30 loss; if it later marks back up to $100, it does not record a $30 profit). However, book value does mark up. And there is still plenty of opportunity in seeing the book value of these companies appreciate.
Last quarter, basically all of my insurance holdings saw their GAAP book value rise substantially. HIG marked its tangible book value up from $6.8 billion to $12.2 billion. As a result, share prices have responded dramatically! XL marked its tangible book up from $5.2 billion to $6.5 billion, CNO from $1.6 billion to $2.4 billion, and GNW from $5.7 billion to $7.6 billion. More markups should be reported this quarter, as most markets have improved over the third quarter of 2009. Thus, whatever discount to book value these companies currently trade at should increase. Further movement upward in share price may result.
Of course, my strategy will be flawed if markets crash anew. Book value for these companies will crash along with them -- again. But I don't think we'll see every asset in freefall, like we saw last fall, again any time soon (if even in our lifetimes).
Another limitation of my strategy is that the bulk of the assets on these companies' balance sheets is in fiat currency -- dollars or euros or yen. Some is in equities, but the preponderance is in fiat currency. If we have severe inflation, the actual value of the companies whose assets are in something tangible (i.e., natural gas reserves, or equipment, or a commodity like coal) will remain worth roughly the same in absolute terms, adjusted for inflation. Thus, their "book value" will remain roughly constant in the fullness of time. However, for insurers with their assets in a fiat currency, their book value would remain, but in absolute terms it would drop.
A final limitation of my approach at present is that these stocks have already moved so dramatically. CNO is almost 20 times up from its bottom, GNW more than 10 times, HIG more than 6 times, XL more than 6 times, and so on.
TMF: How do you evaluate the strategy today? Should investors be looking to follow your playbook now?
CheckList34: It was absolutely the best play in early March, and I believe today it may still be a very good play -- I'm sticking with it for the time being. Insurers have historically traded above their tangible book value, and every insurer in my portfolio remains below, often dramatically below, its tangible book. I'm betting that in the fullness of time, the multiples will regress to the historical norm, and if book marks up further, that may mean that there is still considerable upside in these names.
But it's come so far already that it may be safe to say that the bulk of the gains have been made. That said, if GNW's book value is $22 per share, and it marks up to $26, I don't see why it can't double from here, provided it returns to profitability and starts adding to book value once again. It would still be trading under book value and under historical multiples even after another doubling!
Frankly, I think that today, a more diverse outlook on investing may be prudent. In early March, I thought overweighing this strategy was the right thing to do. Today, I still think some deep value exists in parts of the insurance and BDC space. And I think looking at book value (and for BDCs, future dividends) is the way to play it.
Just don't ignore the overall health of a business. For example, among the BDCs, MCG Capital
(To learn more about CheckList34's approach to investing, you can visit his CAPS member page.)
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