Conventional wisdom erroneously holds that sheep are not the brightest of creatures. This bad impression stems from the common flocking behavior lambs display; they'll follow one another off a cliff, or trot head-on into busy traffic. Many investors are looking similarly wooly these days, following the crowd in writing off any company remotely connected to subprime lending.
Don't get me wrong -- investors are right to be cautious of the subprime mortgage sector. After all, unless you have Nostradamus on speed dial, you can't definitively say that the painful underperformance of Bear Stearns'
Learning from history
I'll spare my Foolish readers a long-winded rehash of the subprime debacle; it's already gotten enough press to make even Paris Hilton blush. In brief, companies such as HSBC
Let's step back a few years and look at another implosion reminiscent of this whole subprime mess: the Enron collapse. In the months following the energy giant's devastation, the market punished numerous other firms for their mere association with energy trading. While investors were right to shy away from debt-strapped stocks that derived significant revenue from trading, the market overreacted against several undeserving names in the general energy sector.
In 2002, TXU
But TXU enjoyed major differences from Enron, including conservative management and diversified operations in heavily regulated regions. As the energy industry reeled, largely because of the lingering Enron scandal, TXU got hammered in mid-October 2002, eventually trading for a measly $5 and change. Any investor savvy enough to buy in then would have earned a 10-bagger five years later.
A value opportunity
Similarly, a protracted housing slump and rising subprime defaults have contributed to continued "guilt by association" for several undeserving names in the real estate and lending businesses. Just as energy trading was mistaken for representing the energy industry as a whole, residential subprime is the misplaced face of real estate-related securities.
On one earnings call I recently observed, management's first slide was emblazoned with the words, "We have not one single dollar of subprime exposure." Yet if you looked at this company's share price, the market was punishing it as if subprime were its main business.
There's an added benefit to finding the babies thrown out with subprime's bathwater. While energy companies are harder to value, many of the stocks being dragged down by the subprime situation have more clearly defined business lines, with holdings and credit characteristics that are easier to assess.
The sky is indeed falling on companies heavily invested in residential subprime mortgage-backed securities. But the emotion that has gripped this sector presents an opportunity for patient investors. In the world of value investing, daring to stray from the rest of the flock is hard to do in the short term, especially if you're worried about getting sheared. But as TXU illustrates, a bit of independence can also increase the chance that your investment returns will stand out as well.
In my next article, we'll look for opportunities presented in the wake of the storm.
For more subprime Foolishness:
Fool contributor Rimmy Malhotra is a New York City-based money manager. He owns shares of Bank of America, an Income Investor pick, on behalf of his clients. He welcomes your feedback at firstname.lastname@example.org. The Fool's disclosure policy prefers cotton to wool.