Thursday, January 17, 2008

Buy the Financials - really? A contrarian view of a contrarian.

Doug Kass on Monday wrote a column in where he recommended buying Financials. -"Buy the Financials. Yes, Buy"- This repetition reads like a self insurance on the part of Mr. Kass and of course his readers. In the past Mr. Kass was about as strong a perma-bear as you can get. His view on the economy, interest rates and Wall Street's unhealthy excesses ranks second only to the likes of Nouriel Roubini. To be fair he mentioned in his column that he still is in the recession camp, which he believes will be "deeper and longer than most expect."

To understand one has to analyse why this change of heart towards the Financials, a sector that has been and still is in the eye of the current storm on Wall Street. Besides mentioning the easing of the seized-up credit markets, looming government intervention, and replenishing the capital base of major financial institutions among other arguments it becomes clear that Mr. Kass is a contrarian by nature.

He mentioned two people who obviously influenced him in his early days in the investment business. This is the quintessential contrarian view:

"Buy when the factory doors are padlocked; sell (or short) when the rate of earnings growth is phenomenal. That growth will not prove to be sustainable."
-- Roy Nueberger, Neuberger & Berman (told to me when I was a young one back in the early 1980s)
Someone less famous than Roy, but closer to my heart, Grandma Koufax, used to put it this way, "Dougie, buy/short on your analysis, sell/cover on the news."

Another reason for this change of heart is valuation. In other words the Financials really do look cheap right now given their historical averages, but buying on the cheap does not necessarily imply profitability. Since he is still forecasting a recession he sees it as a hedge against his "economic blueprint".

My view has been clear -- namely, that the recession will be deeper and longer than most expect, but I could be wrong. And a portion of every portfolio should be viewed as a hedge against one's economic blueprint.

Where I do not agree is his view on the health of the business franchise in general, which I would characterize as benign if not borderline complacent. He shows symptoms of somebody who has lost sight of the forest because of the many trees.

Business franchises are intact. While principal activity will no doubt be curtailed, financial companies' agency businesses -- including underwriting, merger and acquisitions, asset management, retail brokerage, etc. -- are intact and will remain so as the cycle runs its course again. Indeed, one can make the argument that the larger, more established and better capitalized entities will gain market share at the expense of its competitors.

While some of this is still true (underwriting, merger, acquisitions, asset management, retail brokerage will not entirely go away), the underlying bread and butter of this business will be thinly spread to say the least if not completely disappear. I am of course thinking of the structured finance part that has been at the center of the business for the last twenty years and is now its main culprit. SIVs, off shore balance sheets in short what has been dubbed the "shadow banking system" is a thing of the past and will not return for a very, very long time. In addition structuring credit into CDOs, CLOs, CDOs of CDOs and the like will be permanently curtailed. All the things that fed the inexhaustible beast that used to be Wall Street are no more. Mr. Kass is right to suggest that the business franchise is still intact at this point but it is shaken in its foundation and this in my opinion is not entirely realized in the investment community.

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