• Financial & Investment Management Group
  • Tuesday, January 06, 2009

Beauty and the Beast

by Suzanne Stepan
Posted August 11, 2008
FIM Group
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Volatile markets, like those we are currently experiencing, can be beastly for the typical investor. Emotions trump reason, and stock and bond positions are liquidated with a "sell now, ask questions later" mindset. Cash becomes king, and any pledge to follow a long-term investment horizon is thrown out the window. Losses are locked in and made permanent while, in many cases, subsequent entry back into stocks and bonds will only occur long after things have normalized (and, of course, become much more expensive).

For FIM Group, on the contrary, volatile markets have a much more underappreciated beauty. Stocks and bonds sold by the masses at distressed prices become the seeds for our long-term portfolio returns. Our advantages are a sufficient time horizon and the ability to sift through market fear and decisively buy when stocks and bonds are offered at the kinds of terrific bargains we are seeing today.

"All the problems we have in the world today were generated by one type of thinking, and you do not solve those problems by using the same type of thinking."
~ Albert Einstein

One rather controversial area where we see tremendous bargains is that of financials. Financial sector share prices, as shown in the chart below, have been decimated to levels not seen in nearly six years. Our team has been bargain shopping in the midst of this selloff, and one area of particular focus has been the preferred stocks of a broad range of domestic financial firms.

Preferred stocks pay a fixed dividend and have a claim to the assets of a corporation ahead of common stockholders in event of liquidation. Our strategy with these preferred stocks is to avoid concentrating on any one firm, and instead build a basket of positions that we judge to be selling considerably below fair value. We look beyond simply the allure of double–digit dividend yields and focus on positions we believe to be sufficiently capitalized to weather the current financial sector storm. Purchases are made only when we expect to generate a minimum total return (dividends and capital appreciation) of 30% over a two-year time horizon. While there is the possibility that the economy may slow down even further from its current state, the market has seemingly priced in an apocalyptic catastrophe for these preferred securities. We acknowledge that a second round of capital raising and dilutive risks exists, but these possibilities appear to be more than sufficiently pre-priced into the preferred basket we have assembled.

Figure 1

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The basket approach of owning preferred stocks should yield sufficient total return even in the extreme case that 10% of its constituents go to zero. As mentioned above, we target a minimum two–year total return of 30% for each of the preferred stocks in our basket. Even if 10% of the basket gets clobbered and plummets completely (total loss), our basket is expected to still make a respectable 17% total return. Rest assured, our FIM Group team is not betting the farm on these preferred securities to outperform. We are incorporating the basket approach as only one component of our overall portfolios, where we have plenty of non-financial exposure.

In addition to limiting issuer risk by diversifying company exposures, our preferred stock basket is also diversified among financial services sub-sectors. Our holdings of insurers, banks, agencies and REITs (real estate investment trusts) each face different degrees of exposure to write-downs and capital adequacy issues. Market participants have not sorted through the details and in turn have chosen to indiscriminately lump them all together into a big clump of fear that has driven prices to unprecedented levels. It is our belief that both the insurers and the REITs for the securities that make up our basket are more than adequately capitalized, while the banks’ and agencies’ pricing has already been discounted for significant future capital raises.

Our team views each of our preferred holdings as longer–term investments with the possibility of significant short-term volatility. Because of this, we have compensated in some of our strategies by trimming other securities to keep overall expected portfolio volatility within acceptable parameters. In these cases, we sell those investments we view to be equally as volatile but with less total return potential to the preferred basket.

Market volatility can be quite beastly, and that has certainly been witnessed in the stocks and bonds of the financial sector. Our team sees underappreciated beauty in financial sector preferred stocks, and we are not afraid to take advantage of bargain sale prices as others try to perfectly time a bottom. We have been around long enough to know that such timing is rarely achieved, and that when the market offers prices at deep discounts, you better seize them because they rarely last.

 
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