Value investors greet market with optimism

There was almost an unfurled sense of optimism on the United Financial’s conference call to advisors Thursday — a veiled sense of excitement that only value investors can express when they sense the bottom of a market collapse is near.

Indeed, opportunity was the key word being thrown out by Joe Canavan, the CEO of United Financial, as well as by a couple of portfolio managers who manage some of the asset pools for United.

“There are trillions of dollars in cash on the sidelines. This market is a very unusual time in history, but what that does is present a historic opportunity for investors,” he said. “When we hosted this call in September, October and November, we had a balanced to a negative bias, and today we’re going to have a balanced to positive bias. We believe a lot of the changes have positioned this market to be more positive in the near term.”

In fact, Canavan says some of the value managers affiliated in his company are quite comfortable now, deep trolling the beaten down sectors of the market — most notably financial services — and buying stocks that have seen their share price drop significantly.

“I’m going to say the average bear market is about 12 months, and we’re already beyond that. The average severity is about 30% and we’re north of 40%. I think that bodes well for us,” he said. “We’re looking at critical industry groups like financials, which I think are severely undervalued. Some of the companies we’re starting to look at are down between 70% and 90%. These are companies that are not going out of business. These are well capitalized, well run companies that we know in the next cycle should do very well.”

Daniel Bubis, president and chief investment officer of Winnipeg-based Tetrem Capital Management, manages the Optima Strategy Canadian Equity Value Pool. Bubis notes that Canada’s banks are likely the safest bets in financials. If they don’t offer any immediate upside on their stock prices, they are terrific dividend play for a low-interest environment.

The Big 5 banks may lose more money in the short run. Bubis notes that this has more to do with investors downgrading their earning expectations of these institutions rather than the more troublesome problem of having toxic assets on their balance sheets.

“Banks will continue to make money, continue to grow book values, but it’s going to be a slower grind in their ability to grow earnings. Those earnings may decline from where they came from. They had very high return on equity, upwards of 20% at their peak in 2007. We’re probably going down to some sort of sustainable level. It still remains to be seen where it’s going to settle,” he said. “I think book value is likely to grow, and I don’t think you’re going to trade down to it. In particular, there is very strong dividend yield. In most cases, they are up over 6%. Which is a lot different than what we had with credit crises in the early 1980s and 1990s, where there were higher interest rates. [That dividend] provides a lot of fundamental support.”

For investors with a bit of a higher risk penchant, Chris Marx, a senior portfolio manager at U.S.-based AllianceBernstein, says there are some great buying opportunities in U.S. financials. Unlike their Canadian counterparts, many of these stocks are now trading well below book value.

“In the case of Citigroup, they are trading at 40% of book value. JP Morgan, one of the strongest groups, is trading below book value. JP Morgan has put up tremendous reserves to absorb losses on the balance sheet,” Marx said. “We do have significant positions in financials. Our U.S. portfolios are just over 20%, roughly in line with the weightings of financials on the value benchmark.”

Marx implied that the risk priced into some of the share prices may be overshooting the downside, making them compelling buying opportunities.

“Morgan Stanley, for example, is a company that, even if you assume it goes back to a plain vanilla type of operation with leverage coming down from 20% to more like 12% like a traditional bank would operate, it’s still trading at only about four-to-five times earnings,” he said.

Credit remains tight. One of the strongest signs that a turnaround in financials may be coming is the fact that lending seems to be increasing — albeit at much higher spreads. Ultimately, Bubis argues, this is good for the financials.

“What we’re seeing is a bit of an adjustment process. Changes have occurred so abruptly, so painfully, that people have been shell-shocked and it’s taking time to adjust,” Bubis said. “Credit is coming back, but the banks are asking to be compensated — just like everybody else does — for what is a riskier environment. They want to be paid more to get a wider spread. One of the positives of this for the banking sector is that new loans that are being written look to be highly profitable, assuming that they get repaid.”

Marx said it’s one of the ironies of a market downturn that the thing most direly needed to get out is usually what got you there in the first place — which in this case is more unfettered credit and rising asset prices.

“We need more credit, more lending, assets rising. To the degree that the government can encourage some of that — I think that will be a good thing for all concerned,” he said.

One thing helping the outlook for equities is that lower energy prices are also helping to relieve pressure on the balance sheets of many North American companies. Bubis said a couple of months ago that it was reported that the drop in gasoline prices was the equivalent of injecting a $300 billion tax cut into the economy. With prices continuing to drop, he estimates that number is probably in the vicinity of $500 billion.

Eventually, he says, this will lead to demand starting to catch up to the current oversupply for oil. He expects we’re near that point right now, meaning it’s a historic buying opportunity to invest in oil and oil producers. Over the near term — three to four months — he says oil could drop as low as $30 a barrel.

“If barrels of oil go to $30 US, it will not stay there for very long. It could be $40 oil is at a bottoming process. I think it will be a pretty good long-term investment opportunity, ” he said. “For investors with three- to five-year time investment horizons, this [may be] a once-in-a-generation buying opportunity.”

(12/12/08)