The Peridot Capitalist

How Low Can We Go?

2008-10-10T09:18:00.003-04:00

There is no right answer, since we have no idea ahead of time, but looking at the biggest S&P 500 declines over the last 35 years can shed some light on what would be typical for a deep decline. Some pretty interesting similarities here. I will update this chart as times goes on.

History Lesson & Bear Market Advice

2008-10-08T08:36:00.002-04:00

History tends to repeat itself. The economy and the stock market are no different. We have had, and will continue to have, economic expansions followed by recessions. To give you an idea of what to expect, consider the last recession.

It was the result of another bubble bursting (in Silicon Valley, not housing). In 2 1/2 years (early 2000 through late 2002) the S&P 500 fell by 50.5%. Investors felt massive pain and many took dramatic action by getting out of the market. That was the right emotional decision in their minds at the time (because they didn't want to take any more pain) but it backfired financially.

After a 2 1/2 year bear market, the S&P 500 bottomed in October 2002 and rose by 105.1% over the next 5 years. Those investors who stuck with the market and even added to their investments as prices dropped reaped huge rewards. Those who exited the market out of fear missed out.

With the market down more than 35% in the last year, what should investors do now? For the answer all we need to do is look at history. About 97% of all five year periods have seen the stock market go up, as have nearly 100% of all 10-year periods. If you are a long term investor (5 year time horizon or more by my standards) the numbers imply you should stay in the market.

You may have noticed that Warren Buffett has been very active in the market in recent weeks, investing billions of dollars. Is he crazy? No, he simply knows that when prices drop significantly there are bargains to be had. Future stock price returns are going to be higher during bear markets than bull markets because prices are lower. It isn't any different from buying a house, a car, or a cart of groceries. When things go on sale, we should buy more of them. Have you ever been to the store, seen your favorite cereal on sale, and bought a couple extra boxes than normal because of the price? I know I have.

Stock investing shouldn't be any different than grocery buying. It is true that it all sounds so simple, but isn't because emotions and psychology come into play more with stocks. Warren Buffett has the perfect temperament for the market, so he can step in and buy when everyone else is selling. His famous quote is "be greedy when others are fearful and fearful when others are greedy" and he is acting on that principle through all of this.

It is not an easy thing to do, though. Most people want to get out of stocks right now, not sit tight or buy more. That is what their emotions are telling them to do. Unfortunately, it is not the right decision to make for an investor who has the time to wait things out for several years.

I will conclude with a story. During the first week of October 2002 I wrote a letter and sent it out to about three dozen friends and family members. I explained that the stock market was very depressed but that there were tremendous investment opportunities out there. I made the case that allocating money with Peridot Capital at that time would likely prove very profitable over the coming years.

Guess how many people invested new money with me? None. The responses were predictable, although I had hoped some would take me up on my offer. Many recipients simply ignored the letter completely. Some responded by telling me that they had sworn off the market after they had lost so much. One declined my offer by explaining "As you know, this is not the easiest environment to lure potential investors." Very true, but ironically, it was the perfect time to do so.

A week after I sent out that letter, the S&P 500 index bottomed out at 768.63 on October 10, 2002. Over the next five years the market more than doubled and reached an all-time high of 1,576.09 on October 11, 2007.

So my bear market advice in as few words as possible would be:

1) If you have a 5-10 year investment time horizon, or longer, do not sell your stocks simply because prices have fallen significantly and it is scary to watch the daily market swings and read the dire news headlines.

2) If you have the financial means, and are comfortable doing so, adding to your investments during times like these will most likely prove very profitable as long as you can take a long term view on the investment.

3) Don't pay attention to the daily market volatility and headlines if you don't have to. If you are investing for 5 or 10 years, who cares what the market does today, this week, or this month? It's irrelevant. Warren Buffett often says that he wouldn't care if the market shut down for a few years and reopened because he is confident in the long term prospects of the stocks he owns.

If only we could make that happen in times like these. It would ease the short term pain and also ensure long term gain.

After Dropping Out, Wells Fargo Reconsiders & Outbids Citi for Wachovia

2008-10-03T09:30:00.000-04:00

As was widely reported, Citigroup (C) and Wells Fargo (WFC) were the two top bidders for Wachovia (WB). After Wells dropped out, Citi got some help from the FDIC and a sweetheart deal. For about $2 billion in stock they landed Wachovia's banking operations. Evidently, Wells Fargo management was pretty stunned at the deal Citi got and decided it could do better and still not overpay. Wells will now buy the entire company for $15 billion in stock, without any assistance from the government.

This a big deal for Wells Fargo. Despite heavy exposure to mortgages in the most problematic states in the U.S. (notably California, where of course Wachovia has a huge stake), Wells has weathered the storm well so far as their underwriting standards have proven tighter than most competitors. Wells has made money every quarter since this crisis began. Now they are issuing $20 billion in new stock (nearly 20% dilution to current shareholders) to pay for this deal and raise a little extra capital.

Investors clearly think it is a great deal for Wells, as the stock is trading up 8%. As with most of these bank deals, the long term benefits for strong deposit institutions will likely far exceed the short term losses incurred by taking on even more bad mortgage debt. The trend continues... the strong are getting even stronger as the weak die off. The problem, of course, might be that we wind up with a few even larger big banks that are perceived as "too big to fail."

Full Disclosure: No positions in the companies mentioned at the time of writing, but positions may change at any time

Buffett Adds $3B of GE Preferreds, Still Takes No Equity Market Risk

2008-10-01T16:10:00.001-04:00

Warren Buffett is stepping up to the plate again, buying $3 billion in 10% preferred stock from General Electric (GE), after adding $5 billion of Goldman Sachs (GS) preferred just days ago. Many are focusing on the confidence factor the Buffett moves suggest, which I agree with to a large extent. However, keep in mind that this second deal is just like the first in that he is not taking on any equity market risk by purchasing preferred stock. As long as these firms stay afloat, Buffett can't lose a dime, regardless of where the common shares trade in the future.

Full Disclosure: Peridot was long shares of GE at the time of writing, but holdings can change at any time

Nixing Mark-to-Market Accounting Is Not The Solution

2008-09-30T14:53:00.000-04:00

I am a little confused. How will removing the mark-to-market accounting rule, an idea that is rapidly gaining traction, help solve the problem? If balance sheets are not prepared with market prices, it will allow companies to arbitrarily assign a price to the illiquid assets it holds. What kind of price are they going to select? Obviously, a high one!

To me, this will just lend less credibility to bank balance sheets because investors will assume the banks are choosing artificially high prices for the assets they get to assign values to. Will sovereign wealth funds, private equity funds, and hedge funds all of the sudden start to offer new capital injections into firms that are doing this? I highly doubt it.

One reason why WaMu, Wachovia, and Lehman Brothers went under was because nobody trusted their balance sheets enough to invest in them. Marking up those toxic assets arbitrarily would hardly result in more confidence than there is today.

Full Disclosure: No position in any of the companies mentioned at the time of writing

An Alternative Bailout Plan

2008-09-30T13:07:00.000-04:00

Now that both sides of the U.S. House of Representatives cannot agree on Hank Paulson's $700 billion TARP package, the need for an alternative idea is clear. One of the ideas I have heard sounds pretty interesting to me.

Essentially, rather than buying $700 billion worth of mortgage-backed securities, the plan would be to have the government issue insurance on them and guarantee the holders against realized losses. How is this any better than the current plan? From what I can tell, in at least two ways.

First, it would cost far less to insure mortgages than it would to buy them outright, so the taxpayer would save money versus the current plan. Many people believe the current prices these bonds are fetching (if trades occur at all) are not reasonably reflecting the ultimate losses from the mortgages underlying the securities. If that is true, the losses that the U.S. would insure against would be far less than the current marks on these mortgages are predicting.

Second, and perhaps more importantly, if we woke up tomorrow and these mortgages were insured by the U.S. government, there is a very good chance that demand for them would increase significantly. All of the sudden a market for these securities would not only exist (essentially one does not now), but prices would likely rise and the banks could reverse some of their mark-to-market losses and write-up the value of their assets. With more clarity on the value of these assets, even more capital raising would occur in the banking sector.

So, what do you think? Would such an idea convert some of the naysayers of the current plan?

Witnessing History

2008-09-29T16:28:00.001-04:00

Can you recall the last time the Dow fell 777 points in a single day? Well, it never has, until today. This post will be brief. I am going to forget about the market and focus instead on the Ravens/Steelers game tonight (I am from Baltimore, but moved to Pittsburgh earlier this year) to try and take my mind off what happened in Congress today. In coming days we will likely see another bill come up for a vote, perhaps better, perhaps worse, than the current one. The Republicans will vote for it and hopefully we can make back much of today's loss in relatively short order. Hopefully people will begin to realize that this kind of bill does far more than pad the wallets of Wall Street (heck, 40% of the big 5 firms have gone belly up already). The banks we all hold our money with are not Wall Street. Rather, they are the lifeblood of Main Street.

The Strong Banks Survive, Get Even Stronger

2008-09-29T08:58:00.000-04:00

It appears the FDIC has decided that in order to protect taxpayers and customers of the weaker banking institutions, it needs to coordinate private deals to boost confidence and limit the government's deposit insurance losses. So far they are doing a pretty good job given the current turmoil in the banking industry.

So who are the winners and losers? Well, it's not rocket science. Poorly run banks are paying the price and the strong banks are getting really sweet deals to take over deposit bases, bank branches, ATM networks, etc for pennies on the dollar or are simply gaining market share as customers find new banks to use.

As for investment strategy, those people who have avoided the bombshells and focused their financial services allocations on those perceived as the stronger players have done relatively well if their analysis proved accurate.

From Peridot Capital's perspective, I have thus far avoided the disasters (knock on wood). Rather than avoiding banks altogether, however, Peridot is invested in four institutions with strong deposit bases and manageable bad loan exposures. I have mentioned all of these names on the blog over the last couple of years, but below is a recap of the banks that Peridot owns along with their stock performance in the current quarter (Q3 2008):

*Bank of America (BAC) +57%
*Capital One Financial (COF) +45%
*PNC Financial (PNC) +34%
*U.S. Bancorp (USB) +30%

Now, am I piling into these names at current prices? No. They have had huge runs this quarter because they are the stronger players and capital has flocked to the likely survivors. However, strong banks should be on investors' radars because there will be more financial shocks and during widespread financial share price weakness, everyone gets hit hard, presenting opportunities for those who want to separate the baby from the bath water.

Full Disclosure: Peridot was long all of the companies mentioned at the time of writing

Thoughts on the "Bailout"

2008-09-25T08:51:00.001-04:00

A reader asks:

"Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?"

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bailout Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers' expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional (typo, corrected and replaced "nominal" with "notional" -CB) value. By doing so, we are converting unrealized losses on the banks' balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn't functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn't want to do that anyway since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don't understand why anything needs to be done or are misguided in their belief that all we are doing is "bailing out Wall Street." The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.

Buffett Treads Lightly With Goldman Sachs Investment

2008-09-24T08:54:00.001-04:00

If one of your first reactions upon hearing of Warren Buffett's $5 billion investment in Goldman Sachs (GS) was, "Wow, I didn't think Goldman was a Buffett-type company," you are probably not alone. Warren has typically preferred consumer-related businesses with wide moats (high competitive advantage and barriers to entry). He often tells people that he would feel perfectly fine owning Coca Cola (KO) or Wrigley (WWY) if the stock market closed down for five or ten years. It would be hard to have the same level of confidence with Goldman Sachs.

So before you go out and load up on GS common stock on this news, let's review exactly what Buffett is getting, and more importantly, the price he is paying. The $5 billion deal involves two parts:

1) $5 billion in preferred stock

These preferred shares are senior to common stock and pay a 10% annual dividend. Think of them as unsecured bonds paying 10% interest. He is not buying common shares with the initial $5 billion. In addition, if Goldman ever wants to retire these preferred shares (companies typically "call" preferred shares when they have excess cash), they have to pay Buffett a 10% premium to their face value. The vast majority of normal preferreds are callable at par, not at a premium.

2) Warrants to buy $5 billion of common stock at $115 per share

Buffett has the option to buy $5 billion of common stock at $115 per share at any time over the next five years. Keep in mind that while this part is common stock, there is absolutely no risk for Buffett on these warrants. Five years from now, Buffett earns a profit of $43 million for every dollar GS stock trades above $115 per share. If the stock is below $115, he does not lose a dime, as there is no risk on his part. These warrants are essentially call options he is getting free of charge.

From the terms of this investment, we can see why Buffett has decided to invest in an investment bank even though he typically goes for much safer and predictable operating businesses. Goldman does have a superior management team and great talent, but investment banking is not a business I would expect Berkshire to expand into anytime soon.

While he is taking a bit more risk by banking on Goldman's survival, consider how the landscape has changed for Goldman in recent days. Not only has the government indicated they are willing to take dramatic action to help these firms survive, but it also has allowed Goldman to become a bank holding company. Goldman may very well use this new capital to build out their commercial banking operation.

With this deal, Buffett is banking on government intervention succeeding in greatly lowering the risk that Goldman Sachs gets into deep trouble. For such a bet, I'd say Buffett got a great deal by waiting things out and not investing until he figured the odds were stacked strongly in his favor.

Full Disclosure: No positions in the companies mentioned at the time of writing

U.S. Economy: Widespread Recession or Financial System Crisis?

2008-09-23T08:44:00.001-04:00

Most of the steps taken by the Federal Government so far have been an attempt to prevent the current financial market crisis from getting worse, which would undoubtedly spill over to Main Street and the rest of the economy. The reason why there is a debate about whether we are in recession right now, or whether we will fall into one next year or not, is because the problems thus far are contained to a few areas. If those problem spots can be resolved to any measurable degree, we could get a quick economic and market recovery. If they spread, we are in for a prolonged and expanded downturn.

To see exactly how well most areas of the economy are holding up, we need to look no further than a breakdown of S&P 500 earnings by sector. Below is the breakdown of earnings from 2006 through current 2009 estimates:

Notice what while S&P 500 earnings will be down this year, for the second straight year, eight of the ten sectors are expected to have earnings gains for the third consecutive year in 2008, as well as further gains in 2009. This data shows exactly how much impact the financial sector's woes are having on the market. The consumer discretionary sector is an obvious casualty of such fallout, but everything else is fairly strong.

Personally, I think 2009 earnings estimates remain too high, though they have come down some already. Although I think the odds are remote, it is easy to see that, when one assumes the financials will rebound sharply, such a high S&P earnings number is possible in 2009 because the other sectors remain on firm footing.

Our economy is not yet in a widespread recession. Financial services are in trouble and are spilling over to the consumer sector. It might not be very comforting, but if we can get the financials consistently back in the black, even if they earn half the amount they did a few years ago, the economy and markets could hold up okay next year and beyond.

Morgan Stanley Becomes A Bank, Gets Overseas Investment

2008-09-22T08:36:00.002-04:00

Thanks to the Fed's actions last week, Morgan Stanley (MS) has averted an emergency sale to Wachovia (WB), received permission to become a bank holding company, and has sold a minority stake to Japan's Mitsubishi. The company is going to try to remain independent, for now anyway.

With the competitive landscape having changed in recent days, namely fewer competitors in the investment banking marketplace, the stronger players who can whether this liquidity storm will clearly be in a great position to take market share in this volatile environment.

It will be interesting to see if Goldman Sachs (GS) seeks a partner of some kind, or simply builds its bank holding company on its own. Outright mergers with banks are less likely now with the Fed's intervention, but leverage ratios and funding sources still need to be refined to protect against future shocks to the financial system, which are certain to occur.

Given the uncertainty of how all of these things play out, my view on the investment banks has not changed (see my piece entitled Investment Banks Nothing More Than Black Boxes). I still prefer commercial banks due to more transparency of how they make their money, as well as far lower leverage ratios. If leverage falls meaningfully and investment banks disclose more in the future about what they hold, that opinion could potentially shift, just not yet.

Full Disclosure: No position in GS, MS, or WB at the time of writing

Short Selling Ban Is Dramatic, But U.S. Can't Allow Firms To Fail For No Reason

2008-09-19T11:31:00.002-04:00

The SEC's 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let's be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company's fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It's that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don't have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they'll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country's largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won't be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

What To Do In Times Of Panic

2008-09-18T13:42:00.002-04:00

Is "panic" too strong of a word to describe the markets in recent days? I don't think so. Consider a couple of examples outside of the investment banking space:

1) Constellation Energy (CEG)

My old utility company when I grew up in Baltimore, Constellation is the parent of Baltimore Gas & Electric. CEG gets 20% of their earnings from energy trading and had contracts with Lehman Brothers. Although CEG's net exposure to Lehman's bankruptcy was immaterial, investors panicked and sent the stock down from $60 last week to as low as $13 on Tuesday. Today Warren Buffett's 88% owned MidAmerican Energy agrees to buy CEG for $26.50 in cash, or about 75% of the company's book value, in a deal that alleviates counterparty concerns over CEG's liquidity.

2) State Street (STT)

State Street fetched $68 before 10:00 this morning and hit $29 shortly after 1:00pm. State Street is listed as a large holder of all the troubled financial stocks, which worried people, but STT is a custodian for their clients and index funds and does not own the vast majority of the stocks in question. They simply act as custodian and collect fees for doing so. STT issued a press release this afternoon trying to clear things up and assured investors their money market funds had not dropped below $1 in NAV.

There is no doubt in my mind that we are simply in the midst of a worldwide financial panic. The UK just restricted all short selling in financial stocks until the dust settles. Fear and mostly unsubstantiated rumors are driving price action right now.

So what should an investor do in this environment? It might surprise you, but I have been making very few moves during all of this craziness. Trading when fear, panic, and rumors have taken over doesn't make much sense because prices are not based on reality but rather perception. Lack of confidence and uncertainty about what is true and what is not is a deadly combination for financial markets and many firms. It doesn't matter if Morgan Stanley (MS) is not in trouble. If clients think they might not be, they will pull their money and set off a "run on the bank"scenario. That very situation will likely forced them to sell the company in the heart of the panic, regardless of what the reality is.

As long as you know and understand what you own and have done adequate fundamental analysis, I would suggest standing pat and waiting for things to settle down. Like LTCM, the Asian financial crisis and every other financial market panic, this one too will be over at some point. When that happens we can get back to good ol' fundamental investing. Fortunately, most of the people reading this blog, as well as myself and my clients, can wait for the storm to pass.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

One By One, Financial Firms' Issues Being Resolved

2008-09-18T10:15:00.000-04:00

The recent leg down in the markets has been due, in large part, to the fact that specific firms have been forced to seek individual solutions to survive, whereas before we were more focused on general economic statistics. We are attacking each one and the list I came up with above is almost completed. What are the next shoes to drop after these are resolved? If there aren't any/many more, could that mark a short-term bottom?

Commercial Banks Ready To Pounce On Goldman Sachs And Morgan Stanley If Market Forces Them To Deal

2008-09-18T08:29:00.000-04:00

People are correct when they point out that the market is forcing the stronger investment banks, Goldman Sachs (GS) and Morgan Stanley (MS), to do a deal with a deposit institution even though they are making money and aren't liquidity strained. It is a shame, but when your business model requires short-term funding sources from the market, and at the same time the market is crushing your stock based on fear and not actual problems with your business, you might have little choice.

Today we are hearing that Morgan Stanley is talking with several parties about a capital investment or an outright merger. Wachovia (WB) is on the short list of potential merger partners. If Goldman and/or Morgan are forced to do a deal by the marketplace, you can bet that the buyer will be getting a steal (like the one many thought Ken Lewis could have gotten if he waited a day or two to buy Merrill Lynch).

The result is that investors should look at any deal for Goldman or Morgan as a potential opportunity. The Wachovia story is interesting because they clearly have their own issues to deal with right now (notably $120 billion in Pick-A-Payment mortgages in California they are trying to rework with borrowers). A bank like Wells Fargo (WFC) would be in much better position to take on one of the two remaining investment banks, or a troubled bank like Washington Mutual (WM).

At any rate, any deal for GS or MS done because of market reaction and not on business fundamentals is likely going to be done at an absolute bargain basement price (even better than the Merrill Lynch deal).

Full Disclosure: No positions in the companies mentioned at the time of writing

Ridiculous Item of the Day

2008-09-17T13:39:00.001-04:00

Have these people been alive and breathing in recent days? Hilarious...

From the San Jose Business Journal:

Merrill Lynch & Co. Inc. shareholders have filed suit against the brokerage firm’s chief executive, John Thain, and its board over Bank of America Corp.’s proposed $50 billion buyout of the company.

The lawsuit, filed in New York State Supreme Court, claims the deal is “wrong, unfair and harmful to Merrill shareholders.”

The suit says the defendants “have clear and material conflicts of interest and are acting to better their own interests at the expense of Merrill public shareholders.”

Americans: Add AIG To Your Investment Portfolio!

2008-09-17T08:52:00.000-04:00

As one of ~300 million Americans, we each now own about 0.000000002663333% of AIG.

I think the Fed did the right thing here by requiring some financial benefit in return for such a huge loan. Not only do taxpayers get a 79.9% equity stake in AIG, but we also are collecting some hefty interest on the deal, to the tune of LIBOR plus 8.5 percent.

Why The Fed Should, And Probably Will, Give AIG A Loan To Help Fight Off Bankruptcy

2008-09-16T13:35:00.000-04:00

The Federal Reserve Bank serves as the "lender of last resort" in this country, meaning they stand ready to lend when nobody else will. For this reason, I think the government will give AIG the bridge loan it believes it needs to try and avoid filing bankruptcy.

Keep in mind that this is not a bailout. A bailout is a hand out. A loan is money that needs to be paid back, and in AIG's case, probably within a relatively short amount of time. The Fed should even be able to charge interest on such a loan to make some profit for the taxpayers.

Reasonable minds can argue whether Bear Stearns and Lehman Brothers should have been treated equally or not, but given that AIG is solvent and simply needs a short term loan to sell some of its assets to eager buyers, the Fed should step up and play its role of lender of last resort. With the Dow up now, after being down 175 this morning, it appears Wall Street is pricing in some kind of resolution sooner rather than later. Let's hope so...

Full Disclosure: No position in AIG at the time of writing

Market Says Bank of America, Merrill Lynch Deal Fails

2008-09-16T08:33:00.002-04:00

*BAC closing price: $26.55
*Share exchange ratio: 0.8595
*Implied MER purchase price: $22.82
*MER closing price: $17.06
*Discount to deal value: 34%

Full Disclosure: Long shares of BAC at the time of writing

Lesson Learned from Failed Investment Banks: Leverage Feels Great Until It Bankrupts You

2008-09-15T15:06:00.000-04:00

How do companies with such great assets go belly up within days once a cascade of bad things start happening? At the outset of 2008 we had five major independent investment banks and now we have two (Goldman Sachs & Morgan Stanley). A core reason is that the leveraged finance business model is a very poor one. It allows you to make a killing when times are good, but on the flip side it can bankrupt you within days when the tide turns. That is not a risk-reward scenario that companies should embrace.

Imagine how easy it is to get caught up in the leverage game. Pretend you have $10 and are allowed to borrow $300 against it, for a leverage ratio of 30-to-1 (a common ratio for investment banks in recent years). If you are paying 5% interest on the loan and can earn just 6% on the $310 in capital you now control, you can earn a profit of $3.60 ($18.60 less $15.00 in interest) on your original $10.00 in capital for a return of 36%. Pretty cool, huh?

Well, only when you actually make money on what you are investing the money in. Consider the same example when your investment loses 5% of its value. After paying interest on the loan, you only have $279.50 left but still owe $300 to the lender. Now you are in trouble. To pay back the loan you need to borrow another $21.50 (if someone will lend it to you) and even if you can do that, you have lost your original $10 in capital.

The leveraged finance game, at least at the level these investment banks were playing it (leverage ratios of 25, 30, or 40 to 1) is very, very dangerous. Investors beware.

A final note about business models. AIG (AIG) is trying to sell assets in order to raise at least $40 billion in new capital because the ratings agencies may downgrade their credit rating if AIG can't come up with the new money. Reports are that a ratings change could bankrupt AIG within days if that downgrade should occur.

What kind of business model is this? Moody's and S&P downgrading your credit rating results in your company going bankrupt in 2-3 days? Not only is that simply ridiculous in terms of relying on one party to remain solvent, but even more unreal is that these are the same ratings agencies that don't have a clue how to rate anything. Remember, they had triple A ratings (the highest possible) on packages of subprime mortgages! If subprime mortgages are of the highest credit quality, what would prime mortgages be considered?

Short term, the unraveling of these firms will hurt, but long term, from what we are learning about these business models, maybe they should never have been anywhere near as big as they were to begin with.

Full Disclosure: No position in AIG at the time of writing

What BofA Gets By Passing on Lehman, Gobbling Up Merrill

2008-09-15T11:20:00.000-04:00

We can certainly second-guess Bank of America (BAC) deciding to buy Merrill Lynch (MER) today rather than tomorrow or next week, when the price could have been meaningfully cheaper. There is speculation that the government pressed Merrill do to a deal now, so as to avoid another weekend bailout session later. Not only that, but by acting now BAC ensures they get Merrill, rather than having to pass up on a chance that may not come along ever again.

While the price they paid (and whether it proves justifiable based on long-term profitability at the Merrill unit) will be one of the key factors in the deal's ultimate success, my job as a portfolio manager and a BAC shareholder is less about speculating on whether they could have paid less tomorrow and more about what they are getting for the deal they actually announced, a stock swap of 0.86 shares, valued at $29 per MER share based on Friday's closing prices.

While the bad assets are abundant at Merrill's investment banking arm, it is important to remember that the crown jewel of this deal is the Global Wealth Management division, not the investment bank. MER owns 50% of Blackrock (BLK) and has a network of nearly 17,000 financial advisors.

The BLK stake is publicly traded, so we know that is worth $14 billion. The Merrill Private Client Group does about $3 billion per year in pre-tax net income, so a conservative multiple on that division of 10x gets valued at another $30 billion. In sum, that comes to a $44 billion valuation for about 45% of MER's revenue base, which excludes their entire investment banking operation.

Bank of America shares are trading around $29 each this morning, which values the Merrill deal at ~$43 billion. As a result, BAC shareholders are getting MER's investment bank for free. There is a price to pay for that luxury, however, because further writedowns of Merrill's bad assets will now be incurred by BAC. Long term though, it is hard to argue that BAC can't make this deal successful over a multi-year time frame. Jut how bad future writedowns are will play a big role in determining such success.

Even Oppenheimer's Meredith Whitney, the extremely bearish analyst on the banks, today pegged Merrill Lynch fair value at between $27 and $35 per share. At today's prices, BAC is paying less than what Wall Street's most bearish analyst thinks the company is worth. That can't be a bad thing...

All in all, this deal is much like the Countrywide one. BAC is accepting near-term problems for the possibility of tremendous long term upside. I would much prefer that strategy to the one a company like Wachovia (WB) implemented when they bought a mortgage company (Golden West) and an investment firm (AG Edwards) at the top of the market. At least BAC did so when the firms were in distress, and might have gotten a bargain as a result. Time will tell.

Full Disclosure: Long shares of BAC at the time of writing

BofA's Lewis Still Making Deals, But Now Aiming For Distressed Assets

2008-09-15T07:34:00.000-04:00

Lots to get to this morning, so I'll be writing on several topics throughout the week, but first let me address a reader question re: BAC.

Shepherd writes:

Chad,

If the wires are correct, it looks like Lewis paid a premium to purchase Merrill Lynch. I'm curious why you hold BAC, given that he seems to have an almost emotional need to acquire things, which gets in the way of negotiating the best price for his shareholders. My guess (admittedly from afar) is that he could have done better...

Shepherd, your characterization of BofA CEO Ken Lewis and his love of acquiring things is spot on. Earlier this decade BAC has acquired companies like FleetBoston, MBNA, and U.S. Trust, and paid full prices for all of them. As a result, BAC rarely traded above 10x earnings since most of their growth was coming from acquisitions, not organic growth.

During that time Peridot clients did not hold BAC shares. It was only after the subprime crisis started to bite the big banks that I invested in BAC. There were a couple of reasons I chose BAC. First, relative to their size, BAC had less subprime exposure than their large cap bank peers. They did take writedowns, but given they are the largest bank in the nation, firms like Citigroup, UBS, and Merrill Lynch had far more exposure. On that front, BAC's losses were manageable, and they were forced to dilute shareholders far less than others via capital raises.

The second reason was that BAC is the largest bank by deposits in the country. As we have seen with the investment banks like Bear Stearns and Lehman Brothers, without deposits to fund your business, capital can dry up overnight and a freefall can result.

On the acquisition front, people have criticized the Countrywide deal, but Lewis actually bought them on the cheap. Time with tell if he gets a decent return on the investment (I suspect he will over the long term, despite short term losses), but buying distressed assets on behalf of shareholders is far better than what he used to do (pay a huge premium for assets that were already fully priced).

The Merrill Lynch deal is a similar situation. We can argue if the price he paid was fair, but at least he is buying on the cheap. That will increase the odds of a very successful deal. I'll have more on the Merrill deal in another post to examine exactly what BAC is getting for their money.

Full Disclosure: Long shares of BAC at the time of writing

Ken Lewis Mulls Another Deal as Lehman Reaches Brink

2008-09-11T16:47:00.002-04:00

As soon as Lehman Brothers (LEH) shares hit $4 today and reports came out that the company is up for sale to try and survive, only one name came to my mind as a potential buyer; Bank of America (BAC) CEO Ken Lewis. The guy loves doing deals. Who else would have bought Countrywide?

Since Peridot is long BAC, one of the two things I am worried about (the first is obviously Lehman's ugly balance sheet) is the price that Lewis might agree to pay for Lehman should a deal be reached. Lewis isn't shy about overpaying for firms he really wants, and he loves to grow by acquisition. FleetBoston, MBNA, U.S. Trust... not a bargain among them (Countrywide is still a question mark).

Now that Lehman CEO Dick Fuld has completely blown it (even after seing exactly how things played out with Bear Stearns!), BAC is likely the most probable suitor at this point, and thus I am not surprised their name is already being mentioned in press reports this evening.

Don't overpay, Ken!

Full Disclosure: Long shares of BAC at the time of writing

Update Friday 9/12 9:05AM ET
Rumors today are that the U.S. government will not provide public funding to aid in a takeover of Lehman, as was the case with Bear Stearns. In that case, Bank of America should balk at buying the whole firm. I would love if they just bought a stake in Neuberger Berman, which was the kind of deal LEH was seeking several weeks ago. NB is the crown jewel of Lehman and would be a great asset for BAC to buy in order for LEH to get much needed capital.

Despite Earnings Warning, Corning Retains Strong Balance Sheet & Market Position

2008-09-11T10:07:00.000-04:00

There are many times, particularly in bear markets like this one, when I look at a company and am quite baffled as to how investors can let a stock drift so low. Then I remind myself that Wall Street is short-term oriented and only cares about today, this week, and maybe this month. What the reality will be a year or two from now is ignored, which creates the very investment opportunities that long term, value-oriented investors like myself focus on.

I have been a long time investor in Corning (GLW), a leading provider of glass for LCD displays as well as fiber optic cable for the telecommunications industry. The company possesses strong market positions in its two core businesses, has a strong balance sheet, and could generate growth from a budding environmental products division in the years to come.

Given that GLW's main business is supplying glass for LCD displays (think flat screen televisions, computer monitors, etc), quarter to quarter financial results can vary greatly based on the supply and demand dynamics of the end markets GLW serves. That said, the company has been generating strong double digit earnings growth and has built up a net cash position of more than $5 billion, or $3 per share.

After producing several strong quarters in a row, GLW warned on its third quarter recently and as a result 2008 earnings estimates have been sliced from $1.93 to $1.82 per share. The stock, meanwhile, has cratered to around $16 per share. The only conclusion I can draw is that the adverse reaction to the earnings miss is an overreaction. Corning is surely not immune to an economic slowdown by any means, but even if the company only earns $1.70 this year, the stock trades at less than 10 times earnings and investors are getting the operating businesses for only $13 per share (given $3.30 per share in net cash on the balance sheet).

Even if growth rates slow as the global economy sputters through this business cycle, it is hard to argue that GLW shares will remain in the teens for an extended period of time, unless global demand for LCD glass really falls off a cliff and takes years to recover. While anything is possible, I still consider GLW a growth company that can grow earnings per share by 10 percent or more over the next three to five years. As a result, I am adding the stock to the Blog Model Portfolio at the close of trading today.

Full Disclosure: Long shares of GLW at the time of writing