Those who have said the mortgage market's survivors will thrive due to fewer competitors are certainly right, but as the Capital One (COF) announcement last night shows, even those that could survive might not even try to do so. The company has decided to shut down its GreenPoint wholesale mortgage unit and cut 1,900 jobs as a result. The secondary mortgage market is to blame, as Capital One is one of many banks that can no longer sell mortgages at profitable prices to investors in order to fund new originations.
Despite the headlines that will undoubtedly result from this news, let's go through what it actually means for Capital One in dollar terms. GreenPoint was hardly in shambles before this announcement. After losing $12.6 million in Q1, the division actually earned a profit of $2.6 million in Q2, and management was assuming a breakeven year in 2007. During the second quarter, wholesale mortgages represented an immaterial 0.3% of Capital One's net income. For the first half of 2007, the unit's $10 million loss negatively impacted the company's earnings by only 0.7%.
Why the rush to shut down Greenpoint then? I was actually surprised they didn't halt new originations for a while to see how the secondary market shaped up in coming months, but given that there were 1,900 jobs within GreenPoint, and the odds of it generating any significant earnings in the short or intermediate term was essentially zero, it does make sense that Capital One management decided it was not a good use of resources to continue to fund the division. Why not just save a ton of money and cut the thing loose now?
Interestingly, even in 2006 when the mortgage market was great, GreenPoint only earned$138.5 million. That's a lot compared with this year, but even then it contributed only about $0.33 to Capital One's earnings of more than $7 per share. As you can see, even in good times GreenPoint might not be missed all that much, especially if the company can reallocate that money into higher return projects, which I suspect it can.
And keep in mind that this decision does not mean that Capital One is no longer in the mortgage market. They will still be loaning money to home buyers in the form of new mortgages and home equity loans through their local banking operations. They simply decided to halt the wholesale business in order to have more control over their loan operations.
All in all, this decision sets Capital One up nicely heading into 2008. The mortgage pressures on earnings will be lifted meaningfully, much of the merger related charges and other restructuring charges will be behind them (2007 was an integration and transition year), and the yield curve has steepened somewhat in recent weeks, so the company's margins should improve.
Given that Capital One is still slated to earn more than $7 per share this year before one-time special charges related to the GreenPoint closing and merger-related charges will decline in 2008 as cost savings are further realized, I would not be surprised to see an earnings per share number meaningfully above $8 next year, (perhaps even approaching $9). In addition, after the company's current $3 billion buyback is completed (it is more than half done), I would expect a new "bank-like" stock dividend put into place as well. In such a case, Capital One stock should no longer be anywhere near the current $66 quote.
Full Disclosure: Long shares of Capital One at the time of writing
Post-Vacation Thoughts
Wow. What a week and a half to take a vacation. Either it was a great time to miss, or it was the opposite. Obviously I'm biased, but I'd have to go with the former. Sometimes the daily volatility of the market sends investors on more of an emotional roller coaster than anything else, and that isn't usually helpful. After all, roller coasters end up right where they started for the most part.
It looks like the S&P 500 traded in a 8.9% intraday range during the 8 trading days I missed, from 1370 all the way up to 1503. Despite that, when all the dust settled, stock prices dropped only 2 percent during my time away, so really my trip (I was in Boston and Cape Cod) saved me some emotional highs and lows.
I haven't had a lot of time to catch up yet, but one thing did get my attention, so I thought I would share. I don't know if it got a lot of airtime or not (likely not given it was pretty eventful with the Fed moves, etc), but the market finally got the long awaited 10 percent correction (at least on an intraday basis -- 11.9% -- it was only 9.6% on a closing basis).
Now, normally this would be unimportant enough that I might not even mention it, but there are a couple reasons why I think it is notable this time around. First, there were tons of people who were refusing to jump in with excess cash until we got that "official" drop. It sounds silly, but when investment strategists think the market is overbought, as many had for several months as the S&P crossed 1400 and then 1500, they need a significant sell-off to be convinced some excesses are removed. I have no doubt that market players who were waiting for a 10% down move are beginning to put some cash to work slowly.
Normally, a 10 percent correction is no big deal. We expect them to happen. I don't have any statistics handy, but I'd guess we see one every year or so on average. They are normal and very healthy. Amazingly though, we had gone four and a half years without a full 10 percent drop in the S&P 500 index. This worried a lot of people because it was the longest streak ever without a sizable market drop. I don't think it signaled the end of the world or anything to anybody, but when you go that long, you are due for a fall, and while nobody knows exactly when it will happen, it still prevents investors from getting overly bullish and firmly committing investment funds. The streak, in the eyes of many, was simply a symbol of the times, an overbought market that was being powered by many things, including the private equity M&A boom, which appears to be normalizing.
As I comb through the individual company news times of interest from the last week and a half, I'll be sure to share anything that catches my eye that would have otherwise been posted had I been in the office. Feel free to let me know if there is anything you would like me to write about in coming days. It's good to be back, and thanks for your patience during my vacation time.
What A Difference A Week Makes
I can hear the class action lawsuits being lined up already. On July 30th, mortgage REIT Luminent Mortgage Capital (LUM) issued a press release confirming that their 32 cent per share quarterly dividend would be paid as scheduled and not canceled, as many on Wall Street were predicting. The stock closed above $7 per share on the news. A week later on August 6th, they canceled the dividend and may be on the verge of bankruptcy, as evidenced by the stock's more than 85 percent drop to less than a buck.
Either Luminent's management team has no clue about their business, or there was some wishful thinking inside the company that will likely have to be defended in court. You often hear investors getting upset when companies fail to come out and deny Wall Street rumors that appear are untrue. However, in the case of Luminent it appears that even if a company does issue a statement it might not be accurate.
Now, it's true that the mortgage-backed security (MBS) market has dried up quickly, but given the market environment, if there was any chance at all that things at Luminent could have worsened that much in a week's time, the company really blew it by confirming the dividend. Just think how many people held on to the stock (or even bought) because of that press release.
If you own stock in any mortgage REIT, make sure you understand how quickly things can turn for them. Since they are forced pay out their income in dividends each quarter, they can't stockpile cash for tough times. As a result, when the margin calls come there is no money there to pay, causing the stocks to be worthless nearly overnight. New Century Financial might have been the first mortgage REIT to go under, but it wasn't the last, and Luminent won't be either. Many think NovaStar (NFI) might be next.
Full Disclosure: No positions in the companies mentioned at the time of writing
Hedge Funds Can Just Freeze Redemptions... Must Be Nice
Maybe it's just me, but is anyone else amazed that when hedge funds run into trouble (as many have recently by investing in mortgage-backed securities) and investors ask for their money back, the fund can simply say no? This is astonishing to me.
Now, don't get me wrong. Managers can run their funds any way they want. Typically, fund rules stipulate that investors can withdraw money only during certain windows (quarterly and annually are most common). That makes sense, as it can be tough to put on positions if people can just come and go as they please. But how about when you ask for your money back during a pre-approved window and the hedge fund comes back and says "Sorry, but we have frozen redemptions."
Bear Stearns (BSC) did this with their recent funds that ultimately went bust and are being sued right now because of what they allegedly told investors regarding the riskiness of the portfolios when they tried to get their money out.
Why on earth would anyone invest in a hedge fund that gave you no guarantee that you could take your money out if you wanted to? How can hedge funds get away with simply denying one's request? Do any readers out there invest in hedge funds? Are you worried about wanting to get your money out at some point and being told you can't? Seems risky to me...
Full Disclosure: No position in BSC at the time of writing
Fear is Driving Market Volatility
We find ourselves in a market that doesn't trust what companies are saying. Other than mortgage lenders and home builders, company conference calls this quarter have emphasized that things are not as bad as the markets are indicating. However, investors are scared and are selling indiscriminately, regardless of what companies are actually saying their exposure is. People just don't believe them.
Should they believe them? It depends. If a senior management figure gives their opinion as to when the dust will settle and how bad things will get, you might not want to simply take what they say at face value because, after all, it is simply an opinion. What you can take to the bank though are statistics that companies give you. What kind of exposure they have to mortgages and other types of credit. Remember, numbers don't lie, people do.
Fear is king right now. Somebody started a rumor that Beazer Homes (BZH) might go under. The stock fell 40% this morning within minutes. Some people might be bottom fishing in the home building sector, based in large part to their seemingly attractive price-to-book ratios. Beazer's book value is $38 but the stock traded as low as $8 today (it has since rebounded to $11 as investors bet the rumors are untrue).
This shows you that you can't always trust book values. Land values are often carried on the balance sheet at cost. However, the actual value of the land may be far below what a company paid for it. I don't know if BZH will go under or not, but I have not purchased any home builders and have no plans to do so. They are simply too hard to value, in my view, since stated book values might not be anywhere close to accurate.
Conversely, when Citigroup (C) tells investors that perceived risky loans make up only 5% of their exposure to the credit markets, you can put things into perspective. You can find out what percentage of the big banks' loan portfolios come from mortgages, or investment banking, or sub-prime borrowers. We don't know exactly how many of these loans will go bad, but you can make aggressive assumptions and still realize where the overreactions are in today's market environment.
Personally, I still stand by my opinion that the mortgage mess will not spill over into every other credit area. This is not to say that people aren't losing their houses when interest rates reset to levels above a threshold that they can afford on a monthly basis. They will lose their houses, the banks will be on the hook for the loans, housing inventories will rise, and lower home values will result. But will these consumers default on their credit card bills, student loan bills, and file bankruptcy as a result?
I don't think so, in the vast majority of cases. They will simply lose their house and be forced to move somewhere they can actually afford. Employment remains tight, so the ability of consumer to pay their everyday bills really shouldn't questioned at this point. I feel confident about this view because when I look at credit card payment statistics, for instance, people aren't defaulting at above-average rates.
If the sky was really falling, you would see deteriorating credit in every segment, not just housing related loans. As long as people keep their jobs, I am confident they will be able to make regular credit card and student loan payments, even if they are forced to move into a smaller house after their adjustable rate mortgage resets. After all, they should not have been in the other house to begin with.
Full Disclosure: No positions in the companies mentioned at the time of writing
Bank of America Dividend Yield Sits Far Above 30-Year Bond
Bank of America (BAC) is not a stock that has gotten my attention very often in recent years, but last week after the shares dropped to $47 and the company boosted its dividend yet again, I switching into the bullish camp (from neutral) for the stock.
BAC currently yields 5.4%, which is about 50 basis points above the 30-year treasury bond. That also equates to a trailing P/E of 10 times. I am very much aware that investors are spooked about mortgage lending and financial market exposure with the big banks, but compared with larger rivals JPMorgan Chase (JPM) and Citigroup (C), Bank of America has less exposure and should fare better should credit issues persist or get worse from here. Not only do they tend to avoid the very low end of the credit spectrum in the mortgage area, but a smaller portion of their profits come from financial markets than the others.
Given where the stock trades and the enormous dividend yield, I doubt the stock has big downside potential from here, and if the current worries prove to be overblown and BAC's earnings growth continues, you could get decent capital appreciation in addition to your more than 5% annual payout, which is better than the projected performance bonds are currently offering.
Full Disclosure: Long shares of BAC at the time of writing
Just Don't Panic
On days like this the best advice I can give is, don't panic. Panic selling just because the market gets a little scary will, more often than not, prove to be a big mistake. Every once in a while the psychology of the market takes over. Regardless of fundamentals, stock prices simply move in irrational ways. The best thing to do is simply sit tight and wait it out.
This is not to say that every stock's move lately is irrational, but a company can post strong earnings, have a good conference call, get a nice stock price bump, and then a few days later the market tanks and the shares are much lower than they were before. In the short term, psychology always trumps fundamentals.
However, if you've done your homework and are confident in your investment thesis for particular names, just wait it out. You can add to positions if you want, but that can be hard in a tape like this. Selling into the panic most likely will cause you to have called the bottom and not profited from it.
Are there any real contrarian buys out there? I would not try to bottom fish in the mortgage area. There will be a point in time where Countrywide (CFC) is a buy, but I think we have a long way to go. It looks like the housing market won't improve much, if at all, in 2008. I think it's too early to jump in.
That said, the reason why CFC will be a buy at some point in the future is because of the valuation. Unlike the brokerage stocks, which could be facing peak earnings, Countrywide is staring at trough earnings and the stock still trades at a 10 P/E. It could certainly get worse before it gets better, so CFC's recently reduced 2007 guidance of $3.00 per share might be too high. Who knows, maybe they'll earn $2.00 when it's all said and done, which means there is plenty of downside left. Until housing stabilizes for a long period of time and inventories diminish, I would stay away.
All in all though, just don't panic. We've gone through periods like this before (earlier this year in fact), and things always wind up being okay longer term. Unless we see serious and sustainable ripple effects in the economy from the housing market, I am not overly concerned. However, patience is required during times like these more than others.
Full Disclosure: No position in CFC at the time of writing
Akamai Crushed, Outlook Still Attractive
This will be a fairly short post since I had no plans to write about Akamai (AKAM) today, but after reporting in-line earnings this streaming video content provider is getting slammed to the tune of 18% this morning to $38 and change. Akamai is one of those high multiple growth stocks that everyone expects to beat numbers every quarter. After meeting expectations and guiding in-line for the third quarter, analysts are downgrading and investors are fleeing.
I think the sell-off is overdone and I am initiating some positions this morning. The company's fundamentals remain strong as online video has years of growth ahead of it. All of the sudden the stock trades at only 23 times 2008 earnings. For a growth stock like AKAM, I think that is a bargain. Many investors will worry about margin pressures and such since it appears they are giving price discounts for long-term contracts, but most likely the company is just being conservative.
Given the market they serve and their leadership position, I think a 23 forward year multiple for the stock is pretty cheap. These are the types of earnings season sell-offs that I often like to play on the long side. AKAM shares weren't worth the price at their highs ($57), but now that they are down 35% to $38, I think that falls into "growth at a reasonable price" territory.
Full Disclosure: Long shares of AKAM at the time of writing
Consider Natural Gas ETF for New Energy Investments
Quite predictably, crude oil has been on a roll in recent weeks as the summer driving season has driven seasonally strong performance. With oil trading around $75 per barrel, fresh money investments into the energy sector might not be ideal at these prices. Don't get me wrong, I am still bullish on oil in general, but investors should not jump on the energy bandwagon with new money when we are in the middle of peak oil season.
For new money right now I would suggest investors take a look at natural gas. In fact, in mid April a new ETF was formed to track natural gas prices. Even while oil has soared from the low 60's to the mid 70's, natural gas has collapsed from more than $8 to below $6. Another non-existent hurricane season has contributed to the drop, but natural gas prices will remain volatile in the future, and given the weakness lately, it appears to be an attractive entry point.
The natural gas ETF trades under the symbol UNG and has plummeted from above $54 to $38 in the last couple of months, as you can see from the chart below. After a 30 percent drop, I think it looks attractive for investors looking to add some energy exposure but are wary of buying crude oil stocks at current prices. You can also play this via unhedged natural gas producers, but since this ETF is new, I figured I would point it out as another potential investment vehicle in the space.
Full Disclosure: No position in UNG at the time of writing
Why Would a CEO Stick with Quarterly Guidance?
I read an interesting take on this question today and I think it has a lot of merit. While many of us would prefer public companies abandon quarterly guidance, there are reasons why a CEO would keep giving it out. One reason might be to make them look good, and therefore enhance their job security.
If you are an active investment manager (whether for personal assets or professionally) you have likely observed in recent years that a pattern has developed during earnings season on Wall Street. Companies tend to beat estimates for the most recent quarter and guide estimates lower for the current and/or future periods. The end result is that most quarters finish with earnings coming in ahead of estimates on the whole.
While stock prices might dip in the short term because investors care more about future guidance than earnings already booked, this practice sets the bar very low. By keeping expectations meager, it maximizes the odds that the company will beat numbers next quarter, and that makes management look good. Under-promise and over-deliver ("UPOD" as Jim Cramer calls it). It works, and it's what public companies should do in general (although maybe less often than every three months).
I think this is a great explanation for why many companies will keep playing the guidance game. It sets the bar low, makes them look like they're doing a good job running their companies, and boosts their job security. If you don't give guidance at all, the analysts could set the bar too high, forcing you to miss numbers and get an earful from investors.
How can investors play this growing trend? Buy stocks after a post-earnings sell off due to a guide down. After the company sets the bar low, investors adjust their valuations accordingly. Over the next couple months, Wall Street will realize the numbers are too low and the stocks will get a boost as strong performance is priced in again. Use that strength to pare off positions before the next earnings report if you think they might be lackluster or conservative.
That seems like the best way to trade the ever-growing trend of beating earnings and guiding lower for future quarters.