When is it wise to catch a falling knife? Received wisdom says never. But that has not stopped some investors from trying to take advantage of adverse market conditions. And when the investment world’s most highly regarded value investor starts to get long of an underperforming sector it’s perhaps time to re-evaluate it. The news that Warren Buffett’s Berkshire Hathaway had purchased $5 billion of Goldman Sachs preferred stock, yielding 10%, was enough to send its stock soaring above $125 – giving Hathaway instant profits of $437 million as it has an option to purchase Goldman common stock at $115 for another five years.
Even given the uncertainty then surrounding the proposed US bailout, it was enough to temporarily support the financials sector and Goldman’s subsequent $5 billion stock offering – such is Buffett’s reputation.
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"When you get a sense of panic...when no one is trading on rationality, everyone is latching on to sentiment"
Andrew Goodwin, SVG Investment Managers |
Markets overshoot – it’s a well-known phenomenon but one that is often understandably ignored by investors during the heights of euphoria, or the depths of despair. During moments like these, stocks’ valuations can offer a great opportunity for a long-term investor, says Andrew Goodwin, fund manager of the SVG European Focus Fund at SVG Investment Managers.
"When you get a sense of panic...when no one is trading on rationality, everyone is latching on to sentiment," he says. "There can be a disconnect between real world metrics and the stock markets."
Goodwin points to how bad things looked for Japanese banks in the early part of this decade, with the banking system widely perceived to be creaking under bad assets. The stock market had not recognized that the banks’ operating profits were increasing. Furthermore, asset deflation was ending; it wasn’t long before the market turned around.
"That same opportunity is presenting itself again but for European financials," says Goodwin. Clearly this approach requires a very long-term outlook and SVG expects there to be bumps along the way. It might not suit those investors that are looking for relative returns against benchmarks. The SVG fund is open and tradable but its investors are aware of the strategy and typically take a three-year view. This segment of SVG Capital uses private equity principles to invest in public companies that are labouring under weak valuations, relative to their potential cashflows and growth prospects.
As problems in financials have increased, the number of private equity firms trying to get involved in the sector has also risen. In April, Texas Pacific Group led a $7 billion injection into Washington Mutual. It was also looking at the now defunct Bradford & Bingley. Lone Star has taken over IKB Deutsche Industriebank. Private equity typically tries to take a controlling stake in target companies but this is more problematic in regulated financial institutions.
To some extent, obtaining a controlling stake is relatively unimportant because the tough environment is helping management to make the kinds of decisions that are right for their company’s long-term future. And times are certainly tough. Capital and funding are in short supply and expensive, so banks are having to focus on underlying operating profits and concentrating on their traditional businesses.
Goodwin argues that the ratio of a bank’s market capitalization to total assets provides a useful guide to value. Using the 4% minimum capital requirement stipulated under Basle regulations as a guide, he says that when a financial’s market cap to total assets ratio falls substantially below this benchmark it is often time to consider buying, or alternatively it means that the institution in question desperately needs capital.
This ratio for Japanese banks went to 1% to 2% in 2002 when there was a sense of dread about the state of financial institutions in the country. In mid-September, many banks were in this range, including some European banks that SVG has taken a long-term view on, such as Hypo Real Estate, UBS and ING, whose ratios were at 0.2%, 2.8% and 3.2% respectively.
The rationale for backing ING is that it should be able to grab share in the Dutch market following the disappearance of ABN Amro. As for UBS, even with the hits to its investment banking operation, the bank still has a pre-eminent private client and wealth management business.
"Do you believe that the franchise of UBS’s private bank is bust? I don’t," says Goodwin.
And yet the extent of the risk in markets at the moment should not be underestimated. The due diligence conducted by Texas Pacific Group on WaMu did not stop it from losing billions in the now bankrupt bank. When JC Flowers invested €1.1 billion in Hypo Real Estate, taking a 24.9% stake, Goodwin took a level of comfort as Flowers conducted due diligence. But that was not enough to stop events overtaking the German bank at the end of September as refinancing difficulties at its DePfa subsidiary led to a hastily arranged €50 billion emergency loan from public and private sector local banks.