Investing – To Live in Interesting Times

Oh my, oh my, where to begin. By any measure, it has been a historic month. Wild gyrations in the market indices. Fannie and Freddie, taken over by the government. AIG, acquired for pocket change by the government. Lehman Brothers, gone. Merrill, sold. Washington Mutual and Wachovia gone. Goldman and Morgan Stanley, now banks. And Congress might actually enact a bill in a week. That’s the most astonishing of all.

I joke, of course. What was more astonishing was that Congress didn’t enact the bill the first time around. I guess it’s possible to look at all this and see it as something remote, something that just affects those New York bankers. And I think many people do, which brings us to where we are today – “ Congress trying to enact a bill, and lots of people across the country thinking that this is just a bailout of some rich fat cats. Not so. Not so at all.

Let’s start back a few weeks. I will confess that as Lehman went under, as Merrill sold itself, as Morgan Stanley and Goldman Sachs stock was sinking, I was scared for the first time in the midst of this upheaval. We can go through the myriad of explanations, but the simple fact was, several stocks could have gone to zero. Meaning, several companies would have disappeared. And they would have taken down the entire system with them. Yes, we were on the precipice.

The immediate catalyst was the lessons of Fannie, Freddie and AIG. Yes, the government stepped in and took them over. But the market learned something in the process: that the government might protect bondholders, but the equity would be squashed. It might have been short sellers, we may never know, but hedge funds, traders and short tellers decided they could make money by destroying vulnerable companies. And so they – “ meaning whoever was on the selling / shorting side – “ went after Lehman. And when they were full, and had made a bundle of money, they went after Merrill. And Morgan Stanley was next. At the time, it wasn’t hard to see the next targets on the list: Goldman, WAMU and Wachovia.

The long-term problem, as everyone knows by now, was the mortgage-related assets on the books of these companies. These assets kept declining in value, because no one wanted them. It’s not that they were all bad, it’s just that no one knew what they were worth. So they didn’t trade, and that just made matters worse, because when they did trade, they traded lower. So the value kept going down. Given the mark-to-market rule, which says that companies have to mark these assets to current market prices, the balance sheets of these companies kept getting worse. And to fix the balance sheets, these companies had to raise money. But no one wanted to give them money if the value of the assets were going to continue to go down.

That’s the general pattern. Each case was a little different. AIG was providing insurance in the form of credit default swaps. As the value of these mortgage-related assets fell, they needed more cash to back up their policies, much the same as insurance companies need cash to pay claims when a hurricane or an earthquake hits. Add the ratings agencies, which were more than willing to help AIG kick the bucket. They were ready to downgrade AIG, a step that would only make matters worse for the company. With a downgrade, AIG would need even more cash, and at a much higher cost. Initial estimates were $30 billion or so; as the downgrade approached, word was that the number was as much as $70-80 billion.

For Lehman, it was management that was slow to get rid of the unwanted assets on their books. For some reason, Mr. Fuld, the CEO, thought that he could hold on and eventually the value of these assets would be higher than what the market was offering. It was a gross miscalculation, because that’s when the sellers stepped in. And as the selling continued, confidence faded. For a bank, there is nothing worse than a loss of confidence. Merrill, seeing the writing on the wall, decided it was better to sell itself at a relatively decent price (at the time) rather than face the vultures in the market. And so in one weekend, Lehman went under and Merrill was sold to Bank of America.

Morgan Stanley was next. But by then, Hank Paulson and Ben Bernanke were ready to declare that the nation was on the brink of a major crisis. And news that the government might step in with some kind of legislation to stop the bleeding propped up markets. And despite last Monday’s jaw-dropping failure by Washington to pass legislation, the hope that the government will step in is still holding us up.

There seems to be a belief out there that this legislation is a “bailout” of the Wall Street Fat Cats by the average citizen that had nothing to do with this mess. That’s the way Washington has painted it, that’s the way the media seems to bill it. And nothing can be further from the truth. Should the legislation fail, every person, every business would be affected. And not only in the United States, but around the world. The financial world is so interconnected that it’s impossible to segregate it.

Should the legislation fail, every retirement fund, every 401k would get hit. Last week, even a few mutual funds and CDs were in trouble. Then consider all the companies that would have problems borrowing to run their everyday businesses. And to cut costs, the first thing companies do is fire people – “ fast. And don’t forget all the city services and municipalities and teacher’s funds that have invested in some Wall Street related vehicle. Yes, the scene would be bloody indeed.

We could still point the finger and blame Wall St. for this mess, but I think there’s enough blame to go around. Every person who took advantage of a low-interest mortgage, who took out an equity line and went shopping, who gave money to a broker that said, “if you invest in this, you’ll make a lot of money”… we’re all guilty of trying to benefit from the situation before us. Wall Street may have created the vehicle, but truth be told, we all used it.

There are also arguments running around saying that there are other ways to solve this, that the government just has to insure debt rather than buy assets; or that changes in the mark-to-market rule or the short-selling rules will fix things. I think they miss the point: if the government, aka the big gorilla, is unwilling to step in, then the predatory side of the market will just step in and pick off companies one by one. It’s more about confidence than specifics. And right now, we need a big gorilla to have any confidence. Change a rule, the market will find a way to side step it. Consider the suspension of the mark-to-market rule. Just because you change the rule doesn’t mean that people believe the assets are worth more. It’s like owning a house and changing the appraisal. You have to believe the appraisal to buy the house.

One other point that seems to be lost in all this: I think the government will actually make money. Not all these assets are worthless, or “toxic”, as they have been labeled. A lot of theses assets will do just fine if they don’t have to be sold right away. The best analogy I can think of is a house. There are lots of houses now that are worth less than their mortgages. Imagine that someone says to you, “if your house is worth less than your mortgage, we’re afraid that you can’t pay us back, so you have to sell, now.” That’s exactly what’s happening in financial markets. And the problem there, which is just the same for our homeowner, is that no one wants to take out a mortgage and buy that house. Because in a short while, the buyer might have a house that’s worth less than the mortgage, and the new buyer would also have to sell. Now we all know that most people just hold on to their houses and do just fine. And so can the government. It’s not definite, but it’s a very real possibility.

Handling the Interesting Times

And let’s not forget the flip side of all this. Sometimes in these markets, there are great opportunities. So if you’ve had a tough trading situation, or things look bleak, don’t forget, that also means some opportunities are lying around as well.

For a while, it’s been a trader’s market. I’m usually a long-term player, but I have to say, I had to do some day trading in this market. The moves were big, violent and temporary, and under those conditions, you have to react quickly, and with a level head. If that’s not for you, then the best thing to do is, very honestly, stay out. And by the way, I’m not saying that I’m quick with a level head; I had to fight the tendency to sit in front of the TV and drown my depression in cake or chocolate chip cookies (I’m not a drinker, just an emotional eater).

When I did pull myself off the couch, there were some very interesting opportunities. Let me highlight a few going forward, and update some trades that I’ve talked about in recent articles. Also, I will identify what I consider lower risk vs. high risk trades.

The Banks

If this legislation passes, the strong banks should rally. But that’s a trade; the lower risk approach is to buy the strong banks and hold them for 2-3 years, at least. Why? Let’s first look at who the stronger banks are: Wells Fargo, Bank of America, JP Morgan, Citibank and US Bancorp, to name the more well known. Basically, some of these are the buyers – “ Bank of America, JP Morgan and Citibank. Keep in mind that these buyers got Bear Stearns, Merrill and Wachovia for cheap. And I mean, really cheap. Wells Fargo could have been a buyer, and US Bancorp is simply a very conservatively run bank. With more consolidation, it’s not inconceivable that Wells Fargo and US Bancorp will become buyers, too.

And once these buyers clean up the mess, they will have gotten the fixer-upper deals of a lifetime. They’ll be bigger and better – “ more depositors, more lines of business that generate revenue. And they’ll have fewer competitors.

For the record, I continue to own Citibank and US Bancorp. If you’ve been reading this column, you know that I’ve been buying Citibank. I’ve bought as high as the $26 and the $24 range, but have been buying more as Citibank fell to the $18-$20 range (it has been lower than that, but at the time, I thought it would keep going down, which is the reason I didn’t buy then). This reduces my cost basis, and allows me to sell my higher priced positions if I wish, leaving me with the lower cost basis for the long-term.

Keep in mind that the coast is not all clear for Citibank. The “bailout” will help a great deal, but Q4 earnings are coming up, and when Citibank buys Wachovia, it plans to cut its dividend. So there might still be some bad news or dips coming up. As I’ve said, it’s very difficult to call bottom, and I don’t claim to be able to. But over time, its possible to build a favorable cost basis. Again, you have to be willing to handle the lows and the pullbacks in the short- to medium-term.

I expect to continue holding US Bancorp. It pays a respectable 4.7% dividend, and remains a well-run, low-risk bank. Amidst the recent turmoil, US Bancorp stock actually went up instead of down. That, I think, speaks to investors’ confidence in the company. The stronger banks, in the long-term, are a good play for conservative investors, I believe.

Energy and Commodities

I haven’t bought into the energy trade, and I remain cautious. In the longer run, the government “bailout” will mean more spending, which will be inflationary. Because commodities are denominated in dollars, that will keep the dollar in check, and should favor energy and commodities. On the flip side, there is a general belief that the world’s economies are slowing down. That will put downward pressure on stocks related to these goods. In addition, energy and commodities have been momentum-driven; with the “fast money” retreating from the market, there are fewer buyers of these stocks. So in sum, there are factors that favor these stocks, and factors against them; I don’t know which is stronger. I can’t say that the probability is high in one direction or the other. Because of that, I’m staying cautious. As I’ve said before in my column, all I can do is tell you my reasoning. When I buy a stock, it’s about making decisions based on given the information and the probabilities at the time. If the probability (as my reasoning has assessed it) doesn’t favor one direction or the other, then I prefer to stay away.

Altria & Phillip Morris International

I will continue to hold these two stocks, and I believe that the recent dips represent buying opportunities. They have held up well in the midst of recent problems, and I consider them conservative investments.

With the acquisition of US Tobacco (UST), Altria will probably go through a period of integration. Stocks entering this phase often take a dip as the company undergoes this transition process. Domestic growth will also continue to face challenges. If you hold this stock, expect it to be slow and steady, and more a dividend-driven investment than one driven by a growth in stock price.

On the international side, the worldwide slowdown will also be a challenge for PM. In recent weeks the stock fell as low as $48, compared to a recent year high of $56 or so. These pullbacks are solid buying opportunities, I think, and the only reason I didn’t buy more is that these two stocks are already a substantive part of my portfolio.

Huntsman

In previous articles, I’ve written about Huntsman as a merger arbitrage opportunity. Last year, Hexion agreed to buy Huntsman for $28 a share, and I bought shares in the $21-$24 range, betting on completion of the transaction. Management had bought huge amounts of stock in the open market, a vote for completion of the transaction, I thought.

Earlier this year, Hexion tried to back out, claiming that the combined entities would have been insolvent. The stock subsequently tanked, falling to the $10 range before rising to about $14. In recent weeks, concern that market conditions would forestall any merger, the stock fell back, dropping as low as the $8 range.

True, market conditions do not favor completion of the merger. But I bought again in the $10 range, reasoning that worst case, once things stabilize, the stock could reach $15-18 within a year or two. As a chemicals company, the rise in oil prices have hurt margins. When the market stabilizes and oil falls off its highs, that should improve Huntsman’s margins and bring the stock up. Buying at $10 brought my cost basis down to the $16-17 range. So if the merger didn’t go through, the stock would hopefully rise to $16-17 or so, and I would be able to exit with substantially less in losses.

Huntsman sued Hexion to have the merger completed, and yesterday, the Delaware court ruled in favor of Huntsman. The stock jumped $5.25, closing at $12.60 today. Given that the transaction price is $28, the $12.60 closing price reflects the market’s doubts about the merger. Obviously, arranging financing will be very difficult under the present conditions, so closing the transaction at $28 is by no means certain. Still, I will hold on to the stock to see what happens. If the “bailout” is enacted, that should help markets stabilize, and that might give the stock another bump. The key sign to look for in this situation is whether banks start lending to each other again. If so, confidence in a merger will rise. So for the moment, if you hold a position in this stock, that’s the thing to monitor. For a trade, buying Huntsman pre-bailout for a trade is a reasonable bet; once the bailout passes, and if Huntsman rides that wave and rises, then better to reassess the credit markets before buying. At that point, it’s definitely in the riskier category. Just to be clear, I consider an investment long-term, a trade as buy based on an expected event, and sell after the event passes.

That’s it for this month. Perhaps in the next month, we will live in less interesting times. Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.