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This Time It's Value Traps

Most financial bubbles are pretty easy to spot: An asset class climbs way beyond what old-fashioned valuation measures used to define as reasonable, market participants start acting like idiots, and pundits rationalize the madness with learned "new era" theories. Think late-90s tech stocks or California houses in 2005 or today's Shanghai stock market. This kind of bubble announces itself loudly, making it easy to ridicule and/or bet against.

But today's U.S. stock market is a different, trickier, far more dangerous kind of bubble, because the stocks that are wildly overvalued actually look pretty cheap by traditional measures: Banks and brokerage houses at 12 times earnings, homebuilders at 1.5 times book, retailers at 1 times sales. In terms of historical trading ranges, there seems to be nothing here to get excited about.

But look a little closer and you see that these are classic "value traps," stocks that seem cheap but are actually wildly overvalued because their underlying earnings, book value, dividend yield or whatever are artificially inflated. Value traps are common at the end of long expansions, when corporate earnings have spiked because of supply constraints, but stocks haven't, as investors begin to suspect -- rightly -- that demand is about to slow, thus compressing profit margins and sending earnings off a cliff. Hence the juicy-looking valuations.

A few weeks ago I interviewed Bill Laggner and Kevin Duffy, principals of Houston-based hedge fund Bearing Fund LP, for a magazine article. Great interview, much of which, as is always the case with magazines, ended up on the cutting room floor because of space constraints. But their thoughts on value traps are so timely that I've asked their permission to post more of the interview here:

Bill Laggner: Today the faith is clearly in central bankers, that they've got things totally under control and have engineered a synchronized global boom. If you're not participating in this global boom you just don't get it. It's not just faith in the Fed but in all the central banks. A good example of this thinking is BusinessWeek's recent cover story 'It's a Low, Low, Low Rate World.' The idea is that foreign central banks will continue to finance our excesses, they always have and always will, and as a result interest rates will remain low.

Kevin Duffy: This time around the inflation has been the good kind, like home values and stock prices, rather than the things we buy at the grocery store. That was a common theme with Japan in the late 80s and the U.S. in the late 1990s. It's exactly the same script. Back in the late 1990s all the talk was 'hey, we don't have any inflation.' Today we have a little more, but it's not enough to worry people.

The last bubble was in valuation, with all the hot money flowing into technology. This time around it's value traps, primarily financial companies. 45% of corporate profits come from financing. Financial stocks account for 23% of the S&P 500's market cap. Add in the GMs and GEs [which earn most of their profits through financing] and it goes even higher . How many people said "we've got to buy New Century because it's trading at book value and the dividend yield is so high?"

BL: Bloomberg just ran an article on how everyone is looking at financials and saying 'gee, based on valuations, financials are the cheapest they've been since 1996.' Easy credit has created this gain-on-sale love-fest and they've extrapolated it like in any bubble.

Ken Fisher and a lot of other money managers have been telling people to buy the homebuilders because based on price/earnings and price/book this is one of the cheapest sectors in the marketplace. But book value is misleading because land values are highly inflated. Most of the big builders were constantly acquiring land and other builders, assuming interest rates would never go up and we'd have this mass influx of people and the demand for housing would keep increasing. Now they're writing down their land, which is an impairment to book and could go on for the next three or four years.

Hovnanian [a leading homebuilder] has taken earnings estimates down twice in the last 40 days. They posted a loss before impairments, so on an operating basis they're losing money. This is an example of people catching falling knives like tech sell-off of 2000-2002. 'We're gonna buy these things because they're cheap,' but they can get a lot cheaper.

MBIA, the municipal bond insurer, looks cheap at 11x earnings and 1.4 x book value, but when you look at the balance sheet, which very few people look at today, you see that it's levered 94 to 1. The statutory capital that they keep on hand is 3.5 basis points of their bond guarantees. Compare that to Citigroup, which has almost 9.5 basis points of reserves. Ten years ago just 14% of MBIA's business came from structured finance guarantees on asset backed securities. Today that number is 32%. Of course the structured finance world is all based on numerous assumptions, including stable interest rates and low default rates. We would say that those are very generous assumptions.

On the pure bank side there are a few, primarily in California, like First Federal and Downy Savings & Loan where 75%-80% percent of their book is negative amortization mortgages. Most of these borrowers are not even making the minimum payments, so the principal grows -- and these banks are booking that as income. They can do it until the borrower's principal gets to 110% or 120% of the original loan, which might be a couple of years after the origination. This is a classic case of nonperforming loans not being categorized as nonperforming loans.

KD: I was at a conference in Boston in 1998, right before LTCM [Long Term Capital Management's implosion]. David Dreman [a prominent value investor] was speaking at this conference, and I asked him how you avoid value traps. And his answer was 'that's kind of the risk in what we do; we're just not very good at that.' I find it interesting that today Dreman is one of those people saying you should buy the brokerage stocks. Ken Heebner [manager of the CGM Realty Fund] was smart enough to see the housing stocks as value traps but he's now buying the brokerage stocks. These are two guys with stellar reputations now staking those reputations on brokerage stocks.

Everyone is saying subprime is contained, the brokers make money on the unwinding of subprime, they make money in any direction, they're the smartest guys in the room and all the rest of it. There's just a tremendous amount of optimism about the brokers. The estimates for the big five, Goldman, Merrill, Lehman, Morgan and Bear have them at a P/E of 10.6 and price/book of 2.29. In the mid-80s we were buying brokers like Legg Mason at book value. That book was a lot more real than what we're looking at today.

So many things are done off-balance sheet today that it would be very difficult to get a real book value for the brokers. Today they're leveraged something like 25 times total assets to tangible equity, and we don't know about the games being played off balance sheet, or how much the over-the-counter derivatives are being inflated by mark-to-model pricing. Also, the big five have at last count total assets of $3.9 trillion, and in the first quarter they were growing at a rate of 34 percent. There's practically no limit to how much they can borrow.

BL: They're posting smaller reserves for these various assets, and this is just the leverage we know about and doesn't take into consideration the leverage we don't know about. For example, some of the big brokers don't even report their swap exposure.

KD: The brokers are really at the epicenter of all the big bubbles: private equity, commercial real estate, and hedge funds. They've got a tremendous amount of exposure and litigation risk. They're not just brokers in the traditional sense. They're risking their own capital now, more than they ever have. Goldman for example gets 65% of its net revenues from trading and investing. Some of this is skill, some is just leveraging asset inflation, some is writing insurance, and some is cheating. We're starting to see that there's a lot that going on. A boom hides a multitude of sins, and the bust exposes them. Also, in retrospect, I'm sure that we'll see that there were all kinds of conflicts out there.

This credit bubble has morphed over the last several years. It was focused initially on residential real estate - amateur hour. The housing bubble obviously hit the wall in July, 2005 yet the stock market is up over 20%. What's going on? It's a credit bubble, not a housing bubble, and as the air has gone out of that balloon the torch has been passed to the professional speculator who shows up in commercial real estate, hedge funds, and private equity. It's amazing how this bubble has changed its spots over the past few years. It also makes it more dangerous, because we have a new bubble on top of the older bubble. The new bubble has masked the damage of the older bubble, so we'll end up with both deflating at the same time, which could be quite spectacular.


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