August 2007 Archives (Tom A's Stock Picks)

August 2007 Archives

More MBI

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Bought 800 MBI at the market price

From MBI's 8-K on 7/26: "We have carefully reviewed our credits backed
by residential mortgages and remain comfortable with our exposure to
that sector."

MBI to do a webcast tomorrow on RMBS, I will plan to listen in. In the meantime, I am increasing my position to 70% of my planned maximum, relying on the last information I have from the company as to its subprime exposures.

JNJ cost cuts

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JNJ announced cost cuts yesterday. I was initially enthusiastic, but after reviewing the article I felt that it was news only to the extent it reassured me that JNJ management is addressing the issues. Because Procrit, Risperdal, and Topamax revenues are going to decline over the next serveral years, I would expect management to reduce expenses accordingly.

They did a presentation for analysts, I downloaded a copy from Thomson StreetEvents and read it. (I dislike listening to telephone conferences.) What I got from it is that they will continue their substantial R&D expenses, which include a lot of Phase 3, as well as the Sales expenses necessary to promote growth, on the grounds that it is what they should be doing to maintain long-term profitable growth. The expenses they are cutting are related to the revenues that are going to decrease or disppear.

Consumer Products - the Pfizer integration is ahead of the original plan. In Medical Devices, six our of seven franchises are doing well. They believe the drug-eluting stents business still represents an opportunity, and that issues will be resloved.

They don't intend to try to do an acquisition to compensate for any deficiencies in their existing lines, but would naturally look at opportunities.

I added 500 shares of JNJ today, based on my favorable impression of how they are handling these difficulties and positioning the company for continued profitable growth.

MBI RMBS presentation

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MBI did a presentation yesterday on their RMBS exposure. I downloaded the slides and listened to a replay of the webcast today. I was impressed by the way they presented the situation, they seemed pleased that their policies and procedures have stood up so well under the test of current conditions. Quotes:
- No protection contract written as CDS has been impaired
- Although housing market stress is expected, there are no probable and estimable losses in our portfolio today

So far so good. I was surprised, the stock went down quite a bit today.

Strategy Review

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I had some disappointments last week, the worst of these was MBI, off approximately 10%, similar to the rest of the Financial Guaranty and Mortgage Inurance stocks. As noted previously, I think MBI has done a good job underwritng their subpirme business and I don't think they will be seriously impacted as this debacle plays out. Hopefully this will become evident over the next six months and the stock will recover, reflecting additional demand for their products and improved pricing power. I will hold the position.

I spent some time thinking about Friday's selloff and speculating about whether it will continue next week, whether it is the beginning of a serious correction, how long that would last, and so on. I gave it up. Because I am focused on the individual stock, and invested in stocks that I believe represent quality at a discount, market swings are not a big part of my strategy. From a tactical point of view, it is embarassing to make a large move and catch a downdraft in the market or a new piece of negative information on the stock involved. To limit this, I usually enter my positions on a 40/30/30 plan: 40% of my planned total to start, and two additional increments of 30% as I monitor the news/earnings and market action of the stock.

Last week I added to my position in JNJ after reviewing their cost cuts. I added to MBI because it had gone down; and, with a decent earnings report in hand, I felt that market fear created a buying opportunity. It is likely that the market will be volatile next week, and I will look for opportunites to add to my existing positions at an advantage.

Buying more MBI

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Bought 800 MBI at 49.37, market order

This is my third and final buy here, approximately 20% lower in price than my first buy. I have had mixed results buying stocks that are declining rapidly - some of my largest profits have been made that way, but I have also been hurt buying on the dips.

The thinking here was that absent new negative information on the stock, its decline was part of the panic in Financials, and I would bear in mind the size of the discount to thier nonGAAP metric - adjusted Book Value.

Buying TESS

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Placed a market order to buy 4,000 TESS, 40% of my maximum position for this stock.

TESS is a distributor of wireless products. Their most recent earnings report was a disappointment, and the stock has declined rapidly over the days leading up to and after the report. Trading volume is not heavy and my order is taking a while to fill, the first 40 shares were at 10.65.

Before placing the order, I updated my worksheet on TESS and listened to the webcast on their earnings report. Two analysts asked questions, that is fairly typical as the stock is not heavily followed. What I got out of the call was that the company recognizes the need to expand their customer base and product offerings so as to become less dependent on capex from national carriers. As with many distributors, margins are thin, and management continues to address this problem.

They have a sales initiative aimed at broadening the customer base to get more enterprise business. This is increasing SG&A and does not help immediate earnings. They recently made some sales organization changes aimed at improving execution of this initiative.

On margins, they are developing and presently selling a proprietary product line which gets higher margins. They have also opened a center that does the packaging and I believe some light assembly to convert bulk shipments from vendors to retail packages. This will be an expense savings over outsourcing and provide better control of inventory.

The company has been an active buyer of its own shares, based on my observations they buy low, a plus.

The current price at 10.65 is 10.3 X TTM earnings. Based on the history of Price/5 Yr Avg Earnings and Price/Sales, I see a midpoint price of 17.50/share, and would look for TESS to return to that price level when earnings and revenue growth reflect success of the sales intitiative and margin enhancements.

Buying More OLN

Rating: 1.00 (2 votes) Vote:

Placed a market order for 2,000 OLN

The stock was down about 8% from my first buy. OLN reported its 2nd quarter on 7/26, .48/share, above guidance. Of the three segments, Metals showed better earnings and Winchester has the .50 caliber contract from the US government. Chlor-ALkali had earnings of 55.3 million vs. 67.2 in the 2nd qrtr of 2006, better than I was expecting. I updated my worksheet. Because the last two quarters were better than management's guidance, I marked the current guidance up accordingly and used it in my projections.

This brings my position up to 70% of my maximum for this stock. I will plan to put off buying the last increment until the PONR acquisition is completed.

Buying more TESS

Rating: -2.00 (1 votes) Vote:

Placed a market order for 3,000 TESS, the stock was at 9.30

This is getting very close to its tangible book value per share, which I figure at 8.90. This has been a very good buy in the past when bought close to book value.

Buying CINF

Rating: 1.33 (6 votes) Vote:

Placed a market order to buy 1,500 Cincinatti Financial (CINF), the stock stood at 37.30. This is 40% of my maximum position for this stock.

CINF is a Property & Casualty Insurance company, writing through the Independent Agency system, very agency oriented. Most insurance companies invest primarily in bonds, due to statutory considerations. CINF has a large amount of Equity investments also, because they have capital above and beyond statutory requirements.

I reviewed their Financial Statements and completed my workbook to look at their financials and form an opinion on value. It lists thier equity investments, which are primarily in conservative, dividend paying companies. Their investment strategy is dividend oriented.

Property & Casualty results have been excellent, similar to what others in the industry have been achieving, with combined loss and expense ratios in the 90% area. In the past, this was very unusual in the insurance business, but has been more common lately. Normally, insurance companies compete by writing new business at discounted rates. Lately more of them are doing share buybacks or special dividends to return the excess profits to shareholders. That, together with the concerns about the quality of bonds, may make them more circumspect in competing at a loss, diminishing the effect of the softening market.

At the current price, CINF is trading under its tangible book value per share. It has generally been a very good buy at that kind of price. I think this stock is worth more like 45-50 per share and would look for it to rise to that level as the fear around financial stocks subsides and as their fine, conservative underwriting and investment style is appreciated.

Weekly Review

Rating: 1.00 (1 votes) Vote:

I started the week planning to watch the my portfolio and increase my existing positions if any buying opportunities arose. As it happened, with the extreme volatility, a couple of stocks that I follow got down to buy points so I added two new positions: TESS, a wireless distributor (two buys) and CINF, an insurance company. They both recovered nicely today, giving me gains of 12.35% and 8.36% respectively.

I also added to my positon in OLN, (Metals, Winchester & Chlor-Alkali) when it was down about 8% from my first buy, and was rewarded with a 10.22% increase today.

I feel that the fear factor has been lumping all Financials together, dragging some of them down far more than their exposure to subprime would call for. As Friday progressed, the market started sorting things out, so that CINF and other Property & Casualty or Multiline Insurors were up while the Mortagage Insurance and Financial Guaranty Companies were down for the most part. I will hold my position in MBI, a Financial Guaranty Insuror, because I think they have done a good job underwriting their subprime exposures and they are going to have fewer losses than most investors expect.

At this point I have approximately 80% of my funds invested. I am happy to be showing a profit after putting that much money to work in such a volatile market. It is good to have cash on hand to take advantage of opportunites as they arise without agonizing over what to sell in order to make the next buy. With that in mind, I will continue to hold about 20% cash so I can have the freedom to respond aggressively as situations develop.

Am I running a Quant Fund?

Rating: 2.00 (7 votes) Vote:

I have to ask myself that question after reading in the WSJ that Thursday's peculiar market action, with good stocks down and bad stocks up, was caused by leveraged "Quant" Funds unwinding their positions. Quant Funds, as described by the article, run their portfolios by means of computer programs, assuming that stocks will conform to various statistical patterns and taking both long and short positions accordingly, meanwhile applying leverage in the form of borrowed money.

My system starts with the assumption that a stock's range, in terms of either its Price/Sales or Price/5 Year average EPS, is a lognormal distribution. I review ten years worth of historical financial information, and make the assumption that the high and low Price/5 Year Average EPS (or whatever metric I am using) are 4 standard deviations apart. I assume that the midpoint price of the stock is halfway between the extremes. My Excel workbook assigns a percentile to the stock's current price on that basis, and I make my stock selections from among stocks that are trading below their 30th percentile as I compute it, generally buying somewhere around the 5-10th percentile. I start selling at the 50th percentile, generally I am out by the 70th.

This relies on the assumption that the stock price will revert to its mean, the same sort of assumption that the Quant funds have been relying on for many years. I have reinvented the wheel. For the past three years, this system has worked for me when I was long the stocks involved. The reverse concept, shorting stocks that are high in their range as I see it, has been hazardous: I made a small amount of money doing it, but approximately 1 in 5 short positions went against me badly. The right hand side of a lognormal distribution can extend out a long way. Fortunately the SLO doesn't permit shorting, so I will stay out of trouble.

By no means do I make my decisions on a mechanical basis. To begin with, the minimum and maximum Price/5 Year average EPS ratios are sometimes so extreme that I discard some values as outliers. Also, many companies have "one time" charges or bad years that need to be looked at and left out or included in. Small changes in these assumptions can lead to big changes in the expected price ranges. Some companies have a bad business model or an obsolete product or technology and being cheap doesn't make them a good buy.

Frequently value candidates developed by this system have problems with slowing growth or shrinking margins. I operate under the rebuttable assumption that management will resolve the issues. This is where I read Management's discussion in the 10-K or 10-Q, to see if I can develop an affirmative answer, that they have identified some solutions to the problems and are actively pursuing corrective action. If they have a strong balance sheet and cash flow, they have the resources to perform their task; and, unless they misdiagnose the problem, improvements will occur over time.

Also, this system performs poorly when an industry is in transition, going from a series of fat years to lean years, or vice versa. For example, it got me out of various steel and energy stocks when those industries started to experience improved margins, which were more durable than I thought they would be. Homebuilders, which are now suffering loss of both revenue and margin, would be another case where I question if my methods are workable. This is a critical point where judgment is required.

The positive aspect of this approach is that I don't make a lot of serious mistakes working the way I do. A stock's price movement has three dimensions - direction, magnitude and timing. Direction I usually get right. This is a plus, because you need to go up 100% to compensate for a 50% loss. On magnitude, I don't catch a lot of big moves, but I catch the easiest part and reduce the number of round trips. To improve magnitude, I am working on making fewer trades, focusing larger amounts of my resources on my best picks. Like many value investors, I tend to sell early. Timing is a question of patience. I will wait for as long as two years before I give up on a situation.

To answer my own question, quantitative methods are a tool, a starting point, and not a substitute for qualitative decision making.

BJS vs Oil & Gas Services & Equipment Peers

Rating: 1.00 (2 votes) Vote:

BJS has not been doing well, and is hurting me in SLO and also in my personal portfolio. Under the cirmcumstances, I decided to compare it to its peer group. Taking a list of its peers from an S&P report, I created a portfolio in Morningstar, weighted by market cap, and got a report listing P/E, P/B, P/S and P/CF for each stock and the group as a whole.

BJS is lower than the peer group average on all of the 4 metrics. If it traded at the average, its price would be 37 rather than the current 25.50. Looking at total return ytd, BJS is down 12.7% while its peer group is up 37%.

My interpretation: lack of momentum. There are a lot of momentum players out there, and once a stock loses momentum it is shunned. I am not a momentum player, although I do look at growth as a judgment area when selecting stocks.

What I see is a stock trading at a P/E of 9.8, with TTM and 5 Year growth both at 17% in revenue and higher in EPS. I think this industry is going to grow long term, because it requires more technology to squeeze additional oil from declining or unconventional fields and demand for energy will be increasing indefinitely and exponentially. BJS is a solid player and will participate in this growth.

I will hold and wait.

Buying CB

Rating: 1.67 (6 votes) Vote:

Placed a market order to buy 1,200 Chubb (CB), stock stood at 48.85

Chubb is a large property and casualty insurance company, operating in three areas of the buinsess: personal ines, where they are strong in meeting the needs of high end customers, commercial lines (when I was in the business, they had a reputation for skillful and disciplined underwriting), and specialty insurance, to include Directors & Officers and Professional Liabilty (not easy classes of business, requires expertise.)

At 48.50, they are trading at 10.7 X my projected 5 Year Average EPS. This is the lowest price on this metric that they have had in 7 years. Five year results include some Asbestos liability reserve increases in 2002 & 2003 which are beginning to fade into ancient history. I sort of half look past them, they were so long ago, although in the insurance business it seems like there is always something like that over any substantial period of time. They took a hit on Katrina but still made money, also included in their 5 year average EPS.

Insurance is a cyclical business, and historically the companies have not been able to stand prosperity. Anytime they start making real money they have a price war until they lose money and one or several of the weaker players approach insolvency. I think the current cycle, which is starting down after several outstanding years, will deteriorate more slowly than in the past.

Insurance companies also invest heavilyin bonds, to include Mortgage Backed Securities. I read the section of the 10-K for 2006 which summarizes their exposure. After reviewing it, I am confident that they will not be involved in meaningful losses from any subprime that may exist in their portfolio. As a practical matter, many of their liabilites come from long-tailed lines of insurance and they would of necessity be careful to make safe long-term investments.

Reason to expect that the P&C price cycle will moderate: 1) companies, to include CB, are showing a preference for using their profits to buy back shares rather than underprice new business 2) the bad press around credit risk will give them every motivation to continue to make underwriting profits, since investment profits may be more volatile than reason would call for.

Putting all this together, I see a stock at an extreme buy point. I am starting with 40% of my planned position. This buy is going to give me a heavy concentration in insurance: however, I was in the business for many years and I am comfortable investing in it. I have made good money over the past 3-4 years on insurance stocks, to include CB.

AMAT earnings & conference call

Rating: 2.50 (8 votes) Vote:

AMAT reported 8/14, EPS & Revnue were a little above expectations, bookings and backlog were down. Market reaction has been negative, the stock at 20.55 is off .69 or 3.24% as I write.

I listened to a recording of their conference call, available at their website. AMAT has multiple segements and many of the analysts seemed to be trying to pick up a little information to improve what would be relatively complex models. I don't attempt projections at that level of detail unless the stock only has one or two analysts and I might be able to get something others would not have.

What I heard was a belief on management's part that they will be able to mainatin or slightly improve current margins, which are generous. Over the next year or two, demand for memory should improve due to the amounts required for mobile storage and the amount required to accommodate VISTA when that achieves corporate acceptance. Foundries have been achieving higher utilization rates before resorting to capex, and the move to 65 nanometer has been slower than anticipated: both trends are expected ameliorate over time. They have held or or made small incremental gains in market share where they are dominant and gained share in other areas.

LCD TVs are doing well in the marketplace, but orders for the equipment have not kept pace. Flat panel displays is a growing market as far as I can see.

Cash flow has been good and was used (in part) to buy back shares at an average price of 19.99, a bargain in my opinion and as such it improves the value of the remaining shares. R&D expenditures continue: I think it is a strength of the company that they have the ability to fund as much R&D as it takes to achieve their product enhancement/development objectives.

The solar is ahead of target - they raised their goal from 400 to 600 million in orders for the year. There are a multitude of technologies contending for dominance in this market, AMAT is determined to use their substantial resources in order to be a major factor in this field, and they are not placing all their bets on any one technology at this point. Their point, which I think is well-taken, is that this business is dependent on reducing the cost per watt of solar generated power, and they directing their efforts in that direction.

After putting all this through the blender, I feel AMAT's resutlts are along the lines of what I was looking for. The solar will take years to develop but is ahead of target. My position is less than full size and with a favorable impression of their progress to date, I can add to it. Because the stock is going down right now and the market is volatile, I will defer action in the hope of getting a better price.

Buying more BJS

Rating: -1.50 (2 votes) Vote:

Bought 2,000 BJS at market, filled at 23.99

The major indexes were down more or less 2%, BJS was down along with the rest of the Oil Service Sector, more or less 10% down from my first buy. As planned, I added another 30% of my maximum for this stock. Its not really that much fun feeling for the bottom this way, but I have done my homework on BJS and I think it is a good buy at this price.

Selling some MBI

Rating: -1.50 (4 votes) Vote:

Placed a limit order to sell 800 (of 2,600) MBI at 60.50

It filled, slowly, at 60.74.

The market, and Financial Guaranty stocks in particular, was up very strongly due to the Fed's unexpected action in lowering the discount window rate. While I believe MBI will ultimately escape the sub-prime fallout without material damage, the stock has been very volatile. This reduces my position back from 100% of its planned size to 70%. I am well represented in Financials with the recent additions of Chubb (CB) and Cincinatti Financial (CINF). If MBI continues its yo yo action, I can always buy some more.

Weekly Review

Rating: 2.22 (9 votes) Vote:

Market conditions were chaotic, a week long roller coaster ride. A lot of the action was in the Financials, and fortunately for all of us the actions taken by the Fed seem to have forestalled a general panic and total breakdown of credit markets. As a contrarian investor, I am accustomed to working in sectors that are out of favor or having difficulties. As such my SLO portfolio is heavy to Financials, all insurance companies. My three insurance companies, MBI (Financial Guaranty), CB & CINF (Property & Casualty) all did well. I focus more on value than on sector diversification, but I was a little nervous about the amount of Financial I had and reduced it slightly today, selling 30% of my MBI.

I got a big boost from last week's buys of Tessco, a wireless distributor (TESS). It had reported earnings which disappointed many shareholders, and in the volatile market there was an over-reaction, not unusual in a small growth stock. For the past 6 months I have been able to find a lot of value in large caps and have mostly stayed with larger companies: however, I have owned TESS in my personal account from time to time for several years with good results and I still follow it, so it was easy to make a quick decision and add it to my portfolio.

What also was working was defensive stocks, JNJ and PG, both of which I added to my SLO portfolio during the first week based on the observation that they are trading on the low side of their historical ranges - JNJ in particular.

I don't have any definite plans for next week - I am 80% invested and given the current volatility I can't predict when and if any new buying opportunities will arise. I have an interest in the Homebuilders, I have followed a selection of them all year, and some of them are approaching or recently hit what look like buy points based on Price to Book which is the metric that most analysts seem to favor for the sector. I use tangible book because many of them have goodwill on the balance sheet, subsequent to acquisitions, and which may very well result in charges.

Because so many stocks have recently hit 52 week lows, I may spend some time reviewing a list and evaluating any familiar names.

Selling TESS

Rating: 0.71 (7 votes) Vote:

Placed a market order to sell 2,800 (40% of my holdings) TESS, stock stood at 15.88

TESS is a wireless distributor, I bought the shares at prices as low as 9.19 two weeks ago. According to my Price/5YrAvgEPS metric, this is now at its 40th percentile, approaching the midpoint of its range. I felt that with so much quick easy profit in hand I would start taking some, beginning to exit on the 40/30/30 plan.

This is a little earlier than I would normally start reducing, but over the years I have owned this stock it has had a tendancy to be fairly volatile, perhaps because it is a small comany and doesn't trade that many shares on the average day. This is a volatile market and a sudden downdraft could create a round trip.

The order filled at an average net price of 15.47

Dealing with Risk

Rating: 1.69 (16 votes) Vote:

I worked in the insurance business for many years, and my attitudes toward investment risk are influenced by that experience. I don't mind risk, provided I am collecting an adequate or hopefully excessive premium for bearing it. I'm interested in risk management as it applies to limiting the downside on my portfolio.

On the safety side, it seems to me that in 2000 or 2001 safe stocks fetched a premium - the proven ability to report profits reliably, year after year, was prized a lot more than it seems to be now. Stocks such as JNJ and PG, which I regard as safe and reliable, just don't seem to fetch the kinds of multiples they did back then. My hope is that market volatility will evenually create a situation where these types of stocks will be in favor.

On the risk bearing side, I think the present dificulities in Financials reflect an unwillingness to attempt to evaluate risk on a case by case basis. For the financials in my portfolio, I looked at the information that was available on stocks that I understood and came to the conclusion that the likes of CINF, CB, and MBI (all insurance companies) are not going to experience material damage to their balance sheets from subprime. I have read posts by a number of players who took chances on mortgage companies such as CFC or TMA. Seeing the results they got, I was tempted, but I have decided to stay with what I am familiar with.

As far as spreading risk out by making multiple small investments, I prefer to spend more time on fewer investments, under the belief that investment risk arises from the operations and finances of individual companies. I would rather spend the time to make one carefully thought out investment than spread the same amount of money over a number of companies I haven't taken the time to study and understand.

I keep an eye on sector concentrations but I tend to overweight troubled sectors because thats where the value is.

In my personal portfolio, I have hedged against market downside by carrying Puts on the OEX as insurance. I cashed some of them in last week, but held most of them, I guess because I don't think we've seen the end of this correction. In SLO I have been accepting the risk that the market would go down and take my stocks with it. I notice some players have had success with the Ultra Shorts, I wish I had thought of that, but from where it is now I am going to just stay long and hold a little more cash than I normally would.

I spent some time this week working on my watchlist, with 50/50 hindsight I think I missed some buying opportunities and I am in the process of reorganizing to be able to respond more quickly if we have more volatitlity. I also ran a couple of screens, based mostly on cash flow, looking for new ideas.

MBI - analyst support

Rating: 1.00 (4 votes) Vote:

An article in the WSJ today, headlined "Bond Insurers see Ill Winds Batter Shares" mentions MBI (roughly 10% of my SLO portfolio) and includes some commentary from analysts which supports my view on this stock.

Specifically, Ms. Kravec, with Banc of America, sees a "worst case" outcome for MBI at a loss of 3.6% of book value, while in a more likely scenario MBI's sub-prime losses would be negligible.

While I do my own analytical work, because I think that where I can make money is where my opinion differs from the consensus, I read what others have to say on stocks I follow, either for confirmation of my thinking, or to pick up on items I might have missed. In this case, I am encouraged to see that a professional has drawn the same conclusion that I have - that MBI is a bargain because the market is pricing in losses beyond anything that is likely to occur.

I printed the article as a pdf file and saved it where I can find it. I keep notes on my stocks, finding it helps my decision making ability, particlularly when prices are down and I need to maintain my composure. My personal portfolio is already maxed out on MBI, but in SLO I could add some and still stay within my position size guidelines, which is 15% of my portfolio in this case.

Effects if Fed cuts rates

Rating: 1.82 (51 votes) Vote:

When rain falls on a parched desert, long-dormant seeds spring to life, a thousand flowers blossom overnight, dunes are adorned with a lush and verdant carpet of vegetation, dry stream beds awake as burbling brooks...So too, when the Fed lowers rates - thrifts, mortgage companies, investment banks, conduits, homebuilders, financial guarantors - all will flower anew - a mighty flood of liquidity will wash across the parched economic landscape. The river of mortgage payments, which only yesterday ran dry, will spring back to life. Torrents of cash will flow down the waterfalls, drenching the equity tranches...

Perhaps the overall effect will not be that dramatic. Anyway, to predict which stock in my portfolio would immediately respond best to a rate cut, I can look at what happened on 8/16-17, as the market plunged and then rallied after the Fed cut the discount rate. MBIA Inc (MBI), a financial guaranty insurer, traded as low as 50.45 on Thursday 8/16, and closed at 63.60 on Friday 8/17, the date of the announcement - a 25% gain overnight. It has since been slowly surrendering its gains.

MBI insures securities backed by sub-prime mortgages against default, and also holds them in its investment portfolio. As I discussed in my blog when I added the stock to my SLO portfolio, based on their presentations and disclosures I don't believe they will suffer serious losses due to the sub-prime debacle.

However, the underwriting and credit analysis for these instruments is complex and relies on models which may perform poorly when credit markets are subjected to extreme stress. While MBI representatives genuinely believe that a worst case scenario would not subject their employer to material adverse results on either its insured or investment portfolios, the market seems to be pricing in a possibility that MBI could suffer crushing losses in a melt-down of sub-prime mortgage backed securities.

Looking at the sub-prime crisis as it affects the economy and our financial system, the common sense conclusion is that the safest course for the Fed will be to ease credit in order to prevent a worsening of the crisis. This will result in bailing out many participants in the sub-prime fiasco. If the Fed acts as expected, the perceived risk to MBI would diminish markedly, because it requires a cataclysmic downturn, something totally beyond what they have reflected in their models, to cause serious harm.

Based on this line the thinking, once the Fed starts the rescue operation, MBI would go up substantially during the days following the rate cut announcement, repeating its performance of 8/17.

Looking several quarters down the road, it is harder to predict the timing of the long-term effects of a rate cut, or series of rate cuts. Investors will be attempting to rotate into the sectors most likely to be affected, and many will be looking for a recovery in homebuilders, banks and finance companies, or building supplies. I follow a selection of homebuilders and own them in my personal portfolio. I plan to add some to my SLO portfolio, feeling for the bottom, primarily based on the fact they are trading in the general area of 1x book value.

Dividend payers generally should do well as dividends will be more attractive in a lower rate environment. With 10 out of 11 stocks in my portfolio paying dividends, that should help me. All stocks in the interest rate sensitive Financials sector should benefit, including Cincinnati Financial (CINF) and Chubb (CB), both insurance companies included in my SLO portfolio. Concerns about possible losses on mortgage backed securities have been depressing their shares, which should cause them to rally as fears are reduced by the rate cut.

On a case by case basis, companies with excessive debt loads or liquidity issues might make impressive gains. Companies generally considered as buyout targets might start trading at a premium again, particularly if they become the subject of rumors or speculation.

I expect MBI to also perform well in the quarters following a rate cut, assuming a recession is avoided or contained. Their quarterly earnings will be carefully watched, for either mark-to-market losses on their investment portfolio or case reserves on their insured portfolio. If they avoid major losses, the stock should rally after each report. Under a best-case scenario, chastened investors will be unwilling to accept credit default risk without being adequately compensated. MBI will then prosper as risk aversion creates expanding demand for their guarantees and improved pricing power. With a combination of revenue growth and margin improvements, EPS and the P/E multiple would expand together, increasing share prices accordingly. I am looking for 75, which would be a 50% gain from the lowest of my 3 buys.

Actually I am not that confident that an immediate rate cut or series of cuts will solve all the problems. The way I remember the last time real estate went down, a lot of banks had to be closed or merged, taxpayers picked up the tab, many homeowners struggled for years with mortgages they could not handle and condominiums decreased as much as 50%, leaving many good faith buyers with no equity. Commercial real estate got involved due to overbuilding. It took years to muddle through it. At this point, securitization has been discredited, and a rate cut or two is not going to restore the willing suspension of disbelief required to pick up where the party ended. Also, when a ship is sinking it is every rat for himself. I am sure that some relationships were damaged while panic swept the markets, and it will take time to rebuild trust and get things flowing smoothly again.

With that in mind, I will enjoy any gains arising from a rate cut, but I will not be making major changes to my portfolio in anticipation.

Tom A's Stock Picks

Tom Armistead

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