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Investment risk can be quantified - so can reward. It sounds so simple, obviously you just compare the two and the decision makes itself. In practice it involves various assumptions, more of an art than a science but still worth doing. The past few weeks have featured fantastic gyrations by my two largest positions, MBI and ABK, so I decided to quantify the risk/reward for MBI, as a way of keeping my eye on my long term objectives rather than being distracted by the stock's market action.
As a procedural matter, working with a spreadsheet, if you can label the rows and columns then the rest is an exercise in filling in the blanks. In this case, column A is possible outcomes, B is estimated share price under that outcome, C is the odds of the outcome, and D is the weighted value (B x C). Totaling D gives you the probability weighted value of the shares considering all outcomes, which can be compared to the share price.
MBI Risk/Reward
A) Possible Outcome B) Price/Share C) Probability D) Probability weighted price
White Knight -
acquired for 1 x Adjusted
Book Value/Share 80.08 .05 4.00
Ratings affirmed, losses
manageable, reverts to midpoint
of Price/Adj Book Value range 67.50 .65 43.88
Stays at current price 28.39 .05 1.42
Downgraded, cannot raise
capital, liquidated for 50%
of Adjusted Book Value/Share 40.04 .10 4.00
Downgraded, Mid point price
after raising 2.5 billion by
issuing convertible preferred 61.67 .10 6.17
Downgraded, losses
unmanageable, shares become
worthless 0.00 .05 0.00
Total for all scenarios 1.00 59.47
With the stock trading at 28.39, and the probable outcomes yielding 59.47, I will hold the stock until I get an outcome. Price going to zero is always a possibility, however remote, so position size has to be kept such that the maximum possible loss is within my risk tolerance.
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Comments (2)
Tom, Is this stock still a hold or dump?
Posted by gullapalli | December 22, 2007 5:52 PM
I am still holding MBI. I sold it at 35 and added it back at 31. With the stock trading down to the 20 area on recent news I have been re-examining my assumptions. I posted a longish article under the heading "Broken Thesis? - MBI."
It has now become clear to me that the major risk here is dilution due to the need to raise additional capital. I read an article that quoted Marty Whitman as being satisfied that the Warburg Pincus deal would not result in "massive dilution" which he considered the biggest risk. His fund had 5% of MBI as of 9/30/07.
With 3 rating agencies having completed a stress test under realistic assumptions, I see a safe triple A investment, if and when the additional billion required by Fitch is added. I am waiting for management to explain how they expect to come up with the additional capital. Hopefully it can be done by reinsurance or something else that avoids further dilution.
Another issue is the details of the shareholder rights offering they expect to do during the first quarter next year. I want to get that information before making further decisions.
Until I get that information I am guessing MBI could be worth about 42 within a year, perhaps 50 in two years. If I were putting new money into Financial Guarantors, I would favor their competitor ABK, which now seems to have greater transparency on their disclosures, more skillful underwriting, and more adroit management.
Tom
Posted by Thomas Armistead | December 22, 2007 9:12 PM