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I'm betting big on BDCs, insurance, and banks ACAS, BX, ARCC, ALD, HIG, etc.

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March 10, 2009 – Comments (13) | RELATED TICKERS: ACAS , ALD , HIG

In my last post I talked about how perhaps the best play on the market was a play betting on eventual mark-to-market accounting reversal.

For those not familiar, mark to market accounting (ala FAS 157, applied widely to insurnace companies, banks, BDCs, and more (although not to GE)), it works about like this:

imagine you owned a company that made $100,000 every year, like clockwork.  Imagine you also owned $5million of bonds that paid 4% every year like clockwork.  $200k every year, clockwork.  Thast $300k every year and in 10 years or so you get the principle back on the bonds and yo ucan start over. 

But imagine one year the bond market went completely to crap, ok?  And if you sold all the bonds that year you'd only get $3 million.  You're still getting your $200k in interest, ok?  You're still making $100k a year from your business, you still will probably get paid the principle back on those bonds some day, and overall...  you're situation is exactly the same as normal.  But, nevertheless, you would via mark to market accounting report a $1.7 million loss that year.  And people would panic and tell each other that you'd lost everything and run screaming into the streets, crying and yelping and hollering. 

But now imagine that the next year the bond market has a boom time, a period when people can't get enough bonds.  And then you'd be able to sell those $5mil of bonds for $5.5 mil.  You still made $100k from your business, you still made $200k in interest, like the year before, NOTHING CHANGED AT ALL.  But via mark to market accounting you would for this year report $2.8 million in profits.  And people would panic and tell each other you were rich beyond belief and line up to be your friends...

And so it will be with stocks.  MANY MANY insurance companies and banks are going to post EPIC SHOCKING profits in a few years when the mark-to-market value of things like mortgage backed securites comes back up.  THE ONLY LOSSES WILL BE THE PERCENT OF LOANS THAT AREN'T PAID OFF LESS THE COLLATERAL VALUE ETC ETC ETC.  right now even paying loans are being market to market, causing enormous losses ON PAPER in banks, insurance companies, etc.

After my last blog post I totally overhauled my portfolio and bet heavily on insurnace, banks, and my favorite category...  BDCs. 

BDCs are like REITs in that they are required by law to pay 90% of income out as dividends (good for shareholders most years), and like banks they are required to mark their assets to market.  And like banks, the market for tohse assets is currently very illiquid and consists mostly of distressed sellers, which in turn results in a situation where most of "fair value market prices" are very low.

Which has wreaked extreme havoc on the book value of most all BDCs, sending them at times into violation of loan covenants and sending their share prices into a black hole of apparent oblivion.  Due to vilation of the loan covenants some of them have been issued going concern notices.  Its not a pretty situation at all.

But like our imaginary business above, business is actually ok for many of them.  Cash flow is positive, they aren't behind on debt payments at all (in fact paying down debt) and their losses are nearly all on paper.  Or vastly on paper.  Or largely on paper as the case may be. 

And, like our imaginary business above, these companies stand to one day be able to mark their assets BACK ONTO THEIR BOOKS, which may result in eye popping profits at some future time when the macro environment is calmer and gentler. 

I've loaded in the past 2 weeks up heavily on ALD, ACAS, ARCC, BX, and MCGC (all BDCs that i judge to have undervalued shares and good chances of survival), and so far those buys ar eall above water. 

In the case i've loaded up on th emost - American Capital or ACAS - they are trading at about 1/30th of book value EVEN AFER THE UNFAIR MARK-DOWNS, never mind after alot of asstes are marked back up with time.  And about 1/5th of annual cash flow.  Not a price/cash flow of 5, which would be good, but a price/cffromoperations of 0.2 or so. 

Not going to get too many chances in one lifetime to bet on companies that

1.  aren't delinquent on any debt or behind on any payments

2.  have positive cash flow exceeding their market cap

3.  have a price/book of 0.05 or so 

4.  have paid, on average, more annual dividend than the current share price for 10 year so rmore

So i've made large bets, and i'll continue to expand them.  So far so good.  I'm 2x my cash on ALD as of close today, a few cents up on ACAS, and a bit up on the rest.  My purchases have weighted MCGC hte lowest, then ARCC, ALD, and BX about the same, and ACAS the highest. 

Good luck to everybody who's long on the market, may all shorts suffer.

13 Comments – Post Your Own

#1) On March 10, 2009 at 6:13 PM, 100ozRound (29.49) wrote:

What's going to happen to their BDC status if they can't make their div payments?

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#2) On March 10, 2009 at 7:37 PM, Varchild2008 (85.29) wrote:

I love the news this week.  Check out my blog.  Very beginning of March I declared that we have finally saw the bottom of the economy and America's economy was booming again.

I pointed out the economic turn-a-round perhaps before anyone else did.  I did it on the same day as the CPAC meeting.

However, as bullish as I've been since March 1st...
I'd be careful and cautious with your betting at this point.  We are not flipping from Bear Market to Insta - Bull Market.

In this economy the Bull Market we get out of the positive news flowing this week and even if mark to market is reversed with something far better. . . . .  What we will have is what I would call a "Fragile Bull" Market.

I expect a trend upwards long term and the stock market's bottoming out process is meaningless.

I.E.  I recommend not throwing money at umpteen million banks and insurance companys.  I think the growth potential is if you put your money into the strongest banks and insurance companys.  Not the ones you think have a wider 'beta.'

The technical analysis decision of choosing which stock was beaten up the most will make you buy Citigroup or BAC when you should probably buy TCB, MI, JPM, WFC, or perhaps GS.

Just something to think about... In a weak bull market the strong recover faster than the weak is my theory.

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#3) On March 10, 2009 at 7:39 PM, Varchild2008 (85.29) wrote:

One more thing....

I think the ultimate strong buy stock in this "Weak Bull" market....  Is "AFL."

I am seeing if I can pool enough cash together to scoop up some solid shares of AFL. 

American Express (AXP)  is also a possibility.  But I think Aflac recovers sooner than American Express.  Still a Credit Card mess out there to worry about.

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#4) On March 10, 2009 at 7:47 PM, checklist34 (99.71) wrote:

Thanks for the ticker ideas, I love it!  AXP at 10 i missed which is a shame.  Maybe i'll get another chance at it...

In insurance I'm betting on XL and HIG most heavily.  HIG responds wildly to the market itself as a considerable amount of its portfolio is related to equities and its AA credit is in jeopardy, which makes people really shy about this thing when the markets are down and suddenly bullish when the markets rebound.  I'm up nearly 50% on some shares of HIG bought last week, so i'll take profits in the morning, buy mor eif it goes back down...  XL is considerably well on its way to being out o fhot water and is priced through the floor.  It'll never recover its former highs due to dilution among other things, but has huge upside nonetheless.

I'll check out your blog, varchild.

100ozround:  they are temporarily allowed by the IRS to pay their dividend as 90% equity and 10% cash.  That is a negative for shareholders...  as we will still be taxed on the equity component even though the dilution it brings means it has no value to us (neutral, zero value, neither good nor bad, but we're taxed).  oh well...

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#5) On March 10, 2009 at 8:21 PM, Harold71 (22.90) wrote:

If you get a big gain on these financials, take it.

The financial death march is only 1.5 years in, of a 10+ year cycle.

Good luck to everybody who's long on the market, may all shorts suffer.

LOL. 

I'm sure the shorts are hurting for being so keen on the reality of the situation the past few years.  The shorts are also not making these companies go BK.

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#6) On March 10, 2009 at 11:31 PM, checklist34 (99.71) wrote:

harold, a great deal of the bank liquidity situaiton and the losses that they have taken relates to fas 157 and mark to market accounting.

the wild irony of that is that ... someday they can mark those assets back up, which means that the radical dramatic paper losses they are having now will, in part, be reversed into radical dramatic paper gains at some future date.  Same for insurance companies and BDCs

Additionally, the cost of money fo rbanks has never been lower, which will drive future profits.

The bank situation is not as bad as it seems, as Vikram Pandit alluded to today

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#7) On March 11, 2009 at 1:25 AM, Harold71 (22.90) wrote:

the wild irony of that is that ... someday they can mark those assets back up, which means that the radical dramatic paper losses they are having now will, in part, be reversed into radical dramatic paper gains at some future date. 

I'd be willing to take the other side of that trade.  (After another false hope rally, of course.)  The optimists have been saying this since the crisis began, but most people have figured it out by now.

In my judgment, the world's financial/monetary system will be reformed because of this debacle, and you regard it as some kind of simple accounting method problem.

It's not a liquidity problem, it's a fundamental solvency problem.  That goes for the US government as well.

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#8) On March 11, 2009 at 3:55 PM, checklist34 (99.71) wrote:

harold, the solvency problem relates to capitalization at the banks, which is killed by M2M markdowns of assets.

in the case of ACAS they paid about $1billion for a portfoio of mortgage backed securities. 

In Q4 those securities were marked down to $186 million... despite the fact that cash flow from those assets in Q4 alone was 122 million.

Assets on bank balance sheets are marked down too far, which hurts their regulatory capital situation.  These assets are not priced at a value realistically correlating to their worth right now, they are priced to a non existent market with only distressed sellers... 

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#9) On March 11, 2009 at 4:25 PM, 100ozRound (29.49) wrote:

they are temporarily allowed by the IRS to pay their dividend as 90% equity and 10% cash.

So this wouldn't really be an issue if you were on a DRIP or were otherwise going to reinvest the div?  Or would they be issuing new shares to pay the div?

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#10) On March 13, 2009 at 5:18 PM, checklist34 (99.71) wrote:

100oz, I don't really know anything about DRIP or taxes and dividend reinvestment i'm afraid.  But thanks for the thought... i'll look into it.

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#11) On March 13, 2009 at 5:26 PM, bubabar (20.93) wrote:

I don't feel comfortable with the sweetheart deal that Malon got recently, but bought in for 91 cents. I really believe the m2m will be a boon for this company, at least short term.

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#12) On March 13, 2009 at 5:46 PM, maxhoffa (< 20) wrote:

the ACAS managment team is just flat out one the best around and i have little doubt of ACAS coming out of this mess bloodied but very much alive.  they fell out of my portfolio back in, november, i think, but are still very much on my watch list.  i held their REIT cashcow, AGNC, for a bit too.  another good play that i sold out of when it started to roll south.

i'm also knee-deep in financials at these prices.  i'll take a closer look at ACAS again this weekend.  

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#13) On June 28, 2009 at 12:12 AM, checklist34 (99.71) wrote:

well here we go. This blog will, i suppose, never really be read by much of anyone.  It was one of my first 5 or 10 posts on the internet blogosphere, it was written by a guy with precious little experience, perhaps not phrased as eloquently or dramatically as it may have been by someone else at another time, and it was written at a time when bearish sentiment so completely engulfed these blogs that anything without a doom and gloom headline wasn't really read.

It got 2 recommendations.  A typical hyper-bearish post at this time got dozens.  

And i must now, with a hint of pride in my type, note that Q2 earnings are coming up here in 2009, and I think we will see BDCs and insurance companies finally reap the rewards of the bounce I described, and we will see their book value bump up and some non-realized profits recorded.  

And i must note that financials have come into fashion on the fringe leading edge of the market with guys like Doug Kass and others blogging things a bit like this.

And mostly, I must note, that anybody who would have followed the advice laid forth above and bought banks, insurance, and BDCs at that bitter market bottom would now be double to triple their money.

Sometimes in life one gets it wrong, and in those times one has to just bite the bit, sit down, analyze what went wrong and try to extract from the misery, pain and failure what lessons are there to be learned.  

But, sometimes, in life, one gets it right, and in those times one must take a moment to reflect and enjoy.  

I am one of the people who cleared double my money in just a few months (much more than double actually from the march bottoms, much much more) by following these thoughts to no small extent.

And now, today, I'm still riding this bet and nearly at the eve of Q2 earnings season, we will see if what I predicted above starts to materialize in earnings reports as it already has in share prices.  If it does, those share prices will once again find some room to run.

good luck to everybody

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