Financial Gearing

As I’ve said in past few weeks, the financial sector remains interesting for investors with a fairly high risk tolerance, and it’s time to wait for the sector to turn around. Ironically, there are two mutual funds out there that focus on the financial sector and are outperforming the S&P 500 in a pretty impressive way. After today’s close, the S&P 500 is down more than 42 percent year-to-date, but Burnham Financial Industries, which combines the use of both long and short positions, has given up only about 14.5 percent. Burnham Financial Services, a long-only fund, is down by about 20.7 percent, but it’s still outperforming the broader indexes.

We sat down with fund manager Anton Shutz in early October to find out his thoughts about the industry and discuss his decision-making process.

Ben Shepherd: Given that the problems in financials are ongoing, why are your funds attractive now?

Anton Shutz: With the Industries fund, the ability to short for the right reasons in this choppy market is important. We short to make money, not just to protect. We also love to use options; we love to write covered calls on our longs at targets we’re willing to sell the stocks, and we actually like to write covered puts on our shorts at targets we’re willing to cover.

We’re very proud of the fact that we’re up year-to-date and that we’ve shown much less volatility than any other fund. We think we’ve built a pretty good mousetrap in this environment, not only to benefit from the volatility of stocks going up and down and being able to cover or re-short, but also from the perspective of option volatility, which has been reasonably high on a historical basis. And we’re actually able to get paid from that as well.

We’re excited about the near-term future because a lot of financial services are cheap on an absolute basis, but we’re going to see some more capital rises at very attractive prices. A lot of the money that was made in the early 1990s wasn’t on the first or second round. We’re analyzing every deal that’s coming to market.

But I also think we take a very different view of financial services stocks than the generally perceived view. People talk about financial services as a sector, and I look at it as a series of subsectors from different lines of business; obviously, there are insurance companies, investment banks, money managers and mortgage real estate investment trusts (REIT). And even in the depositories, there are very different business models between the money centers and the processing banks and the savings and loans. You can even delve deeper into that on the geographic side and the product mix.

So you really have to have a macro view and look at the credit environment, the interest-rate environment, the shape of the interest rate curve and the health of the capital markets to make decisions about where you want to be--and not in terms of those subsectors. Then you have to decide the geography: What’s the shape of the balance sheet, what’s the opportunity set, what’s the catalyst? So, we’re always hunting for ideas, and I think this is very much a stock-picker’s environment.

Ben Shepherd: You have several smaller banks. What’s the interest there?

Anton Shutz: That’s very interesting, in that you’ve got an environment where geography matters. If you’re a lender in most of California, Arizona, Nevada or Florida, it’s a very difficult time. Credit is an issue across all lines of business because those economies are really suffering. If you’re in a more stable environment like the Northeast, you not only have a chance to avoid being a disaster but also to benefit because, if you have enough capital, and most of them do, you’re no longer competing with Wall Street. So the community banking model is back in vogue, and since Wall Street’s no longer offering ridiculous terms to your borrowers, you can now lend on your terms, with your underwriting criteria that’s much stronger than what Wall Street was doing and at interest-rate spreads that are much more attractive.

On the deposit side, you’ve got less of the lunatics around trying to fund crazy paper. So you no longer have Countrywide or IndyMac flooding the market with CDs while they’re booking subprime loans on the other side. They’re gone. The community banking model is actually alive and well in any reasonably healthy markets because you’ve got less competition on the lending side and less lunatics on the deposit side, so you have a chance of making a very nice spread without taking big credit losses. It’s a pretty good time for a regional institution.

Ben Shepherd: You said you liked mortgage REITs, but aren’t they still in trouble?

Anton Shutz: That question is exactly why these investments are at such great values. Obviously, you’ve heard what Bill Gross has said and what the most attractive paper is that he’s buying, which are the agency pass-throughs. And that’s exactly what these guys own. They don’t own the preferreds, and they don’t own the holding company debt; they own the pass-throughs.

You know, there has always been an implied backing by the federal government, but Paulson has made it pretty clear that that paper is good money. That’s exactly where the opportunity is because that paper still trades at historically high premiums to Treasuries. So you’ve got very high yielding assets; you’ve got very good funding from the repo markets and a very wide yield curve. You have a dividend-paying ability that’s extraordinary; American Capital Agency’s forward dividend yield is in the low 20s, Annaly Capital Management’s is in the upper-teens, Capstead Mortgage’s is probably close to 20 and MFA Mortgage’s is in the upper-teens.

Here’s the kicker. Fannie Mae and Freddie Mac get solved, and they can get solved lots of ways; they get capital injected, they get taken over, or, the world decides they’re going to make it. Any of those scenarios means that that agency paper will trade at much tighter spreads to US Treasuries, meaning these guys will have very large capital gains. So you’re getting a very nice dividend and book value can appreciate meaningfully. And if you’re making a 20 percent-plus dividend, that’s very good protection on the downside. Also, the Fed isn’t raising rates any time soon.

Anton Shutz: The problems with inflation have been mainly driven by commodities, and commodity prices are up for several reasons. One of them was demand, and there’s certainly been some demand destruction.

But I think one of the other very important reasons is the dollarization of commodities and the fact that the US dollar was under assault for so long. Now that you have the rest of the world looking like its going to get into an easing mode; if Europe’s not in a recession, they’re going into one. They’re not raising rates, and they’re probably going to have to cut them. Commodity prices will fall, which will be very good for inflation.

Believe it or not, the Fed not only doesn’t have to raise rates, it actually has the potential to cut rates if it needs to.

Ben Shepherd: Are there any other sectors that are interesting or that should be avoided?

Anton Shutz: The capital market environment is very weak, and it’s very difficult for the pure-play investment banks to do much in terms growing or even producing earnings because liquidity is an issue. A lot of assets on their balance sheets are stressed from a mark-to-market perspective, so avoid those guys right now.

I like some of the insurance companies, particularly AFLAC’s business model. I’m a value guy, so I love buying stocks when they break. AFLAC broke down after its last earnings report, and I was able to buy some at very attractive prices. They’ve just announced very large buybacks, so I’m please that they’re using some of their excess capital. I’ve also had the opportunity to buy MetLife at very attractive prices and Prudential as well, so I like it when you have market disruptions because it gives me opportunities to buy at great prices.

Ben Shepherd: It sounds like you haven’t gotten into insurance companies that went into the crazier financing schemes. Do you see any new regulation coming down the pike because of what’s gone on?

Anton Shutz: There’s no doubt that life is different. You almost have to start at the rating agencies, gauging how they’ve functioned and the damage they’ve done. They did damage on the way up by inappropriately ratings companies higher than they haven’t been. And now, on the way down, they’re scaring the heck out of everybody by cutting. Their business models have to change drastically--whether it’s more regulation or whether they should even exist.

I’m a free-market guy, but there are times you need to make sure there are no abuses in the free market. Quite frankly, if you look at the incentives for Moody’s, the more deals they could rate, the more money they could make, so go invent some more three-letter acronyms.

We learned many lessons in terms of companies that were providing credit enhancements. They strayed from their core business models. There’s no doubt that MBIA or Ambac, if they make it, will be very different in the types of business they pursue down the road.

Ben Shepherd: You mentioned Bill Gross and his agitation lately for the government to step in and buy more troubled assets. What are your thoughts on that?

Anton Shutz: Obviously, I would benefit from that as well. But the crisis deals with confidence. Companies can run on a shoestring if people are confident in them. If people lose confidence, a company that’s very well capitalized can go out of business. So the Fed definitely has to stand somewhere to create confidence in the functioning of the financial system, which starts with Fannie and Freddie because they’re such an integral part of how the system works.

We can talk about moral hazard and a lot of other things, but there are plenty of structures the government can put into place without taking a ridiculous amount of risk. I don’t expect that the Fed is going to literally takeover Fannie and Freddie. They may, in some form of guarantee, back some paper or even buy some paper to shore up their balance sheets. But don’t forget how steep the yield curve is; Fannie and Freddie are making a lot of money on the securities they have.

So yes, they’ve got losses to take, but much of that humungous portfolio is creating incredible spread. So they’ve got a lot of income coming in on the securities they hold. So, technically, their balance sheets are ugly, but could they earn their way out of it? It’s possible, and that would be preferential for the government. But either way, the paper Bill Gross is buying or my mortgage REITs own will gain in value whether [Fannie and Freddie] earn their way out of it or there’s some other resolution.

Ben Shepherd: Ultimately, how do you see this whole thing playing out?

Anton Shutz: I don’t mind the volatility [of the current markets], but I think everyone will look around and the dust will settle. These stocks will be 50 percent higher or more. The confidence will suddenly be restored and everyone will want to own these.

If you look at any one of these financial services stocks, and I don’t care which subsector you’re looking at, they’re under-owned. The big mutual fund companies don’t own them, so not only will they have to buy them, but the other thing is short interest, which is anywhere from 5 to 20 percent in some of these companies. Those shorts will have to cover, too.

So this is very different than the last big rally we had coming off of the ’01 mess. Once the market goes, it will be going for weeks, and the moves will be very powerful. So you have to be invested because none of us will know it’s the bottom until we’re looking in the rearview mirror. You have to be willing to take a little bit of a loss to make a lot of money, and we did see the lows in mid-July, which I don’t think we’re going to retest. We can certainly have more downside, but the opportunity set is fantastic.