Arohan’s investing life

A quick note regarding several investments that were recommended (and the author took a personal stake at the time of recommendation).

WSCI: WSI Industries was recommended as a growing metal working company with excellent prospects. I took a position in the company in the $4-$5 range several months ago. In the last one month, I have liquidated my entire position in the company in the $9-$10 range for close to a double. Very satisfying return for a few months work. The stock today is trading close to $14. If I had held for another month, I could be looking at a triple instead of a double. But I have no regrets. The company is approaching 40 PE and is getting quite frothy at these levels even if you take into account their projected growth for the next few years.

CFC:I am still holding Countrywide. If you recall, the play here was to buy Countrywide as a cheaper way of getting into Bank of America. The risk is that the Bank of America acquisition of Countrywide may not close. I am still comfortable in my position and will continue to hold

WM: I am still holding Washington Mutual and am currently underwater. However I am willing to wait out the current crisis of confidence as I think the company is taking the right steps to ensure that it survives
C: I have since my last writing on Citigroup increased my position in the company. The company is very quiet on what they are doing to improve their capital structure. However, they recently entered in an agreement to liquidate a part of their debt portfolio (to private equity) for about 10% discount. I think the company will correct course and come out stronger than many expect and in 3-5 years time should reward a patient investor handsomely

Additional notes: I have also increased my stake in BAM (Brookfield Asset Management), MKL (Markel), ACAS (American Capital Strategies), LUK (Leucadia), SLT (Sterlite Industries) and added positions in BRKB (Berkshire Hathaway B shares) and EPI (Wisdomtree India ETF)

Please note that if you choose to act on any of the recommendations/ideas outlined above, make sure that you conduct your own due diligence and understand the risks you are taking. I am not a financial advisor

There is a brewing opposition to Bank of America’s proposed acquisition of Countrywide

First there was a news that the hedge fund SRM Global Fund with its 5.2% stake in Countrywide is opposing the BAC deal . The feeling in the market at that time was SRM may not be able to find any allies in other shareholders

Then comes the new yesterday that Capital World has acquired a 6.1% stake in Countrywide recently. Although Capital World appears to be a passive investor who may or may not side with SRM, they clearly think that the current price is a good value

Today it is revealed that Legg Mason as requested and received approval to raise its stake in Countrywide upto 25%, and its stake has already been increased upto 15% of the company. Additionally, Bill Miller of Legg Mason in a note to investors indicates that he is not in favor of Countrywide sale at the current prices

With many investors now gearing up to oppose the CFC sale to BAC, expect more buying in the stock and gradual appreciation of the stock price. A likely scenario that eventually plays out may include BAC sweetening its offer for Countrywide by possibly offering more BAC stock in exchange for CFC stock. This is getting interesting and even if buying CFC may not work out as a way of getting BAC cheap as suggested in an earlier article (that is if the sale does not go through. If the sale goes through at the current or higher prices than the strategy works beautifully), all the institutional support that is coming back to Countrywide bodes well for a good return on investment on CFC stock itself

If you are invested in CFC I would recommend to stay put. (Of course, there is always a risk of bankruptcy and that is something that you need to weigh)

Believe it or not, the best way to buy Bank of America today may be to buy Countrywide Financial

Bank of America’s previously announced deal to buy Countrywide was a stock deal. For every share of Countrywide stock, the holder will receive 0.1822 shares of Bank of America stock when the deal closes. The deal is expected to close in 3rd quarter of this year.

As of the time of this writing, BAC was trading at $44.14 per share and CFC was trading at $6.83 per share. 0.1822 shares of BAC represents a value assigned to CFC by BAC of $8.04 per share at these prices. Countrywide stock is therefore trading at a 15% discount to the acquisition price. In the past week the stock has traded as much as 25% below the price offered by BAC

What this means is that an investor buying Countrywide stock today can expect atleast 18% appreciation by Q3 IF the stock price of Bank of America stays at $44.14

Here are two points worth noting:

1. If you believe as I do that Bank of America is undervalued today, you can expect that the Bank of America stock will actually appreciate quite a bit by the time this deal closes
2. If you decide to purchase Countrywide stock today, Countrywide will pay you 9.5% dividend (annualized) for you to wait until the deal closes. Buying Bank of America stock today directly will only give you a 6.1% annual yield

That being said, there are certain risks involved. Countrywide can actually cut or eliminate their dividend in the interim. This is likely but even if this happens the discount on offer today is simply too attractive.

The bigger risk of course is that Bank of America may decide to pull out of the deal. Apparently this is what many in the market are afraid of and that is why this discount exists. However, Ken Lewis (BAC CEO) has reiterated that there is no question of BAC pulling out. Truthfully, since BAC is hitting the deposits cap in US, this acquisition is probably one of the few ways the bank can continue its growth domestically. Bank of America has also coveted Countrywide franchise for a long time and it is not likely to just give it up

The rate cuts of the last two weeks also work to make the Countrywide asset quality a little less risky and will function as a trigger to bring the mortgage buyers back in the market. I believe that the deal just became less risky for Bank of America with the rate cuts

There are many ways to play this discount. One is to arbitrage on the  pricing gap by selling short the BAC stock and buying CFC. This is apparently a riskless way to capture the spread assuming the deal will close as it is immune to how the BAC stock price performs. Another variation would be to use options to get the same result. I however am of the opinion that the BAC stock is keepers for the long term (and also I tend to be a long-only investor) and therefore would like to keep it simple and just buy CFC at current prices, let it convert to BAC stock and let it ride

New fed plan to slow foreclosures will be announced tomorrow. It is reported that the deal has already been reached between the feds and the mortgage industry. I view this as a net positive for the mortgage industry

The worst situation a lender finds itself in is to foreclose on a loan. It is much better for the lender and the lendee to compromise and continue the loan even if it means the lender loses revenue in terms of a reset mortgage. A lender like Countrywide can do this adjustment on their own (and many have been doing it) but the fed intervention provides a real guideline on what can be done. It is also a strong signal that the feds are not going to let the sub prime fiasco affect other parts of the economy and they will do all they can to bring the liquidity back in the market

As I sit here today I feel more comfortable about my position in CFC and WM that I took a few days ago. When the industry rebounds, these companies will come back stronger with greater market share (as many weak players have fallen). Also the feds injecting some calm/stability in these markets should help bring in some industry consolidation

Any further rate cuts at the upcoming fed meeting would just be another support for the industry and should help the stocks of the lenders

I am happy to wait out on these positions for long term

Inherently value investing ignores macro issues. Warren Buffet does not believe in letting market decide what to do (top down macro approach), nor did Ben Graham have any use for macro considerations

The Efficient market theory attempts to neatly segregate risk into two parts: 1) company specific risk (micro), and 2) market risk (macro)

What Buffet and Graham tell us is to ignore the market risk (well not really ignore it, use the concept of “margin of safety” to cushion any curve balls that the market may throw at you) and focus solely on the company fundamentals. Is the company inherently strong? Does it have a growing franchise? And above all, is it attractively valued?

However, it is not always this simple? What if the company you are looking at investing in is a solid company with large marketshare, good management, provides services that are needed now and are going to be needed in the future, is very attractively priced, has good strong fundamentals, etc but the market conditions are such that the company has a potential to be forced into bankruptcy due to a ‘market collapse or breakdown’? A market collapse or breakdown that has the potential to push the country in recession, create major upheavals in the business environment, to the extent that there is a real fear that by the time US re-emerges from this, it may not be the most powerful economy in the world anymore

And what if a detached pragmatic line of thinking suggests that the regulators and the government will do everything in their power to ensure that such a collapse or market breakdown does not occur

You know, Chrysler at one time was a company knocking at the doors of bankruptcy. Very few had guts to invest in Chrysler stock at that time. Peter Lynch did, and he did it because he recognized that this is a company that is too important for the American economy to be allowed to fail

There are companies like that in the market today. I am of course talking about Financials. For starters, here is a list compiled by Jim Cramer of 10 companies that cannot be allowed to go under.

For starters, allowing a company like CFC or WM to fail does not do anything to fix the problem of bad loans in the system. These loans do not magically disappear. They will just migrate to someone else’s books. The problem is the bad loans and the breakdown it has caused in the market pricing mechanism. A solid response to this issue is to ensure that these companies survive and put in a process to slowly work out these bad debts over time. Just what Paulson is attempting to do now. If these lenders fail, the impact on the market and the confidence destruction will be enough to push US in deep recession ( and the problem will still not have been solved)

I realize that investing in these stocks at present time has an appearance of taking on too much risk. To me, this is an acceptable risk with low probability of permanent capital loss but with high potential rewards

Disclosure: I own stock in CFC, WM and BAC.

Note: Please do not invest in these or any other stock unless you have done your own due diligence. Standard disclaimers about this not being an investment recommendation, invest at your own peril, etc, etc, apply