Arohan’s investing life

Hmm, looks like the credit issue is throwing up a lot of bargains! Sometime ago we wrote that Leucadia recently purchased a sizable stake in Americredit. The word is now Leucadia has boosted its stake in Americredit by a factor of 2 and currently owns 22.4% of Americredit with a group of partners. It individually owns about 20.7% stake in the auto-finance company

The following appears in the recent 8-K filed by Americredit (on Feb 6)

Item 8.01 Other Events. On February 6, 2008, the Board of Directors of AmeriCredit approved the acquisition by Leucadia National Corporation and its affiliates (”Leucadia”) of 20% or more of AmeriCredit’s outstanding voting stock. The effect of this action is to make inapplicable the provisions of the Texas Business Combination Law, which, without the action taken by AmeriCredit’s Board of Directors, would prohibit AmeriCredit and Leucadia from entering into any business combination for a period of three years following Leucadia’s acquisition of 20% or more of the outstanding voting stock of AmeriCredit unless approved by two-thirds of AmeriCredit’s outstanding shares not held by Leucadia. AmeriCredit and Leucadia have discussed the terms of a standstill agreement dealing with matters customarily covered in an agreement with a significant minority shareholder, including but not limited to a limit on Leucadia’s ownership in AmeriCredit to 29.9% of the outstanding shares of AmeriCredit’s common stock for a period of two years. There is no assurance that such standstill agreement will be entered into or if entered into, would necessarily be on the same terms as presently being discussed.

Could this mean further increases in this stake are possible?

This is a strong vote of confidence showing a savvy investor like Leucadia believes that atleast some of the stocks in the credit/finance sector have possibly bottomed out

Economists are generally an optimistic bunch. A lot of them would not speak the R word unless it is staring them in the face. The Institute of Supply Management (ISM) service sector report shows a drop in business activity, first such drop in nearly 5 years. This has caused some economists to finally agree that Recession may already be here.

On this site we insisted that the recession is already here, even though it may be in pockets, in an earlier article.

Wasn’t this also the message the feds were sending when they aggressively started cutting the interest rates. The message was, as I saw it, that recession was now a bigger threat to the economy than, say, inflation

Recessionary cycles are normally self correcting, the only question remains how quickly will the economy turn. Since this time around the genesis appears to be in the credit markets, it is logical (and indeed happening now) that the credit will become scarce for most except the most credit worthy businesses.

These are the times when the mind wanders in the direction of asset preservation rather than growth. Nothing wrong with that.But remember, Toyota continued to grow as a company throughout the decades that Japan has been in its extended recession

What should an investor do in recessionary times?

First of all, if you are a patient value investor with a long time horizon, the best advice is to wait it out (or rather be opportunistic and add to your holdings). Here I assume that you do not depend on your portfolio for your living expenses

If you are a short term speculator (technical traders), than you need to be careful as the volatility trends that you may have come to rely on may not work as well. Bankruptcies, sudden changes in fortune, etc are singular events which can distort any system that you may be employing.

For most though, it may be wise to evaluate what companies you may want to remain invested in. Besides looking for undervalued securities, you should look for companies with the following characteristics

• Cash flow generating companies with highly rated debt. These companies have flexibility to manage their operations and cash  based on the economic environment
• Cash rich companies
• Companies with a diversified product portfolio, that includes what may be necessities for most people to live on
• Companies that are geographically diverse
• And strong companies in weak sectors, where new market share can be gained

These are the kind of businesses that will not only survive recession but can come out stronger

Additionally, you may wish to look for a good dividend yield, which you should promptly reinvest. Most brokers now offer free dividend reinvestment so this should not be a problem. One of the benefits of this recession is that the low taxes on dividends in US are more likely to continue

Many of the established consumer staples and  pharmaceutical companies qualify according to these guidelines. My favorite in this sector is Johnson and Johnson (JNJ)

Some financials also qualify. Bank of America (BAC) is my favorite

There are two other types of companies that can do well but may be for a slightly more adventurous investor.

1. Companies that make their profits preying on weak and restructuring them. Leucadia National (LUK) is one. American Capital Strategies (ACAS) is another one with a very attractive and increasing dividend yield to boot
2. Companies that make money insuring risk. Markel (MKL) is one speciality insurer I really like, if only because they have excellent investment credentials in addition to a top notch underwriting team

Added benefit is that all these companies currently trade at an attractive valuation.

I will be interested to know what you think and what steps you are taking (if any) as we settle into this winter of recession

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

You read this headline and say, Duhh!

But really, the economy was kind of stalled for some time now with many institutions taking a wait and see approach. Not that the basic industrial sectors were suffering much, they were still humming along, albeit at a reduced pace. However, what had really taken a hit was the consumer confidence and the risk appetite of the financial firms

A total of 1.25% rate cut is nothing to sneeze at. All of a sudden, many homeowners who were looking at unaffordable resets on their adjustable mortgages will get some room to breathe. The more money that is left in the consumers pockets, the more the American consumer is willing to go out and spend. At this point though I really hope that the consumers have learnt the lesson and start putting some money towards savings and building an emergency cash portfolio

Look for increased mortgage refinancing activity in the coming months. 1.25% drop in ARMs (or close to it, depends on the lender on how much will actually flow through to the consumer) should be enough to make re-financing the mortgage an economical proposition for many homeowners

What this also means is that for many lenders, this will be an opportunity to replace riskier loans with more traditional and discipline-infused product. Should do wonders for their asset quality

Another effect of the rate cut would be to bring the liquidity back in the credit markets. Many institutions were having difficulty syndicating debt as there were no buyers. This situation should ease

And finally, CD and money market rates should decline. This along with the juicy yields now available on many stocks should help investors slowly come back into the stock market

Is inflation still a risk given the scale of the interest rate cuts? Probably, but with everything else going on in the economy and the stress on the housing sector (a house is probably still the most prominent part of any American’s net worth), I really think that the consumers are not likely to embark on a shopping spree anytime soon. I think we will start seeing a fundamental change in how the public spends their money. There will be a move towards smarter spending. That is my hope anyway

My best stock play for a recovering economy remains Bank of America. In the next post I will outline the best way to buy Bank of America today. Stay tuned

It appears that Leucadia National (LUK) is acquiring a 11,316,200 share stake in AmeriCredit (ACF) which represents 9.9% of AmeriCredit’s outstanding stock. AmeriCredit Corp is an auto-financing company providing financing services to retail consumers as well as dealers. Leucadia’s cost is roughly $12.9 per share, with ACF shares now trading at $11.2 per share as of market closing on Jan 16th, 2008

This has to be viewed in the backdrop of a growing concern in the market that the credit crisis is ready to move into automotive credit sector

Leucadia National is probably one of the best investors in North America today, and for the last two decades an investment in Leucadia stock has outperformed Berkshire Hathaway stock by a wide margin. Leucadia has a propensity to take more ‘risks’ than Berkshire Hathaway and is known to buy deeply troubled companies and turn them around. While their bets may be risky, they have shown remarkable ability to make profits. I have great respect for Steinberg and Cummings, the two partners who run Leucadia National and have own the stock for a while

So does Leucadia think that the credit worries in the auto finance sector are overblown? Possibly. However, they do appear to think that now is a good entry point. ACF is currently trading close to its low for the last 3 years

Something to keep in mind. Automobiles have always been and will always be a depreciating asset and so a typical automobile lender has to consider the credit worthiness and income of the buyer. It is not solely based on the asset value. Therefore, it could be argued that auto loans on average are of much better credit quality than some of the housing loans that were made in the last few years