Investors Looking for Subprime Bargains

The Financial Tines and the Wall Street Journal feature two treatments of the same theme, investors looking to pick up bargains in companies damaged by the subprime implosion. The Financial Times discusses the interest of the Kuwait Investment Authority in acquiring stakes in financial services firms; the Journal article is aimed at retail investors that are following the footsteps of sovereign investors.

It would be better if I were wrong, but the timing looks premature. The time to make purchases of this sort is when there is blood in the street, and even then, the carnage can be warranted. In February 2007, when mortgage lenders like ResMae were failing, when Wall Street firms were eagerly pursuing subprime originators to so they could gain market share in this lucrative business on the cheap. As we now know, those purchases now look woefully misguided.

KIA’s enthusiasm seems based on even more questionable premises. As the FT reports:

Mr Al-Sa’ad said he intended to speed up decision-making at the KIA to take advantage of the opportunities thrown up by the crisis. “With Citi, the Abu Dhabi Investment Authority had good timing,” he said, noting that it took ADIA less than three weeks to seal its late November deal to invest $7.5bn in convertible securities in Citigroup.

With all due respect to KIA, which no doubt can hire knowledgeable analysts and said, “We don’t see prices dropping much more.” this looks very much like the “me too” deals so common among foreign investors. One goes in and appears to find an opportunity, and its peers pile into similar deals.

Initially, a purchase of a large stake by a deep pocket investor in a troubled business creates its own luck. The shares trade up, usually considerably, based on the vote of confidence. Even though such a sale is (or will be) highly dilutive, existing investors often seem to regard the benefits of a more solid capital base as offsetting the impact on their holdings.

Although Soros was targeting underperforming rather than troubled companies, his team in the mid 1990s found they could meet their annual return targets (35%) in the first year merely by virtue of the impact of the investment. Now Soros is a more storied name than any of the sovereign wealth funds, but the general premise is the same.

That’s a long winded way of saying it is awfully early for KIA to deem the Abu Dhabi investment in Citi a success. Once the Soros team started to factor in the first year runup, they became sloppy, and an unacceptable portion of their deals came a cropper. Wait until Citi cuts its dividend and the stock finds a new level. That will be a better time to assess the merits of the Abu Dhabi deal.

And if I were looking at taking risk and focusing on distressed organizations, I’d think about debt rather than equity. Historically, the smart way to play troubled companies was via bonds, since the upside potential is considerable (if you buy something, say, at 30, it could easily more than double, and you are much better protected in the event of a bankruptcy than in equities). But the problem in recent years is that companies have vastly more complicated capital structures than they once had, and hedge funds are often involved. That creates considerable uncertainty (and hence difficulty in assessing outcomes) since hedge funds do not play nicely with other creditors.

The Journal piece, “Investors Reconsider The Pariahs of ’07,” is longer and is careful to discuss the downside as well as the potential of taking a flier on subprime-damaged entities:

Fallout from subprime-mortgage woes and the global credit crunch has weighed heavily on stocks in the financial and housing sectors, and has driven down prices of riskier corporate bonds. But while these assets could still drop further, many mutual-fund managers, Wall Street strategists and financial advisers say they are starting to engage in some bargain hunting….

The shifting sentiment comes as some foreign governments’ sovereign funds place big bets on U.S. financial companies….

Citigroup Inc.’s Citi Global Wealth Management is calling for a rebound in financials in 2008. IMS Capital Management’s Capital Value and Strategic Allocation funds have begun buying home-builder stocks. And Deutsche Bank Private Wealth Management says that “junk” bonds, issued by companies with lower credit ratings, are now giving investors good yields in exchange for their added risk.

But investors need to step carefully. No one knows the full extent of the subprime problems, and many beaten-down stocks may fall further or simply take years to get moving again. Many investors also may already be heavily exposed to financials through a broad market holding like an S&P 500 index fund.

A slowing economy, or possibly even a recession, poses added risks. It could prolong the pain for financial firms and home builders. And while high-yield bonds may appear more attractive than they were earlier last year, the current low level of defaults is expected to rise…

“There is no free lunch in the investment world,” says Alan Skrainka, chief market strategist at Edward Jones. “These stocks are cheap because the risks are very high, and there’s a lot of uncertainty.”

The article also discusses some specific investment approaches.

Wall Street lore has it that the Rothschilds attributed their investment success to buying a little early and selling a little early. But my sense is that have a ways to go before a Rothschild would find the idea of taking a punt on subrprimes compelling.