Time To Look At The Glass Half Full

We continue to be concerned with the many obstacles to a strong recovery. Stocks have been rising to new highs for six months now and the bulls and bears continue to battle. We believe the economy has bottomed but remain skeptical that the stock rally can maintain its surge without bumps in the road. Although we have participated in the rally, we also hold plenty of cash and keep some stock market hedges in place.

We have taken a cautious approach to stocks but investors need to search for opportunities within the boundaries of their macro views of the economy. We expect the financial services industry to undergo many changes in the next few years. A year ago the financial system faced Armageddon and many financial companies have been saved with government help; while others have either gone bust or were taken over by stronger enterprises. We can expect the strong to get stronger while many others will need capital infusions, will be taken over by the FDIC, or will be forced to sell themselves. We think the opportunities in financial services will produce some of the best returns to those who have the knowledge and research to find the winners. Many funds have raised capital to buy distressed banks and build platforms to lead turnarounds for the financial institutions of the future. As such, we are buying the Paulson Recovery Fund. Although this is a high risk illiquid fund, we believe John Paulson has a unique knowledge of the financial industry. His firm is best known for identifying the imminent collapse of the housing market and the mortgage securities that came tumbling down. He also parlayed that insight into shorting many financial institution stocks. We believe his firm has extensive research on the banking universe and will now be able to pick the winners in the recovery phase. A select group of investors will also be shown opportunities to invest in or buy distressed banks and Paulson should have the access to what in our opinion will be some of the greatest investment opportunities of our life time.

For months we have discussed our concerns with the rising bankruptcy rates we expect in the corporate world. Many companies have filed Chapter 11 and many more will follow suit in the next couple of years. Leverage was a killer in the housing market, it will create record corporate bankruptcies, and it will severely damage the commercial real estate market. Companies borrowed to fuel the leverage buyout boom which helped to propel the stock market higher. Financial markets collapsed and bank financing dried up. These events coupled with a severe recession has put many companies into default while many more are heading in that direction. We try to invest where opportunities present themselves. We have plenty of knowledge and experience with bankruptcy investing and believe the next few years will produce significant returns for vulture funds who take over distressed companies by acquiring the debt of the target company. It is hard for individuals to participate in these opportunities on their own as large pools of capital are needed to be successful as well as extensive research capabilities. We have decided to pursue these opportunities through Oaktree Capital Management who is raising their fifth domestic fund focused on buying companies through the debt. Their track record is very good through many cycles and we believe the timing couldn't be better than now. A good investor should produce great returns when the timing is perfect.

Finally, we have been talking about the collapse of the real estate market for a year. Housing prices have plummeted around the country and commercial real estate is next in line. Housing has shown some positive signs in the last few months but we remain somewhat skeptical as much of the momentum is driven by government incentives to first time buyers. On the other hand, this may be the greatest opportunity in our lifetimes to take advantage of weak real estate markets. As such, we are focused on buying multi-family housing that produces positive cash flows. It may be a year or two too early to invest in commercial real estate so we are currently focused on housing. If our thesis on future inflation is inevitable, holding real estate should better protect our assets from a weaker dollar.

We remain concerned with the stock market and the many land mines left throughout the economy but it is important to take advantage of the opportunities created from the past year's financial calamity.

A Year After the Lehman Collapse

A year ago, the financial system was on the verge of imploding. The Lehman collapse set off a trying few weeks where many other financial companies such as AIG, Fannie Mae, Freddie Mac, Goldman Sachs, and Morgan Stanley were also on the verge of imploding. The Federal Reserve and the Treasury department flooded the financial system with liquidity and shored up the banking system with loans resulting in improved protection from failure. Today the banking system appears to be healing and the economy has stabilized but many risks still exist.

We have been writing about excessive leverage and our concerns with its likely drag on the economy. This morning Nouriel Roubini spoke on CNBC about his concerns with consumer leverage, corporate leverage, real estate leverage, and finally, the excessive amount of debt created by the U.S. government. His thoughts are very much in line with our concerns for the future. Economic activity can not be robust until debt levels decline precipitously and this can only happen with time.

Another topic we have focused on is banks too big to fail are too big to exist. The Bank of International Settlement has concluded, as discussed in the WSJ, that "big banks' risks to the system increase more than proportionately with their size". We agree and have suggested that capital requirements should rise with the size of a bank. This method will allow banks to self judge wether they can garner sufficient returns on capital as their size grows. The BIS seems to have come to a similar conclusion as they suggest bigger banks pay higher taxes. If such tax is in the form of higher capital requirements then sytematic risk won't be avoided but managed more prudently.

Gold, Inflation, and the Markets

The market keeps rising but the fear of inflation is still embedded in investor's minds. The weakness of the dollar has oil, gold, and other commodities rising again. The federal Reserve and its brethren around the world are focused on curbing future inflation but the fight will be arduous if not impossible over time. Governments continue to spend on stimulus plans while also printing plenty of money to jump start the global economy. We find it hard to believe that in two years, inflation won't start to inch up or even climb higher.

The good news these days is the increase in merger activity. Companies can't seem to grow revenues in this environment so it is a good time to acquire revenues through acquisitions. Valuations are still low if one has a long term horizon and most CEO's make strategic acquisitions with an eye on short term synergies and long term strategic value. We expect Wall street to garner a bigger stream of revenues as well capitalized companies pursue growth through M&A.

Stock prices could benefit with merger activity as the supply of stock is reduced when the acquired company is no longer trading. Incrementally this is a positive for the markets but we still believe a weak economy, high leverage, rising unemployment, and a weakened consumer will make this economic recession last longer than most expect. If we are wrong, the government debt, the corporate debt, the consumer debt, and the real estate debt will create roadblocks to a sustained recovery. We will need to see many more bankruptcies and defaults in order to equitize the system and allow businesses to grow again.