Submitted by A Dash of Insight

Readers of “A Dash” know that for the last year we have been contributing to RealMoney, a subscription service from TheStreet.com (free trial available).  Before contributing, we subscribed for many years, finding the site to be a useful source of ideas and discussion.

One of the most helpful contributors is Bob Marcin, founder and General Partner of Defiance Asset Management.  Bob has a deep value approach and a nice recent hot streak.  He has advised against investment in financial stocks, while recommending early cyclicals which have been enjoying a rebound.

Bob is not one to go with the flow.  He writes authoritatively and forcefully, always bringing some good quantitative evidence to bear.

On Friday, he highlighted one of the key issues of the week, writing as follows:

Recently, Dick Bove wrote that financials offered an excellent long opportunity, one of the best he has seen as an analyst. On Thursday, Meredith Whitney did a piece on CNBC contending quite the opposite. I agree with Meredith.

Many are trying to bottom fish the debacle that is the financials. That seems premature. Don’t take it from me, but from Whitney. There many more write-offs and reserves boosts. There is a wave of dividend cuts and dilutive capital raises ahead for regional and money-center banks and brokers. That’s the fundamental situation.

With the stocks getting hammered, you would think the businesses are cheap. Maybe not. Many financials still trade for 2-3 times tangible book, and that book is declining with higher loan losses and charges. These stocks might represent value traps.

He went on to recommend that readers view the Whitney interview on CNBC.

Our Take

We certainly respect Bob’s conclusion and he has identified a crucial issue for the market.  We are concerned, as some writers like Megan Barnett of Portfolio.com have noted, that financial analysts are engaged in speculation that might exceed their actual knowledge.

We were able to get the original reports from both analysts, and replied to Bob as follows:

Bob - I read Bove’s report and several of Whitney’s. I have also watched interviews with both, including the one you cite. I agree that people should watch it. I have no position in banks.

Here is the part I found troublesome. She believes that the she knows the value of the assets better than the banks. She stated, “If you are truly marking assets to market, you should be indifferent. Just sell them.” She says that banks have mistakenly waited and it will get worse. The ratings agencies downgrade the assets and banks are required to carry more capital.

The banks think that trying to sell into an illiquid market would make matters worse. They believe the assets are under-priced already. The various Fed lending facilities now allow them to make this decision, something that was not the case during the fourth quarter write-downs.

Whitney confidently states that the assets will have to be sold eventually at a lower price, so banks should “take their poison — er, medicine” right now. So if you believe that she knows the value of the various exotic CDO’s and such better than do the banks, or that prices like the ABX are accurate, her argument makes sense.

It is obviously much more complicated than this, but I am trying to pull out the key assumption — and it is an assumption — in her argument. Her reports project write-downs based upon the decline in the ABX (for example) during the quarter. That did not really play out for Lehman or Goldman, so who knows?

Conclusion

Reading sell-side analyst reports is a lot like reading seminar papers.  Over twenty years in the business we have read thousands of these reports, usually examining several on the same stock.  There is always evidence and logic, leading to conclusions.  There are also assumptions.  These assumptions relate both to facts and to methodology.  Sometimes the analyst has been pushed into unfamiliar territory.  It is always tempting to follow someone who has had a hot hand.

We have not yet reached a conclusion on this topic, but we are skeptical.  How can some analysts be so confident about the future performance of mortgage-related assets?  That is not their expertise, and it is basically unknowable.  Meanwhile, consumers of the research sell these stocks on each report and hedge fund managers pile on.  It is a crucial question that bears watching.  We have advised clients to avoid banks, and Bob Marcin has been even more aggressive (and right) in his recommendations.

[Disclosure –no bank positions, but long some other financial issues including Goldman, Sachs (GS) and Merrill Lynch (MER).]

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