Circle of Competence

Via Abnormal Returns, I came across a great article written by former Harvard Endowment portfolio manager, and now PIMCO manager, Mohamed El-Erian. He actually put out a book recently, which I may or may not get around to reading this century called >When Markets Collide: Investment Strategies for the Age of Global Economic Change

Anyway, he penned an article for the Financial Times that caught my interest. Why? Well, after going through a laundry list of why “these markets are risky,” (duh), he has some interesting comments on why that matters for investors. I agree with the sentiment:

“This volatile cocktail also speaks to the other side of the duality: the existence of big opportunities. The toxic mix is causing markets to throw the baby out with the bath water. There is now a littering of high quality assets whose prices are divorced from their underlying quality. Rather than reflect fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruption in the financing of highly leveraged owners that have no choice but to continually dispose of assets in a disorderly fashion.”

Gee, distressed sellers and absent buyers. Sounds right up Seth Klarman’s alley, no?
El-Erian says what I’ve been writing for some time now: there are some pretty amazing opportunities for rational, entrepreneurial investors. As the market continues to sing Free-Fallin’, investing in solid companies is becoming a cheap date. Sears (SHLD) is now under $74/share, causing yours truly to contemplate selling a kidney to buy more shares.  American Express (AXP) sells for about 11.5x earnings.  If General Motors (GM) doesn’t go bankrupt, it will probably go up about 10 fold in the next few years.  Heck, Steak N Shake (SNS) is now lower than the day after Sardar Biglari was named Chairman.

The second sentence in El-Erian’s diatribe brings to mind Primus Guaranty. To wit:

“The toxic mix is causing markets to throw the baby out with the bath water.”

The destruction of the monoline bond insurers has caused Primus (PRS) to plummet down below $3/share, less than a third of economic book value, even though Primus doesn’t guarantee any sort of structured product or toxic junk. There are probably dozens of similar stories out there right now for those willing to look around a little.

Lastly, El-Erian says this:

“The answer lies in a phased, multi-quarter approach by investors that benefit from the following structural attributes: a high degree of capital permanency that steers clear of the need to finance sudden withdrawals; a willingness to take long-term views that can be sustained through wild market swings; and a process that accommodates opportunities that, in some cases, do not fit well into traditional classifications of asset classes.

If you possess these structural attributes, today’s markets offer opportunities that are high up in the capital structure and that, in a few years, will be looked at as having constituted incredible bargains. If you don’t, you are well advised to stay on the sidelines, focused on the probability that these same markets will also be treacherous for at least the remainder of this year.”

What are his three necessary structural attributes?  His words and my take as it relates to concentrated business investing:

1.   “Capital Permanency” - Basically, if you’ve avoided using bone-headeded leverage, you’re in a good spot. If you have a stable investor base, you’re in good shape.  If you’re leveraged 30:1 on repo loans, you’re toast. Liquidity becomes all-important when no one else has it. Those institutions and individuals who’ve leveraged themselves to the roof over the past few years cannot take advantage of the fat pitches afforded by the highly volatile securities markets today.

2.   “ Willingness to take long-term views that can be sustained through wild market swings” -  Maintain a long term orientation, plain and simple. You have to be willing to recognize that it’s impossible to see the light at the end of this unbelievable tunnel we’re in, but also have the courage to be buying and holding through the turmoil. Some day, consumers are going to flock back to retail stores, eat out at restaurants, and reach out for healthcare as they age. The retailers, restaurants, and healthcare stocks being flung out of the window will prosper again. In addition, there will be a eventual return to the credit markets. Some of these financial institutions are being tattered like old shoes, and competent iInvestors with the right emotional disposition should take advantage. If I could value a financial company any more complex than something like Primus, I’d be buying ‘em myself (I can’t, though, trust me.)

3.  “A process that accommodates opportunities that, in some cases, do not fit well into traditional classifications of asset classes” - To relate this to a company we’ve written about here on CoC, what the heck is Sears? Is it a retailer, REIT, hedge fund (as has been speculated), or a brand machine? Honestly, it’s hard to tell sometimes, creating widespread uncertainty.  This uncertainty goes for assets in other classes, from structured products that, *gasp*, aren’t toxic waste, to real estate selling at distressed prices in areas like California and Florida. Opportunism and flexibility are assets, there’s no doubt about that.

These are trying times.  My transition from reader to investor began last spring, so my portfolio is singin’ the blues, believe me. That said, I’m enjoying this market fall, if for no other reason then I’m being afforded the privilege of watching companies and stocks fall hard, with the ability to buy into the carnage.

Now, about that kidney…

Disclosure: Long SHLD, PRS, SNS

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