GFI Group (Ticker GFIG)

GFIG (GFI Group) is a great idea right now in my opinion. This is a stock that has been caught up in the credit default swap news flow and is now neglected. Their historic business is acting as a broker between the big dealers (like JP Morgan, Goldman, Citi, Lehman, etc) to help them trade over-the-counter derivatives. If we stop right here, you probably understand why the stock is neglected. A lot of investors will hear credit default swaps and Lehman Brothers and say no thank you.

A quick aside. My observation is that investors make a tiered decision. First, do I want to own this business model at all? If the answer is yes, then they look at valuation or earnings momentum, or their favorite metrics to help them decide if it is attractively prices. My point is that sometimes the answer to the first question is emotionally driven even though the process, once they answer it, might be very rigorous. Here lies the oportunity. Investors are not looking at GFIG and analyzing whether it is attractively priced, because they can't get past the first question.

Here is why GFIG is a good investment idea. This will get a bit technical so I apologize in advance.

Credit Default Swaps (CDS) are a likely to be a growth engine over the next 3-5 years.

The CDS market is currently in disarray because firms are frightened by the prospect of massive counterparty exposure in this bi-laterally cleared market and because many of the participants have been and continue to deleverage. Despite that, I think credit derivatives will become a growth market again within a couple years.

First, credit derivatives are a legitimate product. Any owner of a fixed rate debt instrument has interest rate risk and credit risk. There are others of course but those are two of the most significant. Fixed income owners (or anyone with a receivable balance from another firm) may want to hedge their exposure to both of these risks. The interest rate swap and futures market is well established and very large. The CDS market is in its infancy by comparison. I am convinced that over time, the credit derivative market, in its various forms, will grow to rival the interest rate derivative market in size. A successful derivatives market needs a solid core of legitimate hedgers, with speculators trading around them.

Second, I think confidence can be restored in this market. Much of the current turmoil in the CDS market stems from the bilateral structure of the market. The dealers that have historically provided the liquidity are left with massive counterparty exposure with the other dealers. Additionally, a CDS investor has had counterparty risk to the dealer that they entered the trade with. The regulators have started to approve central counterpary clearing platforms for the CDS market and it should be a matter of months (or weeks) before this counterparty exposure starts to fade. CME just received approval from the CFTC and NY Fed on Christmas Eve. The Intercontinental Exchange (Ticker ICE) is considered the front runner to win most of the clearing business, but for our purposes it doesn't matter who clears the market. Either way, the CDS market will have the option to have a central counterparty that is backed by a collateral pool and with margin requirements on positions.

What does this mean? It means that investors will have more confidence that they will get paid if they made the right trade and so they will be more willing to make trades. It also means that the press will finally stop referring to the "$60 trillion CDS market". A central counterparty will allow positions to be netted down so the public can see the "open interest".

Mickey Gooch, GFI's CEO likes to remind investors that the OTC Energy market collapsed after Enron, but then started to grow again about 18 months later. Energy derivatives then went on to be one of the best growth segments in the market structure industry for over five years. You always have to take management commentary with a grain of salt, but I think this analogy is a good one.

Finally, GFI Group is very likely to be among the biggest beneficiaries of the resurgent CDS market. I am of the opinion that the CDS market will finally start to trade on electronic platforms in the US as a result of all the changes going on now. The dealer community is still vital, but is not in the same position of strength to block changes that it was a year ago. In London, a large portion of the CDS market trades electronically. GFI Group and Creditex (owned by ICE) have captured more than 90% of the electronic market share with their respective platforms. The point is that as the New York market goes electronic, I think GFIG is in one of the best positions to capture market share. Dealers may shy away from giving Creditex too much business since ICE is likely to run the clearing platform and the dealer community would like to keep clearing and execution as far apart as possible.

By the way, Credit Derivative is only about 30% of GFI Group's revenue

I mentioned that this stock is neglected, and now I'm telling you that the issue that is keeping investors away only accounts for 30% of their business. GFIG is also a broker for energy derivatives, equity derivatives, and financial derivatives. Equity derivatives in particular have been growing very quickly the last few quarters, which I only mention because there is some diversification across segments here.

GFI Group can operate in a market that is has exchange traded product readily available and where the dealers are not all-powerful.

The energy markets are an important case study. Energy derivative traders have access to a well established futures market and yet GFI brokers are still used to match trades. Often, traders will find each other through an OTC broker then formally enter into a futures contract. In other cases, the trades are posted to the "cleared OTC" market, such as Clearport, to get the benefit of a central counterparty. The point is that GFI Group does not cease business if there is a centrally cleared option.

Regarding the dealers, the energy market has always been more democratic. An energy producer or distributor can call a GFI broker directly, something that they could not do in the credit derivative market for example. Even if the dealers lose their firm grip on the CDS market, a good brokerage is still valuable; they just have more clients to talk to.

Conclusion:

When the market recovers and stabilizes, there will be quite a few beaten down and neglected stocks that will more than triple in value. I don't want too many of these types of stocks in my portfolio because they tend to be very risky, but I want a few and I think GFIG is one of the best ideas in that category.

Happy new years!

Affiliated Manager Group - A great buy

Affiliate Managers Group (Ticker AMG) announced on December 15th, that they hired Gordon Hogarth to head their distribution effort for Europe. I thought this was a good opportunity to highlight the stock.

Like all equity focused asset managers, the keys to growth are: the markets going up, good performance which will attract net new asset flows, and distribution. The news I mentioned pertains to distribution. As you may know, AMG owns stakes in boutique asset managers. For the most part, they just buy good asset managers and give them autonomy and strong incentives to grow. Of the various services that AMG provides to its affiliates, I think the most important is the global distribution platform they are building. They started with an office in Australia over a year ago, then opened an office in London to serve the Middle East market. Now they hired Gordon to head up their distribution effort for Europe out of the same London office.

As a shareholder, I was very glad to see this article. While most of us are shell-shocked by the volatility and economic developments, it was good to see management continuing to execute on their strategy. This will not generate $.20 of EPS next quarter, but it helps set the stage for longer term growth as these various distribution efforts ramp up over the next year or two.

For those of you that don't know this stock, the special thing about the business model is that they make new acquisitions that are accretive to cash earnings. This provides another growth driver in addition to the market and net new asset flows.

This is also part of why the stock performed so poorly this year, underperforming its asset manager peers. The company promotes the use of cash earnings and a pro-forma presentation of their accounting that give the thesis a level of complexity that investor shun in times of uncertainty. Additionally, they have a credit facility that has some covenants and investors have worried that they will either trip the covenants or they will be unable to make more accretive acquisitions because they need their cash to repay the credit line.

My analysis found that if the S&P 500 dropped to 750 and stayed there, they would not breach their covenant until Q3 or Q4 2009. They have enough cash (or availability to cash through a forward sale agreement) that they can pay off the credit line if it came to that. In the mean time, management is likely to be slow to make new acquisitions.

Investors often extrapolate and call it forecasting, and this is the case here. I think the current stock price only makes sense if you think they will loose 15% of their assets, brush up against their covenants, never make another accretive acquisition, and will never generate another performance fee. That mentality describes the current fearful environment, but I think the markets will normalize at some point and when that happens this stock will fly. This could easily run to $60 if investors start to believe the markets have stabilized. That would just be the the valuation bounce before growth kicked in again.

I like this management team. They are former investment bankers which is good and bad. It is bad because it makes them predisposed toward complicated financial structures and proforma earnings. Investors tend to frown on such things. It is good because they are very smart guys and they have raised equity and debt at incredibly attractive levels with good timing.

All that to say, nice job on the new distribution hire AMG and hang in there. The markets will get better and you can make me a lot of money.

Leveraging our most leveraged asset and deleveraging

From the reading I have done, it seems that in almost all bubbles, speculators borrow money (use leverage) to gain exposure to the asset in question. That's right, imagine leveraging up to buy more tulip bulbs. Additionally, access to credit often comes from non-traditional places.

The most recent housing bubble in the US therefore seems like it could represent a special case in that the US home was already the largest asset for most households and accounted for the vast majority of household debt. I think it is safe to guess that Europeans did not use leverage to buy tulip bulbs during normal times. This time around, the asset we collectively levered up to buy more of was already highly levered and very expensive relative to our incomes. There have been real estate booms in the past of course, but the idea that the average household should have the ability to buy a home with 5x leverage is a new one historically speaking. (More recently, we decided that you really shouldn't have to put any equity into your home because we all "knew" housing prices were going to rise forever)

My biggest question is: What are the implications when the leveraged asset is the largest asset most households own to start with (and is already highly leveraged)?

I won't bother rehashing the mortgage mess, but it seems clear to me that household balance sheet have been stretched this time in a way that may not have happened before, at least not on such a broad scale. It seems like there must be implications.

The most likely implication is that households will be rebuilding their balance sheets for several years. Debt to income ratios for the average household went from about 2.5x to over 5x in less than a decade. Some will reduce that ratio by defaulting on their loans. New home equity loans will be very rare. America will simply need to gradually pay down its debts one month at a time.

My second question is: Should we fight the deleveraging trend?

I just argued that household debt is too high and probably needs to come down. But the impact of a massive consumer deleveraging is a bit terrifying, especially if it happens quickly. It seems clear that the government and Fed are doing everything in their power to slow this deleveraging to increase the odds that our economy can absorb it. There is a feedback loop tendency that scares them and rightly so. Maybe the better question is, "To what extent should we fight deleveraging?"

I have a confession: When TARP was being debated, I thought we needed the banking system to start lending again and TARP had a chance of allowing that to happen by removing some of the bad loans banks were carrying. In retrospect, I'm embarrassed to admit, I naively assumed that the problem was the reluctance of banks to lend. Of course that is one problem, but it is much deeper. Did I really want banks to keep lending at the same underwriting standards that facilitated the current state of affairs? By definition, because I think underwriting standards need to be tightened, then I think banks need to reign in lending. That means banks need to be lending out new money slower than they get repayments.

My interpretation of the changes at Fannie and Freddie as well as the modifications to the FHA loan program, is that the government is simply trying to keep underwriting standards at loose bubble-era levels for mortgages. The banks won't do it so the government has to fund mortgage originations. This probably has to happen but I hope the government is planning on gradually tightening underwriting standard over several years until they can turn it back over to the private market.

I think the Fed and Treasury are on the right track; force mortgage underwriting standards back to "stupid" levels in order to slowly adjust them down. If they can pull this off, it will decrease the pressure on businesses and therefore limit the losses on C&I and CRE loans at the banks. They have infused the banks with more capital with which to absorb the inevitable losses from C&I and CRE loans. Keep in mind that the preferred capital will help keep the banks above regulatory capital requirements, but the book value attributable to common shareholders could still go negative. I own one bank in my personal portfolio but I am aware of the risk and you should be too if you own any (I own ZION). Banks are high-risk investments right now.

I'm not really sure how investors will treat a negative equity scenario. Banks are usually priced as a multiple of book value, adjusted for ROE. Investors may start using a multiple on normalized future earnings if that happens, or they may just demand that the bank sell itself. There are public companies with negative common equity, so it is not unheard of, but it would require bank investors to think very differently than they are accustomed to. I also don't know how the regulators will treat negative common equity. I'll leave that question to someone closer to the regulators.

Conclusion:

I expect US consumer spending to be weak for years, not quarters, as the government and Fed slowly deleverage the US household balance sheet. The banking sector broadly speaking will shrink, especially when consumers start allocating back to equities at the expense of deposits.

Why now is the time to be buying equities

This is my first post and it is purposefully broad in nature. My macro view and resulting bullishness will color my stock-specific commentary so I thought this would be an appropriate starting point. Yes it is scary out there, but I'm a buyer.

Let me be clear, I think the economy is in bad shape and will get worse before it gets better. Americans have too much debt because the most recent bubble was in housing. As Americans reduce debt, consumer spending comes down which naturally impacts business health and spending. In short, deleveraging is a very serious problem and I don't wish to downplay it.

So why am I a buyer?

A lesson from options pricing

As most of you know, in the options market, volatility is a key determinant of the value of an option. If a trader thinks Boeing's stock will be incredibly volatile, they will be willing to pay more for a Boeing stock option because they are more likely to be able to exercise the option and make money. All else equal, the higher your expectation of volatility, the more an option is worth. In an example that will be a perfect segway to the equity markets, imagine you bought a call option on Boeing. At the time you bought it, implied volatility was very high given the union strike and 787 delays etc. A month later, the stock has gone up 10% but your option has not appreciated in value. Even after accounting for the decay as a result of passing time, you think the option should be worth more. Chances are volatility assumptions have come down as well. So even though you were right on the fundamental (stock price) the change in volatility kept you from making money.

Now lets jump to the equity markets. The parallel to volatility in equities is fear/uncertainty. When you buy a stock, you are buying an ownership stake in the companies net assets and future earnings. Of course we are talking about future earnings, so they are inherently uncertain. As uncertainty and fear go up, the price we will pay for a stock goes down.

For the market broadly, my thesis is that the level of uncertainty and fear about future earnings across the whole market is VERY high and that the uncertainty will diminish even as the economic news continues to be bad. Basically, as the economy continues to deteriorate, investors will actually become more confident that this is not the end of the world and it will just be another bad recession. The result will be a flat market over the next six months as the bad economic news is offset by less uncertainty about how bad it might get. This is based on anecdotal evidence as I have gauged the mood of portfolio managers and analysts over the last several months.

The out-of-favor asset class

Another lesson from history is that investors typically do not flock back to the asset class that most recently burned them. This point is less compelling because one could argue that the only asset class that has not burned investors recently is treasury bonds. Despite that, my argument is that equities have been out of favor since 2000. If you look at the Price/Forward Earnings ratio for the S&P 500 index, you will see that it has been falling since 2000. Even when the index itself was going up between 2003 and 2006, the trend in the multiple was down.

My interpretation is that investors have preferred other asset classes since 2000. Housing, commercial real estate, commodities, alternative investments, gold, treasuries have all been in favor recently and either have or will disappoint. My expectation is that as this recession plays out, uncertainty will fade and investors will decide it is time to own equities again. Corporate earnings are coming down dramatically, and the market multiple is very low due to uncertainty. I don't know if that jumps off the page at you like I hope it did, but that strikes me as a perfect time to be buying something; when valuations are low and the hurdle is being lowered.

Conclusion:

Split your dry powder into four slugs to be invested one at a time over the next six months. I expect a lot of mini rallies and retrenchments as my thesis plays out so try to buy when the markets are off at least 5% from a recent high. Don't try to buy at or below prior lows, because that is a recipe for missing the show.



Why might I be wrong (a couple unanswered questions in my mind)

I will spell this out in my next post, but in essence, I think we are living through the repercussions of a special case bubble. Americans used additional leverage to speculate on an asset that already accounts for the vast majority of household debt in normal times. See next post.

It is possible that we are entering a new long phase in which corporate profit margins shrink for a long time. Basically, labor may gain a share of economic output at the expense of corporate earnings. I will admit this is possible, but I don't have an opinion worth sharing and am not sure how to determine if it is likely.