Adopting A Cautious Approach

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August 11, 2007 | Stocks | | Author Asif

Looking back at the gyrations of Mr. Market last week, it is amazing that the major indices ended in positive territory for the week. Huge injections of liquidity by central banks on both sides of the Atlantic certainly helped prop up the markets and this was repeated once again on Monday. There have been rumors about the potential of a large hedge fund blowing up and Goldman Sachs (GS) had to pump $3 billion into one of its hedge funds to keep it afloat. In addition to the two failed Bear Stearns (BSC) hedge funds, three funds from French bank BNP Paribas (BNPQY.PK) were suspended last week. It appears that the Europeans had an equally (un)healthy appetite for John Doe’s exotic mortgage.

I was very surprised to see ABN Amro (ABN) drop last week based on speculation that the takeover of this Dutch bank may fall apart. Potential suitor Barclays (BCS) took a harder hit and I am glad I liquidated our position in Barclays as discussed in the portfolio readjustment section of the August investment newsletter. A lot of investors are getting interested in the battered financial sector and indeed some of the large banks have attractive valuations while paying a sizable dividend. However the headwinds against the large commercial banks are strong with slowing mortgage originations, low interest spreads and a consumer that may finally be scaling back as seen by declining retail sales in July. Unlike Quant Investor who prefers Bank of America (BAC), the only large bank that I find mildly interesting is Citigroup (C) based on its international diversification, a 4.6% dividend yield and a 17.82% Return on Equity (ROE).

However it may be prudent to stay on the sidelines (update: I meant for new positions and not liquidating an entire portfolio) until the magnitude of this subprime mortgage mess becomes clear. The failure of a large fund or bank would put a lot of pressure on the capital markets and there is a lot of fear out there but not enough to make investors capitulate in despair. Capitulation is seen near the bottom of a bear market and it is not even clear if we are experiencing a correction or the start of a new bear market following the bursting of the real estate bubble. In the words of James Stack of Stack Financial Management “if it looks like a bear and growls like a bear, you treat it like one”.

On the flip side, I am very excited about the VMware IPO, which will raise $957 million at $29 per share and was priced at the high end of its forecast just like Chipotle Mexican Grill (CMG) last year.  VMware should begin trading on Tuesday under the ticker symbol VMW. Assuming VMware earns $160 million in 2007 (profits were $75.3 million in the first half of 2007), the valuation with a P/E of roughly 66 is quite rich even at its IPO price. If the stock shoots up like it is expected to, the company will earn membership amongst the rare group of growth companies sporting a triple digit P/E. However if VMware can continue its red hot rate of growth, the IPO price will begin to look like a bargain in a couple of years.

This spin-off has helped our April 2007 pick EMC corp post a gain of 37.55% in the model portfolio and based on how well the IPO does, EMC could head even higher as it will retain an 87% stake in VMware post IPO.

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  1. Hemel
    August 16th, 2007

    Agree with you on being cautious on the financial stocks. However, the banks (WFC, C etc) might be the first to show some signs of stabilization.

    I was looking at the various indexes and the first to break was the Russell 2000 so it might be the first to show signs of stabilization.

    Any comments?



  2. Asif
    August 16th, 2007

    The “flight to quality” combined with the underperformance of large caps for several years could be the reason the Russell 2000 has taken a hard hit in recent months. Looking at a three month, six month or YTD chart comparing the Russell 2000 with the Financial Select Sector ETF (XLF), you can almost make a case for the financials rebounding faster once this carnage is over. I doubt the small caps as defined by the Russell 2000 are going to lead the market higher anytime soon.

    The big banks do appear attractive but I do not want to make the same mistake that some value investors made by getting into the home builders and mortgage lenders a little too soon based on current valuation. Until a clear picture emerges about the amount of exposure some of these banks have to real estate and leveraged hedge funds, I plan to stay on the sidelines even if it means I could miss the bottom.

  3. stock investing blogger
    February 23rd, 2018

    Looking at the present situation, investing in financial stock is quite risky, but with the statement of President Bush and Bernanke to bring more stability in credit market have given a helping hand to stock market at least to stabilize at this point, but still i will keep my finger cross and wait for next Fed’s move.

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