Sunday, August 3, 2008

Portfolio Pick No. 1: Merrill Lynch

I'm fond of bear markets for the same reason I like to visit Brooks Brothers at the end of the season: It's the perfect time to score a ridiculously good deal. And, like the timeless elegance of Brooks, a fat triple-digit return never goes out of style.

I once bought a green camel-hair sportcoat for $99 that I had tried on and nearly bought when the price tag read $575. There are tons of bargains like that in today's market. In fact, I think investors have a far better chance of inking 100% or 200% returns in this market than when times are "good" -- whatever that's supposed to mean.

To that end, I'll post five picks this week, one each day. These are my "Deep Discount" value picks. Each of these companies have been shellacked by the market and are on the sale rack. They're suitable for shorter-term trading, and when they hit my price target, I'm out. (If they drop beneath a certain level, I'll either double down or close the position.)

Later, I'll reveal five other buys for investors with a longer time frame.

Today, let's talk about Merrill Lynch, which is my first pick. Shares are down 50% year to date and are 66% off their 52-week high. I've assigned MER a $53.65 price target, or an even 100% higher than its $26.81 close on Aug. 1. Merrill's an outstanding buy to $30, a great deal to $40 and even at $50 the shares would be trading for less than their fair value. Merrill's 52-week high is $79.72, so I'm not trying to take you up a road the Thundering Herd can't climb.

Merrill Lynch is a beacon of global capitalism. It's a city on a hill; a pillar of the American financial system. (If they had a theme song, I would play it here.) It manages $1.6 trillion in assets, which is more than one-tenth of this nation's annual gross domestic product. Merrill is a great company, the third-largest securities outfit in the country, but it's languishing, along with many of its brethren, in a tepid economy and global credit crisis caused by a meltdown in subprime mortgages.

John Thain, the firm's chairman, has been the subject of intense hurumphing since he agreed to sell $30.6 billion worth of CDOs last week for a measly $6.7 billion.

CDOs are collateralized debt obligations. They're bonds backed by assets, in this case a whole bunch of mortgages. These loans (ideally) generate cash from borrowers' monthly house payments, which pays back the CDO holders over time. If those homeowners default, the CDO loses value.

You know where this is going. The housing market is in the toilet and lots of people are defaulting on their mortgages -- at least, more people than usual. At the end of June, not six weeks ago, Merrill said its CDOs were worth $11.1 billion. Now, that's roughly $20 billion less than their original value. But Thain sold them for $6.7 billion, or 22 cents on the dollar.

Thain took decisive action, ate the loss and moved the most problematic asset off Merrill's books. If a drunk won't sober up, then you've got to throw the fucker out. That's what Thain did, and half of Wall Street has been excoriating him for it. In three years, he'll be giving lectures on the move to MBA seminars at the Wharton School.

But Thain's real coup de grace came a few days later, when Merrill sold stock at $22.50 and Thain, bless him, bought $11.3 million worth. A host of other executives joined in.

When executives sell stock, it's time to leave. Thain & Co. bought. Wall Street skeptics have been wondering when Thain will signal that the worst is truly over for Merrill. And to be sure, he has made those sorts of comments before -- nine times, by one count -- only to come back and say, "Oh, and another thing."

But friends, that's over. Merrill's going to be all right. Thain just said so 11.3 million times. He'll make $10 million on the deal, and he deserves every dime. I'm awarding Thain and every Merrill Lynch executive who cast their lot with him honorary brass umlauts with a fig leaf cluster.

But investors should never confuse the CEO with the stock. Thain could get run over by a Maybach tomorrow and Mother Merrill would be just fine. I hate to be an asshole (OK, so I don't, really), but such as unfortunate turn of events would probably do wonders for the shares. I'm not sayin' that's right, I'm just sayin' that's where we are right now.

A stock isn't just a certificate that sits in your safe-deposit box. It represents a business, and you've got to think like an owner of that company. So while the CEO has to be considered when you evaluate a company, its business and its assets are far, far more important. CEOs come and go, but balance sheets are forever. Or something.

As I noted, Merrill closed at $26.81 on Friday, which means the market valued the company at $26.4 billion. That is too low. That is a fire-sale price. Merrill's brokerage business alone is worth $30 million, and that's if you value it vis-à-vis its peers, without assigning it a premium for being the market leader.

So are we buying a $30 billion asset for $26 billion? That's not a bad deal...

But wait, there's more. Merrill's stake in BlackRock is worth $10 billion. Its private-equity investments are worth $5 billion, and its merger-advisory service is worth $3 billion, according to Morgan Stanley. That gets us $48 billion worth of assets for $26.4 billion. (Plus it has $36 billion in shareholder equity on the balance sheet, which ain't exactly chump change.)

Thain, who did a stint at Goldman, is smart. I think he's good for Merrill, but this is really as asset play. Merrill is grossly undervalued. The market will -- eventually -- get past subprime. The market, indeed, will get past subprime faster if other institutions follow Merrill's lead and relegate the issue to the past tense so we can focus our energy on bitching about gasoline prices.

I'll re-evaluate this pick if Merrill drops below $22.

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