Friday, April 16, 2010

Why Goldman is a Screaming Buy

The SEC shocked Wall Street today with its accusation, duly filed in Federal District Court in Manhattan, that Goldman Sachs (NYSE: GS) engaged in fraud during the subprime debacle.

Shares have taken a dive, losing nearly -13% of their value on fantastic volume.

So the question arise: Is Goldman a buy? Or is it lights out for the storied squid?

The answer isn't hard to find. Read the lawsuit. When you're done, I think you ought to respond to your first instinct. (More on that in a minute)

First, stick with me as we break this down piece by piece.

It starts with a home buyer getting a mortgage. The bank, for whatever reason, sells the loan. This happens thousands of times a day.

Those loans are combined into an entity called a "Residential Mortgage Backed Security." This is nothing more than a bond backed by mortgages. Each month, as borrowers make the house payment, a lot of interest is paid and a little debt is retired.

Those residential mortgage-backed securities can be packaged into yet another type of security called a "collateralized debt obligation." To make sure it's even more complicated, these are further divided into sections called "tranches" and are then risk-rated and sold. So now it's a big bond backed by a bunch of smaller bonds.

Let's be clear about who snaps these up. These investments are only bought by major players who are looking for good returns and willing to take the risk to get them. "Qualified institutional buyers" are legally recognized as sophisticated, well informed investors who need less protection than individuals.

Now: Enter Goldman.

The investment bank was asked by a client to put together a CDO. So Goldman did. It loaded a lot of risky residential mortgage-backed securities into a shiny new CDO and then sold pieces of it to investors. Just like it has done a thousand times before. Just like the other major investment banks do all the time. Goldman was paid a fee of $15 million to put the CDO together. For those of you keeping score at home, that's about 0.0003% of its annual revenue.

What happened? Well, as we all know, the housing market went south. As properties lost value, borrowers defaulted with insufficient collateral to cover the debt. The mortgages lost some if not all of their value, and the over-arching CDOs basically became worthless because no one wanted to buy "toxic assets."

Here's the thing, though. While millions of investors lost and some institutions even failed, a few investors did manage to make money on the subprime collapse.

One who did: The client that asked Goldman to put together the CDO. It was a hedge fund called Paulson & Co. After the CDO it sought had hit the Street, Paulson bet against it by buying something called a credit-default swap.

Forgive the lingo, but there's no way around it. A "credit-default swap" is nothing more than a bet between rich dudes. One says something is going to happen and the other says it's not. It's kind of like a private insurance policy. Instead of going to, say, Geico, I pay a rich neighbor $1,000 to cover me for a year. If my car crashes, he buys me a new one. What's "swapped" is risk. I was taking it, then I paid someone else, my rich buddy, to shoulder the burden.

In the Goldman case, the something being bet on was the mortgages. Some bet on them, some bet against them. In banker lingo, a "credit" is a loan. "Default" refers to the risk that a loan might go bad. So all a fancy "derivative" like a credit default swap really is is an insurance policy against a bunch of loans going bad.

That's what Paulson bought. When the loans went bad, Paulson collected on its default swaps.

Not quite as complicated as it sounds in the papers, right?

Paulson made $1 billion on this deal, incidentally. That money came from the rich dudes who thought the mortgages wouldn't go bad. (And if they had, then they would have just kept the premium, just like the insurance company keeps the premium even if you don't wreck your car.)

Paulson, for its part, is not being sued by the SEC.

Only Goldman. And a (now) 31-year-old kid who works there. He made the mistake of writing a couple of damning-sounding emails in which his ego-driven braggadocio far superceded his prudence and intelligence. He knew, as most did at the time, that the mortgage market was imploding and that CDOs were about to take a hit. He said so. And Goldman was still selling these. And institutions hungry for rich returns were still buying them.

Remember: Every one of these CDOs, even, in some cases, with extremely poor credit ratings, were sold. Someone bought them. Someone read the details, took out his checkbook and said, "I will pay for that." And everyone who did, none with a gun to his head, was a qualified institutional buyer who knew exactly what was going on.

The SEC contends that Goldman has some sort of duty to disclose that Paulson was betting against the CDO.

That's nuts.

Goldman should never tell anyone what one of its clients is doing. It doesn't and, I would guess, it hasn't. In other forms, exploiting or divulging clients' positions would be no different from front-running trades, which is and should be illegal.

Remember: Goldman is a broker/dealer. It arranges trades. A buyer wants something that a seller does not, Goldman puts the two parties together. It's not Goldman's role to talk a client out of buying something that it wants. Goldman's role, in this case, was to make a market. Provide the means for transaction between buyer and seller. It did that. It did nothing wrong.

Look at it this way: What if you called your broker and sold 100 shares of IBM. Would you want your broker to tell the world that you no longer wanted to own Big Blue? And if you shorted the shares, does your broker have an obligation to tell the next customer that wants to buy IBM that you just bet against the company?

Of course not.

And, again, we're not talking about the individual investors that the SEC is supposed to protect. We're talking about sophisticated, well informed masters of finance who knew exactly what they were doing. It's ludicrous to suggest otherwise. That a lot of banks lost money on CDOs just means they were all equally stupid and willfully disregarded the risk.

I mean, c'mon: No one buys a debt instrument with a relatively high rate of default (as reflected in credit ratings and in the underlying fundamentals of the instrument, which are available in detail on any Bloomberg terminal) without understanding that somewhere someone might be betting against it. That's just life. Even the best companies have contrarians who bet against them.

As rumors build against shakier companies, of course, investors short it -- betting it will implode. Others buy it, thinking it will make a comeback and they will make a killing.

There isn't any wrongdoing, even if both parties make their trades though the firm that underwrote the initial offering!

The broader context must be taken into account. Goldman Sachs is a great bank. Smart, admirable and decent people work there. They make good salaries, sure. But that just gives every Goldman employee all the more reason to play it straight.

Goldman does complicated stuff and makes a ton of money in ways that most people can't relate to or figure out. They hear words like "derivatives" and "credit default swap" and "collateralized debt obligation" and they're lost. Most people wonder how the housing bubble burst and how everything really went down, and in the end it's easy to blame an institution like Goldman or Skull & Bones or the Castro regime for things that otherwise defy an easy explanation.

The same people who would be mad at Goldman for selling this security at the behest of a client are the same ones who thought the whole financial crisis would go away if we lowered a few CEO salaries. It is naive populism knee-jerking its way to judgment about something it clearly is ignorant of and has no frame of reference to understand.

This lawsuit is about redistributing wealth. It's about criminalizing financial sophistication and punishing size and success.

That's the bad news.

The good news is that the Goldman case will be tried in the most financially savvy court in the land. The truth will come out. Mark my words: Goldman will be fine.

So what's your first reaction?

If it's to buy Goldman shares at today's fire-sale price, then I'd agree. Goldman's a buy.

Two Positions Harvard Should Increase

Harvard Management Co. has 120 securities in its publicly disclosed portfolio. Its top four holdings, representing 55% of the portfolio's $2.3 billion value, are internationally oriented exchange-traded funds that focus on generating income in emerging markets, China, Brazil and South Korea, respectively.

Given Harvard's clear preference for managing its risk through the diversity afforded by ETFs, I wanted to know which stocks the nation's wealthiest university endowment was holding.

Seven equities comprise at least 1% of the portfolio as of its most recent filing. None are in the same industry, all except one has a multibillion-dollar market cap; most are megacaps valued at more than $40 billion. Three of the companies -- BJ Services, Burlington Northern Santa Fe and Marvel Entertainment -- have since been acquired.

Here are the companies Harvard owns, what the university is betting on, and my take on the investment’s prospects:

The largest stock holding is Barclays (NYSE: BCS). This British bank has seen decent returns since Jan. 1, with a better than +27% gain, and a one-year return of more than +100%. Even so, the bank has lost nearly 50% of its value during the past five years as the global financial system weathered the Great Recession. Investors are still unwilling to pay much for bank assets, which isn't so surprising when you look at the strength of the asset pool that required 8.0 billion pounds in loss provisions in 2009 and 5.4 billion pounds the year before. Investors are only willing to pay 88 pence on the pound for assets, which effectively values the bank's underlying business at zero.

As Barclays and other banks earn their way out of the bad loans they made, their earnings will inevitably rise, as the cash they were allocating to problem loans will flow instead to the bottom line. It's a waiting game. Harvard should keep at it. I'd hold this position.

Teva Pharmaceutical Industries (Nasdaq: TEVA) is an Israeli drug maker that specializes in generics. Sales, earnings and book value have grown every year since 2000. The shares currently command 27 times earnings, a discount to its historical average of about 40. Future profits should be significantly enhanced by a recent acquisition of a German drug maker and by a spate of expiring U.S. patents.

Owning Teva is a bet on cost-conscious consumers in the health-care sector, an economic segment that tends to grow faster than overall U.S. gross domestic product. As recent health-care legislation extends coverage to previously uninsured patients, drugs sales are likely to see an increase. The wager has been a good one so far. Teva has outpaced the S&P this year (Teva +11.4%, the S&P +7.0%) and the company has posted annualized returns of +14.3% for the past five years.

Harvard would do well to increase this position.

BJ Services (NYSE: BJS) is an oilfield-services company, and owning it signifies a belief that drilling activity around the world will remain strong. As oil prices creep closer to the triple digits and each day seems to bring another announcement of a new crude discovery, that appears to be a good bet. The company was recently acquired by Baker Hughes (NYSE: BHI), which trades near its 52-week high at a robust 35 times earnings, a richer valuation than Google.

Baker Hughes is a storied company, and Wall Street likes the story. That's why its valuation has risen to historic highs even despite lackluster 2009 results and ho-hum forecasts for 2010. The longer-term prospects look good, but the company offers a less-than-compelling entry point at these prices.

I see more potential value in offshore players like Transocean (NYSE: RIG), Noble Energy (NYSE: NE) and Diamond Offshore (NYSE: DO), especially as the Obama administration has opened up previously protected U.S. waters for exploration.

Harvard should have some individual-equity exposure to the petroleum sector, but Baker Hughes has limited upside. The offshore drillers are far more promising opportunities: Why buy a company at an inflated price hoping its earnings will rise to lower its earnings multiple when you can buy a company with similar growth prospects but a depressed valuation?

Harvard should close this position.

News Corp. (Nasdaq: NWS) Rupert Murdoch's media empire has about $30 billion a year in annual revenue, but its run of robust profits came to an end in 2009 when it posted a $5.6 billion loss. Yet even those earlier profits haven't done much for the stock, which has achieved an annualized gain of +0.7% in the past five years and an appalling -10.7% annualized loss during the past three years.

Though News Corp. produces news and entertainment, it is primarily in the highly cyclical advertising business. Its recent track record has been rocky, with 2009 earnings coming in below 2008, and its future doesn't look great, with 2010 earnings forecast to come in under 2009's. So the fact that News Corp. is trading at 24 times trailing twelve-month earnings per share of $0.75 is curious. That's higher than the S&P 500, which, as a whole, should be able to grow faster than a $40 billion media company. Its valuation also exceeds the company's five-year average earnings multiple of 18.

Here's the rub: If a company's earnings are worth more than the broader market, then its assets ought to be, too. After all, the premium to book value represents the market's valuation of the business that's going to create those future earnings. But that's not the case. News Corp. trades at 1.9 times its net asset value, a discount to the broader market's 2.2. So News Corp. either needs to somehow erode shareholder equity to lower its book value (unlikely), or it needs to seriously juice its earnings. An increase in earnings, however, is already pretty much priced in.

There's current upside to News Corp. Harvard should close this position.

Pebblebrook Hotel Trust (NYSE: PEB) is an anomaly in Harvard's portfolio. It's a small real estate investment trust as opposed to a large international corporation. It went public in December 2009 and has so far only managed to post a small loss. The REIT received proceeds of nearly $400 million that it plans to "opportunistically" invest in the beaten-down hotel sector, which suffered a -16.7% decline in revenue per available room in 2009, one of the worst years for the industry.

Any wager on hotels is clearly a bet on a strong economic recovery where businesses aren't afraid to spend money on travel and consumers become less discount-focused when booking rooms for vacations. This is an income play that has, of yet, produced no income. Better, more established yields are available.

The last two stocks that made the list are Marvel Entertainment, which was acquired by Disney (NYSE: DIS), and Burlington Northern Santa Fe, the railroad, which Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) bought. After approval by BNI shareholders -- with 70% voting in favor of the $26.4 billion deal -- Berkshire said 40% of Burlington shareholders wanted to be paid in cash and 43% wanted Berkshire stock.

Which leaves one final question on this exam.

Will the smartest university join forces with the world's smartest investor?

To be sure, Harvard got it wrong the first time. The university turned Buffett down flat when he applied to its graduate business school in 1950. If Harvard wants to see serious returns on its assets, however, then it might want to rethink that decision. After all, its investment managers achieved a stunning -27.3% loss on their portfolio in the fiscal year ended June 30, 2009, while Mr. Buffett, who, despite his Columbia MBA, ended 2009 with a +19.8% gain in Berkshire's book value.

The long-term picture is even better with Buffett: He has delivered a +20.3% annualized return vs. Harvard's +11.7% annualized growth, which roughly matches the market.

Here's the crib sheet for the exam: You have to generate some returns in excess of market gain if you're ever going to get ahead. Let's check the numbers: Invest $100 million with Buffett and you'll end up with $4 billion after 20 years. Invest with Harvard and you'll arrive at a $914 million balance during the same time period, less than 25% of what Buffett earned.

Let's hope Harvard got it right this time and took the shares instead of cash. We’ll find out in about a month, when the next filing is due. The cash would have earned nothing, but Berkshire has returned +22.1% year-to-date.

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Thursday, April 1, 2010

How Obama Instantly Created $2.2 Billion in Investor Wealth

With a stroke of his pen -- and after a hellacious fight with the Congress -- President Obama brought massive change to the health-care industry.
He's doing the same with another industry today. The industry is different and he doesn't need Congressional approval. And the plan has already created $2.2 billion in wealth for investors.

So what's going on?

Would you be surprised if I told you it was politics?

Presidential power, some would argue, is cumulative. It builds. Winning presidents tend to keep on winning; losing presidents tend to keep on losing. After more than a year in office, the verdict on whether Mr. Obama will turn out to be a perpetual winner like FDR or a chronic loser like Jimmy Carter has yet to be determined.

Making such predictions is dinner-table sport inside the Beltway. Everyone has an opinion these days, but even the cagiest political operators should be loathe to make too bold a forecast. Today's supercharged political climate is full of surprises.

The fact is no one knows how the Obama administration ultimately will be judged.

But I can tell you what's coming next. As you know, health care was a cornerstone of the president's agenda. With the bill signed, Mr. Obama is wasting no time. He took a quick victory lap to Afghanistan to change the focus, came back and met with the French president for the same reason, and now he's ready for a new storyline.

He's got it. If you saw the news yesterday you know what it is.

Mr. Obama is clearly moving on to another key element of vision: The environment.

We've all heard stories about how smart Mr. Obama is. And though the president is undoubtedly very intelligent -- and calmly disciplined -- both of those labels undersell him. In addition to his brain power and temperament, Mr. Obama is also very shrewd.

You see, though I would suspect he would agree that presidential power is cumulative, I think he also knows he can't just ram through another bill without any support from the other side of the aisle. That's not a purely political calculation, it's bowing to the unavoidable reality that Senate rules don't allow for another reconciliation process this year.

But with the midterm elections coming up, it's unlikely that the White House would railroad through more legislation even if the option were available. Mr. Obama and his advisers know that if you engage your enemy in the same way too long, he will adapt to your tactics. So the president is switching gears. That's why he's been talking about bipartisanship again, going so far as to quote the old Ronald Reagan line about "disagreeing agreeably." It's also why he's been supporting the construction of new nuclear power plants, a key Republican energy priority. The fact is Mr. Obama is priming the political pump.

And what's going to come through the pump next?

Crude.

The President is flip-flopping on a longstanding policy and opening up nearly 300 million acres -- or about 480,000 square miles -- for offshore oil exploration, some of it for the first time.

The action added at least $1.5 billion in market value to the offshore drilling industry's major players. President George W. Bush might have been an oilman -- and, to be fair, he did try to open up some areas for drilling -- but it's Barack Obama who today snapped his fingers and added nearly $1 billion in market cap to Transocean (NYSE: RIG), the leading offshore drilling company.

The president didn't stop with offshore drilling. To placate supporters who are bound to be aghast at the drilling, he threw environmentalists a bone and announced he will also increase the military's use of biofuels and add hybrid vehicles to the government's fleet. He made his announcement in front of a fighter jet that will run on biofuel -- not because that was the most important part of the announcement (it wasn't) but because he wanted a better visual on the news than offshore oil platforms, which would incense Greens.

Investors who own offshore drillers should hang on to them. And all growth-oriented investors should consider them: Offshore drillers are trading at very low valuations -- Noble Corp. (NYSE: NE) sells for 6.5 times earnings; Transocean for 7.3. Diamond Offshore (NYSE: DO) for 9.0. Part of that is uncertainty: No one knew what the Administration was going to do, especially after Mr. Obama said in his State of the Union address that some hard choices about drilling were going to have to be made. Now that those decisions have been made, all three of those industry-leading companies are steals. That's not just because of their long-term prospects but also because of their recent performance.

Transocean, for example, which operates 138 mobile offshore drilling rigs, grew its earnings from $0.22 a share in 2003 to an astonishing $12.48 last year, a gain of +5,572.7%. That's reflected in its historical earnings multiple, which is more than 40 times earnings for the past five years. That kind of earnings growth is possible again. The shares are up nearly +47% in the past year. Diamond Offshore has had similarly strong earnings growth, with an average price-to-earnings ratio (P/E) of more than 30 during the past five years.

Noble has had the most measured results, posting good steady growth, and should be able to regain its typical valuation of about 17 times earnings. Even before the president's landmark announcement today, Noble was worth $108 a share based on its current earnings. That's +157% upside even before new business juices earnings in the years to come.

Investors should and must go into the oil patch with their eyes wide open. First, oil investors have to be comfortable with volatility -- there isn't a "safe" place to stand anywhere in the industry, which is subject to every kind of risk actuaries calculate, and then some. That's not to say there aren't great petroleum investments -- in fact, no sector has ever achieved a better return on equity than the oil business -- but understanding the risk is the first step toward understanding whether any investment is suitable for your portfolio.

Second, even though the president reversed the moratorium instantaneously, the returns are going to take time. The intricate offshore survey work required to find suitable exploration sites will take months and years.

For risk-tolerant investors looking to take advantage of Mr. Obama's bold new energy direction, the offshore drilling space is a great place to seek growth. The president has added billions to this sector today. It's likely just the beginning.

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