Discussion on Recent Market Declines with Particular Emphasis on Financial Services Sector
March 24, 2008
Our pledge to investors includes the following statement “We will communicate with our clients about our investment performance in a manner that will allow them to properly assess whether we are deserving of their trust.” Over the past several months the equity markets have declined significantly led by financial services stocks. We want to discuss recent events with you and explain our current assessment of your portfolios, particularly the financial services sector exposure in our equity funds.
In addition we want to re-emphasize that our approach to investing is long-term in nature as evidenced by our relatively low turnover. One of our equity investment principles states that “Over short periods of time the stock market price is heavily influenced by the emotions of market participants, which are far more difficult to predict than intrinsic value. While stock market prices may experience extreme fluctuations we believe intrinsic value is far less volatile.” Furthermore, while stock market volatility can be unsettling, we note in our equity investment principles “We do not define risk by price volatility. We define risk as the possibility that we are unable to obtain the return of the capital that we invest as well as a reasonable return on that capital when you need the capital for other purposes. If you will need the capital that you entrust to us in less than five years, then you should not invest that capital in the stock market.”
(Exhibit A illustrates the financial services stocks held by our diversified equity funds and the full portfolio for the Diamond Hill Financial Long-Short Fund.)
Currently, all of our equity strategies contain holdings from various industries within the financial services sector. The overall sector weighting varies from approximately 16% – 19% of our equity portfolios depending on the respective strategy. These levels have risen in recent months as we began to find opportunities to invest in companies at prices which we believe are attractive discounts to intrinsic value.
As most of you are aware, the residential real estate debacle and the resulting credit crises wreaked havoc on both the capital markets as well as the real economy over the past several months. With the benefit of hindsight, it is now clear that the combination of low real interest rates during 2004 and 2005, new mortgage products (option arms, interest only, etc,) and lax underwriting created a bubble in housing and mortgage finance that grew well into 2006. Not until home prices peaked in 2006 did the momentum finally stop. In early 2007 we saw the first signs of the crises when sub-prime credit quality began to deteriorate. But the full effects of this situation did not materialize until recently as home prices continued to sink, the credit markets seized up and stocks prices – particularly in the financial sector – plunged.
During the last week, the crises seemed to reach new level of panic as Bear Stearns was essentially shut down by the capital markets and forced to seek a buyer to stave off bankruptcy. One of the more interesting aspects of the Bear Stearns deal is the fact that the Federal Reserve is providing them (through J.P. Morgan) with a $30 billion non-recourse credit facility. After observing this transaction, along with other unprecedented steps the Fed has recently taken, one might readily conclude that our federal government is now paying special attention to this situation and is willing to take extraordinary measures to return our financial system to a state of normalcy. This is extremely important for both the credit and equity markets and in particular for the financial services sector. In short, the Federal Reserve, along with Congress and the White House, will do essentially whatever it takes to stabilize and protect our financial system. As we saw in the case of Bear Stearns, that does not mean equity investors are without risk, but it does greatly reduce the vulnerability to a systemic meltdown and is strongly positive for those companies positioned to take advantage of opportunities as the environment improves.
With that background, we can now spend a few moments on specific areas we are investing in and those that we are avoiding. By far our largest exposure within the sector is the banking industry. We have long been biased to this industry for many reasons, not the least of which are the stability of deposit based funding and the industry’s importance to our overall economic health. The banking system has been under tremendous pressure of late due to concerns over both margins and credit quality. Clearly, credit is now decidedly negative and remains a risk, while margins are beginning to stabilize and the yield curve is quickly becoming more favorable for the industry. On the credit front, we are still seeing deterioration in many different loan classes. However, this industry trend has now been in place for over a year and in most cases, the required reserving is well underway and future reserve additions are now, in our opinion, largely discounted in the stocks. Again, with the benefit of hindsight, credit risk in general was under-priced for at least a couple of years. However, the cost of credit has increased dramatically in last few months and should be very positive for the industry’s risk adjusted margins going forward. In other words, the industry is currently under significant pressure and is being valued at depressed multiples on well below “normalized” rates of return.
We also have exposures – albeit more modest – to the insurance and investment banking businesses in most strategies. Within the insurance industry, a situation worth highlighting is one of our larger holdings, American International Group (AIG). The company has an outstanding track record and an unparalleled worldwide insurance franchise. We see exceptional value in the stock and believe that current GAAP accounting convention has created at least some of this opportunity. The company’s stock has been under considerable pressure over the past month as its fourth quarter income reflected several “mark to market” losses. Based upon our understanding of the exposures involved, we do not see the bulk of these losses as economic in nature. For example, AIG experienced an $11.12b pre tax loss for valuation adjustments with respect to AIG’s super senior credit default swaps. AIG’s own stress testing indicated a $900m economic loss potential on these swaps under a “severe stress scenario”. In other words, the economic reality, while not completely benign, looks much less severe than current accounting rules would suggest. And while this may be an extreme example, similar situations have occurred at many firms throughout the sector.
Areas that we continue to be especially leery of include those business models that are overly exposed to low quality mortgages and/or capital markets based funding. We have seen numerous entities from the mostly non-regulated “specialty financial” space encounter catastrophic problems due to either poor asset quality or the lack of stable and secure liquidity.
Again, at the center of the storm is residential real estate. It has been decades since we have experienced home price depreciation like we have seen in the past 18 months. The mortgage finance industry does not have enough “excess margin” to avoid significant losses when net charge offs are rising to the levels we have seen recently. However, as we pointed out earlier, there seem to be a number of political and regulatory tail winds developing. Two more notable examples are the newly created $200 billion Primary Dealer Credit Facility which is geared towards the brokers/investments banks as well the recent OFHEO (the regulator of the GSE’s) actions to relax the capital requirements for Fannie Mae and Freddie Mac. The liquidity provided by these actions along with lower interest rates and of course, the depreciation we have already experienced, should begin to mitigate further declines in both home prices and many types of underlying securities.
We also do not believe that what is occurring in the residential market is likely to be repeated on the commercial side. As the residential market took off, a massive supply of new homes was built and now that demand did not keep pace, a large inventory of unsold homes remains on the market.
This overbuilding also occurred during the last commercial real estate cycle. However, in recent years, growth in new commercial real estate supply has been modest due mostly to skyrocketing construction costs, investors not wanting to repeat the mistakes of the last cycle and an increasingly difficult permitting process. Also, most commercial properties have long-term leases that will provide some stability. One factor in the rise of commercial real estate prices in recent years has been the ability of landlords to raise rents. Many leases signed at low rates during the last recession are due to reset in the coming years, increasing the property’s cash flow to the owner. Growth rates in rent will surely slow and vacancy rates will likely increase, but ultimately we believe that the supply/demand fundamentals in the commercial real estate space are healthier than residential real estate.
To conclude, as many of you already know, we are an intrinsic value based firm and are always comparing stock prices with our estimates of value. The difference between price and value is often referred to as the “margin of safety” and acts as our most important risk reduction tool. At times, our philosophy leads us to areas of the market where fundamentals are challenged and conversely we are occasionally divesting where things are rosy if the positive fundamentals are fully reflected in a company’s valuation. In the aftermath of the Bear Stearns deal and subsequent Fed easing and market rally, many are once again asking if we have “seen the bottom”. Our response to this question is usually something along the lines of “who knows, we can’t predict short term stock price movements”. All we can do is follow our process of estimating intrinsic values using a long time horizon and waiting for the market to give us opportunities to buy at a discount. For a variety of reasons, many of which we have outlined above, we believe the current environment is providing many such opportunities in the financial services sector.
As always, we would like to thank our clients and shareholders for their continued support.
Originally published March 24, 2008
Investors should consider the investment objectives, risks, charges, fees and expenses of the Diamond Hill Funds carefully before investing; this and other information including fund performance and a prospectus can be obtained at www.diamond-hill.com. Read the prospectus carefully before you invest. Fund Holdings are subject to change without notice. For the Small Cap Fund and Small-Mid Cap Fund, there are specialized risks associated with small capitalization issues, such as market illiquidity and greater market volatility than large capitalization issues.The
Long-Short Fund and Financial Long-Short Fund uses short selling which incurs significant additional risk. Theoretically, stocks sold short have unlimited risk. Diamond Hill funds are not FDIC insured, may lose value, and have no bank guarantee. Distributed by IFS Fund Distributors, Inc., Member FINRA/SIPC, 303 Broadway, Suite 1100, Cincinnati, Ohio 45202.
As of April 30, 2009, BHIL Distributors, Inc. (Member FINRA) became distributor for its affiliate, the Diamond Hill Funds.
Information contained herein is intended as a snapshot as of the date of this investment letter and is retained for historical reference only and should not be relied upon for current information. For current fund information, please go to www.diamond-hill.com.
Performance data previously included in this investment letter has been removed.