This has surely been an interesting year in the equity markets. The sheer amount of stocks that are down between 40-60% is absolutely incredible. Part of that is due to the energy sector, which has been a clear disaster outside of the refining companies. It is also a reflection of the high valuations that exist in many sectors in the market. Areas such as healthcare, retail, and the industrial sector were quite obviously overvalued and investors in those areas have been burned accordingly. The stocks that have led the S&P 500 have been some of the most expensive stocks in the market. The major movers have been Amazon, Google, Facebook, and Netflix. While all four of these stocks are great companies, the valuations reflect extremely optimistic expectations, so that any miss on earnings estimates can create a collapse of 10-20%. Google is the best value of the bunch in my opinion, while Amazon has the biggest competitive advantages.
We have continued to hold and build large positions in the deeply undervalued financials sector. These stocks have performed well but have been volatile along with the general market. Our strategy of selling puts has helped us a great deal, as we’ve taken several rounds of profits on companies like AGO, BAC, Citigroup and AIG. We’ve been able to sell puts as they have declined and bought them back for cheaper when they have risen creating reasonable profits. Our long-stock positions have held steady. We haven’t added materially to energy as the amount of production has stayed to high relative to demand. I still believe the long-term opportunity is very attractive but it isn’t as high of a conviction as our financial stocks. Thankfully, we have avoided the majority of the stocks that have created massive losses for many of the most famous hedge funds in the world as this has been a very rough year for many investors, but I do believe that we have the opportunity to create outperformance as our options expire over these next couple of months.
Assured Guaranty reported earnings a few weeks ago that were exceptional and the stock once again got to its 52-week high, just under $30, only to decline a few bucks since then with the overall market. We have been able to lock in profits on some options on stocks such as GM, BAC, and AAL, and have been able to reinvest more into AGO. Here are the facts. Assured Guaranty’s adjusted book value is just under $60 per share, up significantly each of the last several years. The only major issue facing the company is the distress in Puerto Rico. Currently, the stock trades around $27. The company will most certainly face losses on Puerto Rico and everybody knows that. Management has already started reserving for it and that is reflected in the adjusted book value number.
Management also has an incredible track record of properly reserving that is the envy of the industry and has been proven throughout the Financial Crisis. Let’s say the company is wrong by an incredible $1 billion in its reserves (highly unlikely). This would result in about a $5 after-tax hit to the $60 adjusted book value and would likely be mostly offset by stock buybacks done at a discount to book value over the next 3 or 4 quarters. Now that will not prevent the stock from being volatile and because it is a very large percentage in most portfolios’, that can create significant short-term fluctuations. Don’t let those scare you as they are the price paid for the least risky stock we can buy as defined by the risk of permanent losses of capital with the best upside potential. I expect us as a group to make many millions of dollars on this position! There are so many ways to win as I eventually expect them to consolidate the industry, which would create massive value creation. $60-$80 per share is not impossible over the next 3 years. I write this to you as there will be a lot of news about Puerto Rico over these next few months and in any negotiation to decrease the debt meaning a default, the news is always bad. We’ve been through this before many times in Stockton, Jefferson Country, Detroit etc. Puerto Rico has become a political issue so the posturing is extreme.
All I can say is that even the worst case scenarios we will be fine, based on all of my analysis, which has been extensive. Volatility is an opportunity and not a concern, but it is inevitable. We will get through it and the fruits of our patience will be abundant. I couldn’t be more confident. I analyze businesses every day and there are very few good values out there, but we are in some excellent opportunities and I’m confident that those that are patient, will do really well even if the market doesn’t do well. Within the next 6 months to a year, we’ll have a great deal more clarity on things and that will be the most positive thing for the stock. Meanwhile management will keep buying back stock at a discount, which will increase the intrinsic value of the shares that we own. As always, please let me know if you have any questions whatsoever as I’m here if you need anything!