We are in the early weeks of earnings season, and overall, the results have been quite impressive. The banking sector saw continued improvement in net interest margins, with credit normalizing a bit. One must remember that we are coming off the most enormous stimulus package in history in 2020, which created the best credit environment imaginable. Naturally as that stimulus wanes and inflation leaves its mark, delinquencies and defaults will increase. However, credit is still better than 2019 (pre-pandemic), which in itself was a good year for credit. The unemployment rate is at 3.5% and that is the biggest driver of credit results. Most banks are reserved for the types of losses you’d see if the unemployment rate was around 5.5-6%. This is a strong margin of safety and the stock valuations are exceptionally cheap. Ally Financial reported earnings and guidance that exceeded expectations, and the stock rallied 20% just today as a result. This is a big move and I believe it is a prelude to what you will see in other financial stocks such as Citigroup. They are ridiculously cheap relative to intrinsic value, trading at 4-5x normalized earnings. Those valuations won’t last when the companies already have excess capital and are conservatively reserved for a recession. The market seems to doubt that these companies would remain profitable as unemployment increases, but it is wildly wrong, and that is our opportunity.
In other positive new, Radian (RDN), a mortgage insurance company we have profiled announced a big $300MM stock buyback at a nice discount to book value. This is enormously accretive and the stock rallied as a result, but it still has 50% upside from current levels. The stock trades at less than 7x earnings and pays a dividend of nearly 4%. The $300MM buyback is almost 10% of the current market capitalization.
Results from Netflix, United Airlines, and Discover Financial indicate that consumer spending is still quite strong. Spending has shifted more to activities such as travel, as opposed to the accumulation of things that we saw in 2021. It’s rare for stocks to be down two years in a row and the same goes for bonds. Of course it is possible, but I think we are in a fantastic positions having protected capital in 2022, and now we have a chance to get a bit more aggressive in 2023 when appropriate.
It’s hard to overstate how attractive I believe current investment opportunities are in the markets. Higher interest rates have ravaged equities, bonds, and real estate. This has created the opportunity to buy high quality assets at sizeable discounts to conservative estimates of intrinsic value. One area that I think there is substantial opportunity is in real estate investment companies, in both the equity and the debt. Stocks of some of the highest quality buildings and portfolios have come down by 30-50% over the last 12-18 months.
Kennedy-Wilson is a company that I’ve profiled before with mostly multi-family properties across the growth states, benefiting from strong jobs markets and migration trends. They also boast an impressive office portfolio in Ireland and the UK, which has very high occupancy rates with excellent tenants such as Salesforce.com, Google, etc. The stock yields 5.89% and has at least 40% upside potential from current levels. The company is not structured as a REIT, which have to pay out nearly all of their income as a dividend, so the company is able to retain more of its cash flow to invest or improve the balance sheet. They also manage billions in real estate assets for 3rd parties, specializing in strategic distressed investing, so it is likely they will be able to capitalize on the current challenges. An area of immense stress is seen in office building operators, given the work-from-home trends, and expectations that a weakening economy could create more unemployment. Some of the highest quality companies such as Vornado, have seen their stocks get cut in half over the last year. While the challenges are real, it is very hard to argue that the stocks aren’t undervalued by at least 50%, while paying very high dividends that have been reset to deal with the current pressure on earnings. If one has a 2-3 year time horizon, they should see 50-100% appreciation on some of these names, especially if interest rates head downwards again. That is a lot for today, but I’m very confident things are headed in the right direction!