Finding Survivors in the Financial-Sector Wreckage
David Ellison says the one thing investors have to assume about the credit crunch is that "we're going to come out the other side." Ellison plans for his two financial-sector funds to come out the other side, too, so he is focusing on finding the battered sector's survivors.
He ought to be an apt guide. Ellison learned to invest at the feet of famed Fidelity manager Peter Lynch, then ran Fidelity Select Home Finance for 11 years in the 1980s and '90s. In 1996 Ellison joined FBR, for which he manages two funds, FBR Large Cap Financial (symbol FBRFX) and FBR Small Cap Financial (FBRSX). Over the past ten years, Large Cap has beaten 65% of similar funds, while Small Cap has outpaced 97% of its peers.
Ellison earned some attention recently for his big cash hoard. At the end of June, cash holdings in his small-capitalization fund had climbed to 38% of its assets, and those in his large-cap fund had risen to 50%. Still, he says, he should have taken even more money off the table to protect his shareholders and bought more of the few stocks in his portfolios that held up under pressure.
Credit-card networks MasterCard (MA) and Visa (V) have bolstered shareholders of Large Cap Financial. Top-five holding Visa, which went public in March at $44 a share, closed August 14 at $75.78. MasterCard, whose shares are up 10% year-to-date, closed at $235.88. Both companies are essentially transaction processors. They don't keep customers' credit-card balances on their own books, so they are not at the mercy of cash-strapped borrowers.
And Ellison has been thrilled with his small-cap fund's biggest holding, Hudson City Bancorp (HCBK), which accounted for 12% of assets as of June 30. Hudson City has been one of the best-performing major banks throughout the credit crunch, and the stock has climbed 27% year-to-date. In July, Hudson City reported that second-quarter profits had soared 52% from the same period in 2007. It also raised its dividend, an unusual occurrence among banks nowadays.
Together, those moves have provided much-needed insulation from the tumult in the financial sector. Over the past year through August 13, financial companies in the Standard & Poor's 500-stock index lost 36%, while FBR Large Cap lost 25% and Small Cap surrendered just 7%. Granted, stocks of small financial companies haven't been bruised as badly as their bigger brethren -- the Dow Jones U.S. Financials Small Cap index is down 10% for the past year.
Scanning the market carnage today makes Ellison nostalgic. He's pulling formulas out of his arsenal that he hasn't used in 18 years -- not since he was sifting through the wreckage of the savings-and-loan crisis in 1990.
So what's the magic formula? He essentially assumes that banks' nonperforming loans -- loans that aren't being repaid -- are worth zilch. He further assumes that the dollar amount of each institution's nonperformers will eventually triple. From that back-of-the-envelope, worst-case scenario he gets an idea of which companies will need to raise more capital and which are sitting pretty.
Ellison says the credit crunch has had a leveling effect on the way he looks at stocks: "Two years ago, every company had a story. If you didn't like one on earnings, then maybe you liked it for its business in China or for its credit-card business, so everyone was a buy." Today, by contrast, stock selection mostly comes down to survivability, he says.
But he also says that the savings-and-loan crisis taught him that you don't always know what will work. Now is the time to try out a broader crop of names because enough of them will stick for the effort to be worthwhile, he says. "There's been a buildup of facts in the market that are starting to weigh in favor of the world not coming to an end."