Discovering Value

At SKBA Capital Management, discovering value opportunities for our clients is the central focus of our organization. Here we will share our current market outlook and thoughts about value investment opportunities given the current economic landscape.

1st Quarter 2008

This was no way to start a new year. There were few places to hide from the volatility, mostly downward, and the uncertainty that plagued worldwide financial markets during the first three months of 2008. It has now been roughly nine months since the first inkling of trouble in the leveraged fund market surfaced. We are confident nobody foresaw that the problems in a couple of Bear Stearns funds would result in the sale of that firm to JP Morgan for 5%-10% of the then common share price. The brave new world of repackaging risk for widespread sale and using derivative markets as another place to leverage borrowed capital at 100 to 1 has come hurtling back to semireality. To paraphrase a well-known cautionary bromide; "It's 2008, do you know where your money is AND how much is it worth?" There is a glimmer at the end of this tunnel but it is faint, and the length of the journey to daylight may be surprisingly long.

The housing/mortgage meltdown is merely an unwelcome historical addition to the underlying crisis of credit market seizure that has encompassed much of the global economy. The shoes of massive write-offs keep dropping and financial sector woes have spread to slow economic growth both in the U.S. and abroad. The crushing of the credit markets may be mostly complete, but the real economy is only slowly coming down in its wake. We continue to forecast stagflation with the feverish rescue efforts of the Federal Reserve blossoming into anemic GDP growth 12-18 months ahead accompanied by inflation of as high as 4% to 5%. If this isn't yet a recession, it sure feels like one. It is not a pleasant prospect for investors but, as always, a true long-term value approach yields attractive opportunities. Among world markets and aside from the financial sector, the U.S. economy has held up rather well, but markets remain so leveraged that any bad news turns into a rout.

Media, including those in the blogosphere, are in hog heaven - so much pessimism, so many fallen icons and so much misery in the former sanctuaries of mid-to-upper class America. With the Fed’s aggressive rate cuts, our currency has now been debased to the point that entertainers and celebrities are demanding payment in Euros. Once proud financial institutions are groveling for spare billions in capital markets by selling convertible preferred stock yielding 400-500 basis points above current rates. Congress is in full fury trying to punish the guilty, but there are too many candidates, not enough data, and too many likely unintended consequences as a result. It's also an election year and tax and spending policy for 2009 are definitely prime debate material. The internet now allows for instantaneous dissemination of candidate slurs and gaffes and everybody's life is an open book. Proposed "fixes" by the administration appear both insufficient and unlikely to be adopted anytime soon. But throwing out the good stocks with the bad ones is no formula for investment success. Analysis hasn't mattered much in the complacency and risk seeking of the past few years but, in order to earn better returns, portfolios must be invested before the unwinding ends.

The sub-prime mortgage issues are slowly being addressed, and it is unlikely that foreclosures and evictions will mushroom from current levels. The housing stock is being repriced at varying rates around the country, and the process will probably take longer than expected. There is now little doubt that aggressively sold and mispriced credit (for the risk being taken) was a prime mover in the sustainability of consumer spending. That game will not be replayed anytime soon! Investment banks are likely to be subject to more scrutiny while commercial banks merge and reregulate with less risky lending profiles. The net effect will be a reevaluation of the risk/reward potential for private equity, LBO, junk bond and hedge fund investing, a process which we expect to pick up speed as credit markets are reshaped and unfrozen. Our hope is that the interest rate spread distortion which led to much of the problem can be unwound and reset without further mass destruction of value. The balance of the year, therefore, will undoubtedly hold more tales of woe than expansionary activity. Is it likely, rhetorically speaking, that we will return to the same types of risk assumption and derivative development? Will investors be willing to play the same game and seek the same returns while borrowing freely? Will foreign investors be willing to further prop up troubled businesses? We do not believe so and yet....

The old stories have been resurrected - the 1987 crash, the 1990 S&L crisis, the Fed's bailouts of Long Term Capital and Salomon Brothers, and a rereading of the regulation promulgated during FDR's administration, for goodness sake. It's all relevant, yet it IS in some major ways "different this time around." If the solutions proposed can actually pull credit out from the "shadow" financial system (composed of trillions of dollars of derivatives) while supporting the economy’s productive capacity, and if the Fed's actions do not lead to complete demolition of the world dollar standard, then we will make it through another cycle. Financial analysis will again trump financial engineering and good stocks will outperform bad ones. Our hope and belief is that this will be the case.

For more information see the Annual Disclosure Presentations