Who's Having Fun?

In his 2006 Annual Letter, Seth Klarman wrote:

"The old saw reminds us never to confuse genius with a bull market. Anyone can become 'expert' at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into 'buy anything'; a rising tide that is lifting all boats often proves irresistible."

And then, a favorite of mine: In an interview with Becky Quick, Warren Buffett said:

"You get more excited when there's a lot going on, you can't help it. And frankly, it will probably present more opportunity to us because when dislocations occur, things get more mis-priced and that sort of thing...So it can be a time of opportunity. It won't be for sure, but generally speaking, when there's a certain amount of chaos in certain sections, the fallout, and it's unpredictable where the fallout will be, but the fallout sometimes offers some real opportunities."

I put these two quotes together purposely. While the Klarman quotes heeds caution, the Buffett quote points us to the fact that market sell-offs provide value investors the opportunity to buy assets on the cheap.

Security prices falls, and most of the time, they fall further. Our job as investors is not to pick the bottom. Our job, rather, it to purchase securities with minimal risk of permanent capital impairment loss that offers adequate returns on that capital. We want a return of our capital and ON our capital. To better guarantee the return OF our capital, we require a margin of safety on our purchases.

Unfortunately, a 500 point drop in the DJIA does not constitute a margin of safety. Yes, stocks are cheaper today than they were last week. That does not make equities a buy - it simply makes equities more compelling.

What I find most interesting about today's market is the sheer magnitude that individual securities have fallen on bad news. Three months ago, I believe you'd see 1/2 these sorts of moves. But because, as pointed out in the last post, the tails are fatter, and the chance of zeros are increasing across the board, investors are selling first and asking questions later.

The list goes on and on: PCS, Leap, the long term care providers, CLWR, the mortgage insurers, HUN, DNDN (one of the largest moves I've ever seen), HOV, post-re org equities (slaughter), etc.

JPM's Peter Acciavatti sends out a Daily High Yield Update each morning. On it, he has a list of the dollar price changes for widely held securities. Obviously these are levered names, I'm going to strip out of the list all companies that do not have public equity, and show you how hard these name's stock prices have been hit over the past 5 days:

• Cablevision: -10.5%
• Charter: -12.8%
• Chesapeake Energy: -8.7%
• CIT Group: -9.9%
• Community Health: -13.8%
• El Paso: -13.8%
• Ford: -11.0%
• Frontier: -11.1%
• HCA: -14.2%
• Lyondell: -15.1%
• Sprint: -11.5%

What about the "Distressed" names that still have tradeable equity:

• Eastman Kodak: UP 3.75% (miracle?)
• Hovnanian: -27.1%
• PMI: -59%
• CEDC: -32.5%

This compares to the S&P return in that period of about down 7%. Levered names are definitely feeling the pain. Do these moves make these securities cheap? Absolutely not. Instead, and especially for the "distressed" names, a sense of reflexivity begins to take hold in that suppliers and lenders will view the stock price as a statement on the company's credit worthiness and will tighten terms which pushes these companies closer to a Chapter 11 process.

In high yield land, nothing really feels washed out except for a few of the shipping names like CMA CGM and GMR and more stressed names (HOV, Hawker, etc). Bank debt has held in really well. When CMS came out with their reimbursement changes for skilled nursing, SUNH, KND, SKH saw their equities down 30-50% with bank debt only moving 2-3 points. That doesn't feel right.

So sharpen your pencils folks, because things have gotten a lot more interesting in the past few weeks - and the jobs number tomorrow is the icing on the cake as it were. Know that you can't catch the bottom, but don't let that stop you from doing the hard work, collecting your facts, and doing your due diligence. The worst thing you can do right now is type WEI GO all day long, sit on your thumbs, and watch the red.