I am interested in companies that have solid future earnings power and are managed by competent people. The characteristic that most impresses me is a company's ability to grow sales and profits over the years at rates greater than the industry average. In order to do so, the company needs to posses products or services with sufficient market potential to make possible a sizable increase in sales for at least several years. One of the most followed portfolio managers is Bruce Berkowitz. I think it is interesting to evaluate what he bought and sold last quarter in order to check if I agree or don't with his decisions. I analyzed his holdings using whalewisdom.com.
Bruce Berkowitz bought these stocks:
Jefferies was under attack in 2011 on concerns of its leverage and exposure to both Europe and the MF Global fiasco. Management deleveraged its balance sheet, cutting total assets from $45 billion at the end of August to $34 billion at the end of November 2011. This lowered the firm's leverage ratio to 9.9x from 12.0x. I think that ratio is still very high given the uncertainty surrounding the European exposure and MF Global relationship. Management was fast to reduce the company's European exposure. On November 30, JEF's credit books included $375 million long and $534 million short of debt issued by Ireland, Italy, Portugal and Spain. JEF held no positions in the debt of Greece. The positions held were cash-long and cash-short positions that are essentially matched by maturity and country and did not contain credit to full swaps or exotic instruments as hedges. JEF's net exposure to these countries was net short $123 million.
In the recent report Jefferies Group reported Q1 earnings of $0.33 per share, $0.05 better than the Capital IQ Consensus Estimate of $0.28 while revenues rose 2.2% year/year to $758.1 million vs. the $683.6 million consensus.
Management expressed confidence in the business. JEF's vast majority of credit inventory remains very liquid and the vast majority is Level 1 or 2, which is the most conservative side. I like the fact that management does not need to expand leverage ratios to deliver good results.
I think that JEF is an interesting pick considering that management reduced European exposure, creating a more conservative balance sheet.
Wells Fargo (WFC)
I think that Wells Fargo is the best pick from the banking universe. Credit quality continued to improve in 2011 as well as in the first quarter of 2012, with the company reporting significant reserve releases. Considering the current economic environment, the recent trends in the credit metrics and the company's efforts to improve its credit quality, I expect additional reserve releases in the upcoming quarters which will be a positive catalyst for earnings improvement.
I like WFC's cost cutting strategy. Management is targeting to bring down the quarterly non-interest expenses to $11.25 billion by the fourth quarter of 2012. In addition to this, with the conclusion of the integration process and the continuance of the economic recovery, expenses are anticipated to decrease, thereby providing opportunities for future improvement in operating leverage.
Wells Fargo is cheap compared to its future growth. Wells Fargo shares currently trade at 9.5x consensus 2012 earnings estimate, a 10% discount to the industry average. On a price-to-book basis, the share currently trades at 1.1x, which is attractive given a trailing return on equity (ROE) that is 45% above the industry's average.
Mercury General (MCY)
Mercury General writes risk classifications for automobile insurance. I view MCY as a turnaround story given its past troubles. In December 2011, the company implemented a change in its personal auto rating plan in California (its biggest market) and changed its business mix, resulting in a 16% year over year bump in new California personal auto business, which reflects better pricing and cost trends in the California personal auto market. That type of growth number is fair.
Regarding MCY expenses, management is committed to improve margins. MCY's expense ratio improved 26.8% y/y, and management explained in the last call that they expect a long-term 27% expense ratio.
Recently MCY reported Q1 operating earnings of $0.71 per share, excluding net realized investment gains,$0.02 better than the Capital IQ Consensus Estimate of $0.69 while net premiums written were unchanged from the year-ago period at $658.3 million vs. two estimates averaging $661.5 million.
I think that an effective cost cutting strategy and MCY's dividend yield (5.5%) are interesting positives but I would be wary of a continued reserve development as last quarter was MCY's seventh straight quarter of adverse reserve development.
Bruce Berkowitz sold these stocks:
I expect the shares and earnings of big money center banks to fall significantly over the balance of 2012 due to a confluence of material events, both at home and abroad, led by an increasingly troublesome situation in Europe. Also, the U.S. is heading towards a mandated deficit reduction cliff and key market-related tax cuts are likely to soon expire. That will affect banks like Citigroup.
In the last Citigroup's 1Q12 earnings report, Citi beat expectations. Oppenheimer wrote a research report explaining that the company reported a number of "special" items that distorted line-by-line comparisons, but excluding these items, Oppenheimer modeled the core operating EPS at about $1.05 vs. its $1.02 estimates and the consensus of $1.00. Moreover, this still includes a $0.36 per share drag from Citi Holdings. The ongoing businesses in Citicorp earned an ROE of about 15%, which obviously would deserve a much higher multiple than what the shares are currently being awarded.
One positive aspect from C is its diverse business model. Citigroup has a diverse business model with a significant portion of the revenue being generated from outside the U.S. It has a global footprint with operations in over 160 countries and jurisdictions helping its corporate clients and consumers with their local and global needs. Faced with a slowdown in the U.S. market, Citigroup is emphasizing on growth in the international markets. It is making every effort to expand and tap opportunities in the emerging markets, which are expected to experience a quick pace of GDP growth than their developed counterparts.
I view C shares with a high degree of skepticism, considering its hard-to-understand financials and current macro uncertainty.
Goldman Sachs (GS)
I read a very interesting report from Barclays analyzing Goldman Sachs. Barclays analyst met with GS's management and they expressed a cautious tone with respect to the current environment, noting low risk appetite and trading volumes caused by uncertainty and lack of conviction among corporate and institutional clients alike, as well as still-low levels of inventory. The environment thus far in 2Q12 bears an eerie resemblance to 2011, with similar macro overhangs weighing on market participants.
Goldman shares currently trade at 9.0x consensus earnings estimate for 2012, which is at a 41% discount to the industry average of 16.5x. On a price-to-book basis, the shares trade at 0.8x, which I see as a very attractive multiple in valuation terms.
Over the course of 2012, the operating environment has been dominated by macroeconomic concerns, which resulted in subdued client activity. The market was focused on sovereign risk within the Eurozone, specifically the risk of contamination from smaller GDP countries like Greece to larger GDP countries. Faced with a challenging global economic outlook, investor sentiment remains under pressure. The complexities surrounding various economic considerations have created terrific uncertainty about the state of the world's economy and resulted in limited confidence among market participants. Therefore, many of Goldman's clients in the investment banking division have significantly reduced their risk exposure, and thus, the activity
levels have declined consequently.
Other stocks that Berkowitz sold in the last quarter:
Sears has long been suffering with weak top-line performances and even weaker bottom-line results.
However, management restructured the business and the measures undertaken to revive the operating performance are showing some signs of improvement as evident from the company's margin expansion and narrower loss per share from the prior-year quarter.
In its streak to optimize its financial performance, the company recently announced a string of measures to enhance its growth prospects by dipping investment in sections of the company that no longer contribute significantly to its growth. I think that SHLD is a very interesting turnaround pick.
Regarding Berkshire, I do not feel comfortable with the company's dependence on Warren Buffett. I am not sure how BRK.B will operate after Warren Buffett. Also, the conglomerate is highly exposed to macro scenarios that could affect BRK.B's different business units.