FCStone Group: Time to Buy?

by: Zachary Scheidt

In fast moving markets, things can at times resemble an old west town where the protocol is to “shoot first, ask questions later.” When holding a position that immediately starts to drop with little rationale, it is often wise to liquidate a portion or even all of the position in the name of damage control. By the time the news is out and able to be analyzed, the position may have given up significantly more capital yielding losses that can be difficult or even impossible to overcome.

Conversely, I have even been known to initiate a position based on a stock movement while only knowing a portion of the story. I will not put a significant amount of capital at risk in such a scenario, but I may begin a small “starter position” on a breakout from an attractive pattern while digging into the fundamentals before bolstering the size.

At any rate, FCStone (FCSX) fell into this category earlier this month as the stock sold off sharply in connection with the financial turbulence brought on by the near collapse of Bear Stearns (NYSE:BSC). On March 14th, I had to go ahead and turn out my long position in the stock as it broke down sharply below what should have been a strong support level. As rumors circled and uncertainty prevailed, the following trading day saw the stock lose nearly half of its remaining value before rebounding slightly at the close.

All of the rumors pointed to the fact that commodity trading firms were in jeopardy due to counterparty risk - or the risk that those who held the opposite side of various trading contracts would not be able to meet obligations. While the financial system has been engineered to thwart such fears, an unprecedented run on the bank at Bear Stearns threatened to touch off similar situations at trading firms across the country.

During the panic, traders paid particular attention to MF Global (MF) which had already run into trouble this year with one of its counterparties. While the stock dropped two thirds of its value over the day, management struggled to assure investors that the company would remain solvent.

However, despite its argument that the company had no direct exposure to sub-prime mortgage backed securities [MBS], investors realized that a significant portion of the company’s business was in fixed income prime brokerage. This business line could cause huge disruptions if leveraged clients were unable to make margin calls, and, depending on the extent of the problem, this could drain the company of its available liquidity. Management assured us that their alternative funding solutions gave them access to $1.4 billion in committed undrawn credit facilities, but that did little to stem the selling.

Now that the dust has begun to clear and the shooting is mostly over (or at least a truce is in place), investors can begin to survey the damage and move towards the “ask questions later” stage.

It appears that FCSX may have had much less at risk than panicked sellers were afraid of. The company does not use third party repo lines to provide its liquidity which was a major concern for MF Global. Also, FCSX trades in the energy and agricultural commodities arenas which, although volatile, have not seen the disruptive disconnects found in fixed income markets. The balance sheet continues to be strong as the company holds excess capital to protect against counterparty risk with each of its clients. And finally, the volatility in the market continues to prove just how valuable the company’s consulting services are for producers and consumers of the contracts FCSX specializes in.

So, while I have liquidated my FCSX position in a strategic defensive move, I still have faith that the company is continuing to operate and grow in a healthy manner. Earnings for the second quarter (ending Feb 29th) will likely be reported in mid-April and should help to instill investor confidence. New contracts are likely to be signed with larger clients and the difficult stock market may even give management a chance to make some strategic acquisitions at attractive levels (similar to JP Morgan (NYSE:JPM) pillaging Bear Stearns' assets).

In short, I would consider putting some capital at risk in this name if it continues to trade in a healthy manner, although risk control should still be the foundation from which any investment program trades.

Disclosure: No position.