Credit Cards and Exchanges: The Only Safe Ways to Play the Financials

NAVIGATING THE CREDIT CRISIS

The current credit crisis and liquidity crunch has made even the professional investors balk on calling a bottom. One stomach churning event after another has proven the most optimistic analysts to not only be wrong, but little more than contrarian indicators.

Asset revaluations and write downs are placing tremendous strain on determining book value and earnings projections for financial companies, making it extremely difficult to determine proper multiples and P.E.G. ratios. What looks cheap may actually be the classic value trap. I’m quite sure very smart people dollar cost averaged all the way down on the, not-so-distant, Bear Stearns debacle.

The lack of transparency for the investment brokers and banks really makes it guesswork based on historical valuations. No question, once the current credit crisis dissipates and the economy moves ahead, financials will be the vanguards that lead the market forward. But even the strongest engine of our economy is still anchored to all the train cars in between and even the caboose at the back of the line. You feel like getting “all aboard?” I know I don’t.

The risk of new regulation also means that earnings drivers for the last several years at the peak of a housing bubble are all but gone, and certainly bundling mortgage paper as liquid assets is a broken business model. Structured investment vehicles such as CDO’s, CMO’s, tranches, and Level 3 assets have now become part of the vernacular pulled from the nascent shadows of Wall Street.

We may think we know the story because of the news coverage that has brought the issues to the light of day, but this story is far from over and risk is very relevant even at bargain basement prices for financial stocks. In a sense, it reminds me of a perverse game of chicken in a dangerous head on collision between institutions like Freddie Mac (FRE) or Fannie Mae (FNM) looking for a bailout and the career politicians trying to save their jobs come reelection. Who will flinch first? Either way, something has to be done and soon to restore the confidence and transparency in asset valuations.

Is there reason to be optimistic? Of course, whether or not we’ve hit the true bottom in the financials recently or anytime soon, at some point there will be an absolute entry point and nothing but upside. The dilemma is when and what companies will survive the impact and splash damage that ruptures, once seemingly, rock solid financial companies.

In this respect, you have to be disciplined to stay away from stocks that look cheap by dollar amount per share and focus on investing in companies that are well capitalized and sufficiently less exposed to collapsing real estate values. If your risk tolerance is high and you are well versed in trading the pops and drops, you can potentially make money in the volatility of this market, but for the retail trader this is only inviting serious damage to your portfolio equity.

Of course, logically, it makes sense that the underlying assets behind all this leveraged paper can’t possibly be worth zero at the end of the day, but logic has little to do with a forced liquidation crisis where financial institutions are desperate to raise cash on their books. It doesn’t matter what an account ledger says an asset is worth as much as what someone is both willing and capable of paying for it, and that is further compounded by the stricter lending standards that have created a vacuum of buyers on the open markets.

But I am afraid that a similar issue is occurring in the residential and commercial real estate market. People continue to make false assumptions on what their homes are worth based upon the appraisal values their mortgages were originally underwritten. Basic supply and demand economic principles will be the overriding factor that ultimately determines what the current market value of any asset is, and in the case of leveraged assets like homes and real estate, it matters less what a person is willing to pay as much as it matters what amount a bank will lend a borrower.

Look no further than the recent auction rate securities market that almost collapsed from a lack of buyers. These were debt instruments that were sold and packaged as “cash equivalents” to high net worth investors. If not for the pressure by New York State’s Attorney General Andrew Cuomo, who forced settlement by culpable brokerage houses, I doubt investors would have been reimbursed.

But don’t expect the same treatment for average Americans that face foreclosure risk or the inability to liquidate properties–their primary assets, savings and retirement–in a stagnant and frozen real estate market. I doubt there will be any knights in shining armor that will come to the rescue and force settlement, so that the original underwriter or lending institution would be required to buy back the mortgage on a house just because there is no available demand, or that the current market value of the home has fallen well below what the original appraisal price was.

VISA AND MASTERCARD

Visa (V) and Mastercard (MA) are two of the best ways to play the financials while navigating the current credit collapse. While Mastercard is cheaper on a valuation basis, I prefer Visa because it is has a larger share dilution based on the total amount of outstanding shares, but this may not be such a bad thing because it knocks some of the volatility out of the stock. Mastercard is less diluted in comparison, but a retail trader may have more risk exposure simply due to volatility and, especially, if he or she was unnecessarily exposed by trading on excessive margin.

Visa is the larger company, both by revenue and market share. Normally, such a situation would tend to lean people in favor of the smaller company because of the potential to grow market share. However, in this particular case, I think the logic is misleading due to the fact that we have not seen the rest of the world and, especially emerging markets, adapt to credit card payments as their primary means of conducting transactions.

I do feel, and this is debatable, that Visa has a stronger global presence where the real outlying earnings revenues will come from in the future. But either way, both Visa and Mastercard are set on parallel trajectories and courses that you really couldn’t do wrong with either position in your holdings.

Visa recently reported 3rd quarter earnings of GAAP net income of $422 million, adjusted earnings of $457 million. Total payment volume, year over year, grew by 19% to $652 billion. And net operating revenue was $1.6 billion. Visa also raised guidance for adjusted operating margins. By contrast, Mastercard reported net income of $276 million and a quarterly net revenue of $1.2 billion. However, due to an after-tax charge off related to an antitrust litigation settlement with American Express (AXP), it reported a quarterly net loss of $747 million.

Both companies don’t rely on direct credit exposure and present themselves very well as payment processors, like toll booth operators collecting fees regardless of the direction and flow of traffic. Even as the economy continues to slow down, credit and debit cards are continuing to replace cash as the primary means of conducting business and commerce.

Visa benefited in its record breaking 18 billion dollar IPO debut based on the incredible run forged by Mastercard and, as such, really came to market at fair value, perhaps some would argue, fully valued. I don’t see Visa as being undervalued which might seem to be contraindicative of future returns; however, due to the calamity in the financial sector as a whole, it forces institutional investors to look toward less credit exposed assets. Visa and Mastercard both fulfill that requirement and will, undoubtedly, continue to expand their businesses throughout the world as emerging economies transition from cash to credit and debit transactions.

I think if you decide to invest in Visa or Mastercard, you should recognize that the real major upward acceleration has already occurred in Mastercard, after rising over a jaw dropping 700% from its initial IPO price at its 52 week high and settling back down to a measly 500+% return at current market value. Again, because Visa debuted at fair value relative to Mastercard, it might seem a little late to the game. But I do believe that they are steady players and that the growth model for both credit card companies is still intact. I think if you are patient and try not to game the moves in the short term, you will be amply rewarded down the road.

Perhaps, even more importantly, is that both credit card companies allow you to participate in the financial rallies without taking on the extraordinary risk of less transparent institutions in the investment banking sector. And in a volatile market such as we are witnessing, stability, peace of mind and preservation of capital should trump any ambitious projections and returns.

I think you can actually own both credit card companies in a ratio of 3:1, that is 3 shares of Visa for every 1 share of Mastercard. You don’t necessarily have to pick one over the other. The world is certainly big enough for both Visa and Mastercard to expand their revenue models without having to choose favorites.

There is a risk that needs to be discussed, and that is the lopsided view that many analysts have come on board validating Visa and Mastercard as having no credit risk. I think that such a statement may be true, for the most part, in that neither card company carries debt on its books by lending lines of credit; however, any further and continued deterioration in the economy is bound to have a net effect on total volume of transactions. So, it would foolish to blindly subscribe to Visa and Mastercard as no risk guarantees. Even the best stocks in a down market have difficulty defying the overall trend.

While I believe the risk is low, there is always the possibility that a continued slowdown in the economy will have a reduction in total transaction volumes. And some of the warning signs are evident through banks reducing lines of credit. The continued strength, I would argue, will be debit cards even if the credit contraction continues. However, a lot of banks are beginning to reduce or close out entirely H.E.L.O.C. (Home Equity Lines Of Credit) loans despite borrowers already being approved. Many home owners have been issued credit cards tied to their H.E.L.O.C.’s and are realizing a rude awakening as funds are harder to tap into.

The other card worth mentioning is American Express; however, it holds significant credit exposure and should not be viewed in the same comparison with V or MA. There is continued risk to its earnings growth as consumers find themselves strapped for cash and lines of credit are reduced. What makes AXP interesting is that it is trading at very attractive levels historically, but once again, the valuation may be misleading due to continued pressures in credit availability.

I wouldn’t recommend AXP in the same boat as V and MA, but if you are of the mindset to buy and hold for a long-term investment, AXP is probably worth entering anywhere under $40 per share. It’s almost too cheap to ignore and, quite honestly, very unlikely to rupture as other financial institutions remain at risk.

THE EXCHANGES ARE THE FORGOTTEN PAYMENT PROCESSORS

The once loved momentum trade in the exchanges that caused shares to rise dramatically on acquisition and consolidation rumors within the industry seems no longer willing to support lofty multiples as before. Now, the exchanges seem to be one of the most hated and lost, if not forgotten, sectors on all of Wall Street.

Similar in story to Visa and Mastercard, the exchanges don’t have the risk of direct credit exposure like traditional financial institutions and, certainly, are no different in being payment processors regardless of which direction the market takes. In fact, it’s almost odd but, somewhat understandable, how the exchanges seem to trade as surrogates for the entire market as a whole. In truth, the exchanges make money based on total volume of transactions and, even in a major sell off, they continue to rake in revenues.

At these levels, the New York Stock Exchange (NYX), Nasdaq (NDAQ), Chicago Mercantile Exchange (CME) and Intercontinental Commodities Exchange (ICE) offer very compelling entry points.

NYX has to be one of the most abused stocks I’ve ever seen or, as they call it, a “widow-maker.” But NYX is trading at extremely reasonable valuations and continues to increase earnings while realizing full integration of the Euronext merger. Clearly, the acquisition has been accretive as part of the Euronext merger included the LIFFE, or London International Financial Futures Exchange, which continues to be one of the most prominent international futures and derivatives markets. Continued growth was demonstrated by recent earnings of $195 million net profit, or 73 cents per share. Total revenue was $1.15 billion. I believe, down the road, further industry consolidation and a truly 24 hour global trading platform will change things dramatically.

By comparison, NDAQ reported $101.8 million in net profit, or 43 cents per share. Total revenue was $821 million. NDAQ was recently trading below $25 per share, which put it at a ridiculous p/e ratio of about 6x earnings. Now that it has risen since then, you still have a very undervalued stock and compelling entry point.

The CME is clearly the most dominant futures exchange in the world and a global powerhouse that seems unstoppable. But fears of regulation amid an election year and volatile commodity and oil prices seemed to have tamed the beast from returning to record levels it once enjoyed. The recent completion of acquiring the New York Mercantile Exchange (NMX) was well below what it debuted at as an IPO, and probably will turn out to be an incredible bargain down the road for the CME. The NMX sweet crude contract is still the primary barometer for oil futures markets and their vast array of commodity contracts offers product diversity for the CME.

Despite all the positive arguments for the CME going forward, I think it is at a higher risk for regulation by being a primary futures exchange, and especially if there is potential merging and consolidation of the SEC and CFTC. However, I believe that if anyone could benefit from potential regulation it would be the security exchanges such as the NYX and NDAQ. I say this because, if we are to see any potential regulation, it would most likely be targeted at reducing the volatility in the markets by creating transparency in large institutional block order flow through off exchange services known as “dark liquidity pools.”

While very few seem to discuss the reasons for historically unprecedented volatility in the stock market, I think at some point or another the issue will have to be raised and openly debated. The volatility is, undoubtedly, caused by the evolution of electronic markets and high volume, algorithmic trading platforms that account for nearly 55% to 2/3 of all transactions and allow institutional players to press the market in any direction they desire.

This is not to suggest that the glory days of the floor brokers is ever coming back; no, they remain as obsolete as the dinosaurs. But it would make sense to require all order flow and transactions to be routed through one or more of the major exchanges as opposed to crossing networks, so that there would always be absolute transparency and less of an opportunity for manipulation.

The argument for dark liquidity pools is that institutional traders and hedge funds can keep their positions close to the vest and not allow day-traders, retail traders and momentum players the opportunity to engage in scalping and “front-running,” or jumping in front of the order flow based on visible large block orders. Now, large block institutional orders are dissected into smaller, less perceptible, 100 lot orders and saturated through the system with algorithmic programming strategies such as Volume Weighted Average Pricing (V.W.A.P.).

It is clearly an advantage for large block institutional traders and the argument on their behalf is legitimate but, somehow, seems in complete conflict with the idea of “free markets” and fair play. In my opinion, no matter how big the order is, institutional traders should not enjoy either the advantage or ability to jump the line ahead of the crowd. Current market value literally means the price meeting point of what the buyer is willing to bid, and what the seller is willing to offer; it should never mean what one party arbitrarily decides by pushing volume in one direction or another.

ALL OPTIONS ARE ON THE TABLE

The NDAQ also completed its acquisition of the Philadelphia Stock Exchange which boosts its options market share above 15%. The NYX, not willing to stand by idly, has recently moved to acquire the American Stock Exchange, increasing overall options market share upwards of 16%. I think the options model for growth in the derivatives market is impressive for both exchanges as a continuing demand by institutional and retail investors drives revenues.

The Chicago Board Options Exchange is still the market leader in total options volume with almost 35% market share, but as it completes its demutualization process it will be interesting to see if it actually goes public as an IPO, or are simply acquired before they leave the starting gate. I am quite sure both the NYX and NDAQ are eyeing the CBOE very carefully, and you certainly can’t count out the CME or other global exchanges waiting on the wings. The CBOE will remain an enviable prize to be acquired or a major competitor to contend with.

RECOMMENDATIONS

Both the NYX and NDAQ are simply too cheap, in my opinion, not to own both positions as part of your portfolio. Just recognize they are both neglected and hated, so it may be a while before they have their day in the sun.

The CME is a high beta, high flying stock and not for the meek or weary of heart. I think there is too much volatility and risk to buy CME during current market conditions, it simply doesn’t justify the risk to reward ratio for most retail investors. It’s an incredibly well run company with excellent management, but as much as I like it, I cannot recommend the stock even though it has tremendous upside potential. I think you truly have to sit on the sidelines with this one until you know if there will or will not be any major regulatory changes with regards to the CFTC and the entire futures industry.

ICE will probably be acquired at some point or another, but the NMX acquisition by CME showed what the going rate was and, at those levels, the valuation on ICE had to come down to more reasonable price levels. I don’t see that much upside with ICE under these current market conditions. Of course, if the economy shifts and things change, perhaps it may be caught in a bidding war by being the last available major energy and commodities exchange.

THE OTHER UNMENTIONABLE FINANCIALS

Having outlined a strategy to participate without taking on the risk of less transparent balance sheets, there are other financial institutions that look extraordinarily appealing at these price levels, but I’m reminded of the discipline in my own strategy and remain, guardedly, on the sidelines.

I believe if you were to look at Morgan Stanley (MS), Barclays (BCS), Citigroup (C), Bank of America (BAC) and the many other traditional strongholds of the financial sector over the long run, you will be ultimately rewarded by good, strong dividends and tremendous return on your money. But every time I find myself tempted to acquire some of these positions, I keep leaning back toward my original positions and remind myself to maintain composure and remain a spectator.

I have no doubt that some of the greatest gains will be made in the riskier financials in the future and as long as you can afford to buy and hold, a well diversified basket of financials could offer tremendous upside. I’ll continue to watch and, at some point, I will actually give into temptation by jumping into some of these positions. But not now, not yet, my friends.

If I miss the trade on some of these other financials, I’ll be comfortable with not chasing because I know that Visa and Mastercard will fully participate in any true market recovery and bull run. In addition, as long as we have a functional global economy and stocks to trade, the exchanges will continue to be the venue and, in this respect, both NYSE and Nasdaq remain as surrogates for the entire market.

CLOSING ARGUMENTS

As with all investments, assess your own risk tolerance before wading into the water. I am a strong advocate of applying some measure of hedging techniques, either through the use of options and derivatives, or by utilizing short sector basket ETF’s, such as the Proshares Ultrashort (SKF), (SDS), or (QID) to counterbalance and offset long positions in your portfolio. I do feel that as we close in on the last quarter of this year, one may feel compelled to participate in the markets, but you should not expect dramatic upside return in the short term.

The context of this article was focused on the best way of playing the financial sector exclusively and without, in my opinion, endangering your portfolio with unnecessary credit risk exposure. Please, don’t rush out and buy in fear of missing any upside move in the recommended stocks. These stocks could stay in tight trading ranges as long as the overall market remains unclear and risk adverse. So, there is plenty of time for you to watch patiently and decide where your entry point may be. To be clear, my recommendations are based on a long term investment strategy, at least 2 to 5 years out.

As always, I am a proponent of adding downside coverage on any long position. While it may be a strategy that is far too neutral for some with hungrier appetites for risk, and it is true that you give up some of the upside potential, I remain convinced that a disciplined strategy of risk mitigation helps you stay liquid and flexible in any volatile market.

Of course, for those that are more inclined toward short-term trading strategies, I would recommend different stocks entirely and sectors that could capture maximum volatility. And if you felt compelled to play any of these positions in the short run, then buying the underlying shares wouldn’t make as much sense as utilizing option strategies such as spreads, strangles, straddles, collars, or even naked equity puts to capitalize on capturing premium.

DISCLOSURE: Author holds positions in MA, V, AXP, NYX, NDAQ.

Comments

[iNVestorUnrest:]

very interesting strategy for playing the financial sector. I have been really taken to the cleaners on some stocks I've held for years in the banking sector. I continue to hold Citi and Bank of America because I don't think they will go to zero but I have really been disgusted with the losses and I'm kind a stuck holding the bag.

I like how you emphasize that investors are obviously tempted to jump in the market because "it looks cheap" and if they can't resist these were your recommendations on how to play the financial sector without unnecessary risk in case the market doesn't just snap back up like people hope

2008 Sep 03 10:53 AM

[Umm, yeah:]

I enjoyed the article. Thanks!

2008 Sep 03 10:53 AM

[wise invest...:]

I think this is a well written article that reads like a story and not as dry financial analysis. A lot of financial journalism seems to be just facts and statistics, but I appreciate that this author took the time to work out a very well thought out, very logical analysis.

I think that American Express has to be one of the best buys on the market if you are patient like the author suggests even though it's not his favorite pick.

2008 Sep 03 11:31 AM

[mrbill for V:]

C.S. Best Credit article i have seen on Seeking Alpha yet. let's hear from you more often.

2008 Sep 03 11:36 AM

[BerkeleyBob:]

I took a small nibble on NYX because I felt there was value at $71.75 (mid-May) but sold about a month later at $59.20 because share volume seems to continue in a long term decline. A lot of large transactions seem to happen after market close or "off books" by institutional investors

2008 Sep 03 12:54 PM

[WEBISKING:]

with all due respect the ONLY safe financials are WFC and AXP and USB because BUFFETT is "backstopping" all of them.If you average in you will outperform all others who play this sector.Personally Iam a consumer goods guy and ove PM KFt Ko MSFT Mo BRK etc

2008 Sep 03 04:24 PM

[mrbill for V:]

"Berkeley Bob": Don't give up on a stock so soon and remember not to ever invest more than you can afford to lose. "bmaclaverty" it would be hard to mimic Harvard exactly, remember they are only 12% in domestic stocks however with ETF'S and Sector Mutual Funds and Foreign Stocks you could come close, however a big part of their investment is in Hedge Funds and Private Equity.
Remember Equity Investing just like Real Estate has to be managed it is not like a painting you buy and hang on a wall, hope this helps.

2008 Sep 03 04:24 PM

[BrianZach:]

Why don't you just ignore the financial sector altogether. There are a lot easier plays out there instead of playing one of the most dangerous sectors.

2008 Sep 03 05:36 PM

[Jimmy Lathrop:]

This was an extremely well thought out article with the exception of two small points.

1. This market has no rational relation to fundamentals
and
2. Americans will surrender their guns and their right to abortions before dark pools of liquidity are outlawed.

Even though those two small points strike at the core of this well written article neutralizing its probative value, I enjoyed reading it.

I would like you to explain why a company like Revlon which is described as "the makeup of last resort" by millions of women with the crummiest fundamentals is entering a bullish phase. If you can answer that question, you can shove Warren Buffet aside and be the new Oracle of Omaha. Because that's what this site is about - seeking alpha, not seeking rationality. Because a bet against dark pools of liquidity is a bet looking to get stomped flat.

2008 Sep 03 09:13 PM

[kkin365:]

I thought exchanges are subject to trading-volume (and not credit) risks. The volatility on CME is extremely high.

2008 Sep 04 09:34 AM

[mrbill for V:]

bmaclaverty: You are totally wrong on financials, Look into "BK" and tell me when they will be wiped out? Remember there are many different types of financials.

2008 Sep 04 02:55 PM

[jester:]

Good article. Makes sense....

2008 Sep 04 10:21 PM

[V Winner:]

V Winners is now covering AXP/DFS/V/MA

2008 Sep 14 12:46 PM

[Brazil Inve...:]

A testimonial to Jon
I’ve been reading these posts and am a partner’s of Jon’s on a project we have been heading up for some time now.
This goes out to ‘Mr. Bill’ and all the other sniveling whiners that like to hide behind their computers while hurling insults. Jon is well known on Wall Street by a LOT of people and has been for some time.
Jon puts out more information than anyone I’ve ever met- and has helped a lot of people.

I see people saying that they are “nationally known” and are successful but I see no proof. So to those of you that want to attack an associate of mine- why not post your resume on the net, the name of one deal that you’ve done- or the name of anything you built? Why- BECAUSE THERE ARE NONE- that’s why.

I can personally attest to the fact that Jon is a man of action- and there are dozens more that will do the same. I suggest that you stick to the mission and if you want to have some kind of contest why not do one that counts and put out more and better information as that is why we come here- no to hear someone that is unwilling to come out of the closet and prove their own substance.

2008 Sep 14 10:55 PM

[Mexx:]

Good article. I like NDAQ and I'll patiently wait for another market panic attack to see if I can get the stock to dip below $30 so I can have a bit more of a safety cushion. Thnxs

2008 Sep 24 11:24 AM