While Berkshire Hathaway [BRKA] (BRK.A) may need to swim upstream in order to outperform by any significant margin, given its huge relative out-performance in the last eighteen months or so, the bear case seems more of a marketing strategy for a hedge fund manager than a well-reasoned investment strategy.

Since one of the highlights underpinning Mr. Kass's case seems to be the the supposed under-performance of four major holdings [Coca-Cola Co. (KO), Wells Fargo & Co. (WFC), Kraft Foods Inc. (KFT), and American Express Co. (AXP)], it would seem appropriate to dig a bit deeper into his claims about short and long-term performance, and their relative importance to the equity portfolio and look through earnings.

Despite some relief from the Central Bank and relaxed capital controls on the Government-Sponsored Enterprises [GSEs], the subprime induced housing recession has caused a significant supply/demand imbalance for GSE and non-GSE mortgage-backed paper, and has precipitated a global margin call of titanic proportions. The continued de-leveraging of a whole host of financial intermediaries, most notably, investment banks and hedge funds seems likely to continue for years, given efforts to introduce more stringent capital controls over investment banks in return for access to the discount window, and the concomitant reduction of lending to hedge fund and corporate clients alike.

The softening of the economy and pressure on credit spreads is being further exacerbated by a simultaneous, but not unrelated, collapse in the U.S. dollar. In the eye of the storm are the highly levered (albeit less than a few years back) GSEs known by the monikers Freddie Mac (FRE) and Fannie Mae (FNM), whose combined balance sheet is close to $2 trillion, in addition to guaranteeing another couple trillion or so Mortgage-Backed Securities [MBS]. The mortgage credit crisis is incinerating even what appeared to be reasonably levered players, with consequences that were vastly underestimated by even some of the smartest investors in mortgage-related assets. The fear levels are so high that the spreads on GSE backed MBS paper, though off the widest, are still close to 200-basis points, and exceed materially the expected default levels for the underlying mortgages.

Indymac stock (IMB), apparently left for dead at year's end, has risen from the ashes, dusting its peers in the sector (including buyout candidate Countrywide (CFC)) in the process. On January 31, there were 37.7 million shares still short (close to 50% of float, only 6 million off the highs of 43 million), and the exits (or entry) are getting crowded with short sellers covering, real buyers (doubling down), with speculators and traders going along for the ride. And what a ride it is likely to be.

After throwing in the kitchen sink in the fourth quarter earnings report, and reducing book value by almost 33% to about $16, INDYMAC appears to have put the worst behind it. Well, at least that is what the market thinks, with the stock nearly tripling off the lows (since mid-January to $11-plus) before pulling back to $8 a share last week. What's it worth? Well, by some estimates (including mine) $15 to $20 today (which is a modest premium to Q4 reported book value for a company with a decent chance of making a profit by Q2 in 2008). By the estimation of others, $4 or $5.

The denouement of First Marblehead's (FMD) stock saga effectively ended with the stunning collapse of the stock on Wednesday in a 200 point up-day for the DOW. The bear case is de-facto proven unequivocally and the the bull case left in shreds.

The bearish argument, initiated in December 2006, and repeated in a variety forums and venues throughout most of 2007 was a textbook case in contrarian investing. The fact that the most consistent bulls supplying the opposing "long" views draped their claims for even higher prices with academic type rhetorical flourishes, and scholarly detailed analysis of the securitization process, residuals, and AA tranches, made the exercise that much more comical, were it not for the fact that serious money was lost by what are now incredulous investors. In a market of high single digit return expectations, avoidance of a 60% loss in one stock can make or break performance.

On November 5th we singled out mono-line insurers ABK ($30.42) and MBIA ($39.81) as two of the financial stocks most likely to have bottomed and on the verge of being beneficiaries of a massive short covering rally in the financial sector.

Though we have come a long way in price in many names from the lows, the rally will probably still carry further and there are ways to profit even from here, at, albeit, reduced risk through short hedges.

While the consensus continues to believe the credit cycle has a long ways to go on the downside, bank stock prices (prior to Tuesday's rally) were starting to reflect distressed scenarios not quite warranted given broader economic news outside of the mortgage sector. We suggested buying this group on the capitulation in the financial sector over the last week or so, and we suspect this sector rally will carry further and higher than many believe. JP Morgan Chase (JPM) ($44.50) which avoided much of the trouble by limiting mortgage and consumer credit growth during the recent bubble years, and with Jamie Dimon at the helm, will no doubt be rummaging through the trash, fixing up or buying distressed assets.

This is what he has done in the past at BancOne and in his prior life as the mastermind behind Citigroup's (C) ($35.00) meteoric rise in the Nineties under Sandy Weill, before being unceremoniously (and unfortunately for Citigroup shareholders), dismissed. He can reignite growth both internally and externally now that its competition is so severely weakened. With his photographic memory, the rigor of an actuary assessing morbidity, and the single-minded determination to maximize ROE for a given level of risk and leverage in every line of business, he seems likely to attempt a first strike as this credit cycle reaches its terminal phase in 2008. That now seems especially true, given JPM's stock's relative strength as a currency for acquisitions vis-a-vis its competition.

The selling climax, and apparent capitulation of the financial sector, which, like night follows day, will be accompanied by a massive counter-rally fueled by short covering, is a when, and not an if, event. Like-minded analysts will no doubt be in agreement with this characterization of the next phase that is most likely to occur, even though several issues seem likely to be in dispute:

What is the quality, magnitude, and duration of what may be a bear market rally in the sector?

Another stock, Indymac Bancorp (IMB), has substantial upside, once the short covering steamroller gathers speed. With a lower opening likely today, you could get it a buck or so cheaper than yesterday's close. One dividend cut is priced in, and even if they lost money in Q4 and cut the whole dividend, the stock will be much higher in 2008, perhaps even by late November or early December.

The rolling capitulation sector wide among financials is probably 80% done, and perhaps even more so among the mid and small caps. The near term upside is awesome, as seen in the bond insurers since the lows Monday. SEC filings for Q3 are due next week, but barring a nuclear bombshell in the form of bankruptcy for some big name, most of the bad news (even perhaps more) is priced in. The next big move is up (through Q4 earnings). IMB will survive in a diminshed capacity, as will Monday's favorite short squeeze favorites (ABK) and (MBI), ratings downgrades (or capital additions) and all. Stay tune for best ideas.

The market sure seems to think so. But like bedfellows (or shall we say other fellows like (ABK), and (MBI) that fell out of bed), just the fact that they are conducting a conference call suggests no funny stuff will be filed next week in the 10Q.

As such, with the stock (and overall market) likely to open much lower, and short covering to begin later in the day (pre conference call tomorrow), we think you are getting good odds on your money, should the stock trade circa $2.25 to $2.40 this morning. A daily chart over the last several months suggests the steep decline has been on relatively low volume since the mid teens. And while many will wish to get out of the CDO/ABS/sub-prime mess, there are distressed buyers waiting in the wings. Since absolutely no-one can put a real number on this unknown value, its back to behavioral psychology for financials. There has been a total capitulation here, and the move up could be massive.

Two reasons to buy Sallie Mae ((SLM) $42.86):

First, the odds on your money are pretty good here in the low forties $42.86; Stop loss at 40.50, and upside as much as 15% to 20% through next July. You may get it a dollar or two cheaper, but don’t wait since the short covering rally in financials has begun in earnest, and all boats will be lifted once Citigroup ((C): $35.00) makes a definitive bottom this week (see my post on short covering in financials from Tuesday).

With the financial sector now in the “selling climax” phase, the pain trade seems likely to reverse itself with a vengeance in short order, with a short covering rally of significant proportions likely to unfold within the week, if not the next twenty-four hours.

As such, short financial positions should be closed, and, for those with a short time horizon, long trades in what have been “suspect” names, such as ABK $23.00, MBI $33; CFC $14.5, MTG $18, WM $23.0, ACF, $13, COF $59.0 should be put to work with what we see as potential 15% to 25% upside in a matter of weeks.

The schizophrenic market participants (as opposed to the market) have shown moods that swing from total despondency to semi-euphoria over the last several months, especially in the financial sector. For us, it indicates what we have long believed: few investors have any real convictions about how to value financials and therefore react to the news (or noise) in a herd fashion.

While we firmly believe it is possible (and absolutely necessary) to trade when given the opportunity, one shouldn’t confuse that with investing based on traditional principals.

Much ink has been spilled in the last few weeks by pundits suggesting the Broker-Dealers provide unusual value. Maybe. But maybe not. Few times in the last year were many skeptics willing to go out on a limb to suggest these stocks were expensive at 2 to 2.5 x book value or more. Yet the shorting opportunity presented itself with lightning speed, and any value investor worth his salt knew the ROEs were not only unsustainable, but also hard to imagine achievable without unusual and substantial risks.

What can be imputed from the current valuation? Under normal circumstances, one would say that for a stock like Bear Stearns (BSC) at BV, the market is assuming that the company can barely earn its cost of capital for the next few years; for the years beyond that, it's easier to guess that the answer is a solid NO.

Why the selloff in First Marblehead (FMD)?

Perhaps the stock is still expensive. It is certainly closer to our price target (circa $20) set late 2006 and no longer carries the moniker (provided by us) of the most expensive stock in the financial sector.

The second punitive phase in the financial sector is unfolding here, with too many Johnny-Come-Latelies trying to put on last minute shorts on banks and insurers they don't know how to value. It's likely to lead to unpleasant surprises for many piling on at the last moment.

There were two significant opportunities to short: (1) earlier in the year, when the red light was flashing on credit and leverage, and the broker dealers like GS and LEH were discounting 25% to 30% ROEs as far as the eye could see and spreads were as tight as ever; and (2) a week or so ago, after vicious rally pushed up the group toward the first layer of resistance that may hold for months to come.

The relative weakness of the financial sector portends a difficult road for the rest of the market in the second half of 2007, given the reduction in liquidity likely to ensue and the risk-aversion that is mounting.

In the meantime, the financial sector with the worse fundamentals is the property/casualty insurance group, courtesy of a low loss inflationary period (huh). It's the cat with nine lives, enjoying a profit streak long in the tooth, especially considering the notorious cyclicality of the business. In some ways, it mirrors the sub-prime/mortgage world in the sense that underwriting bad policies are somebody else's problem... a few years down the line.

As long as it didn't come as a complete surprise, investors ought to step back, and let the leveraged longs wreak some havoc with each others' portfolios as they crowd the exits. In a single-digit return world for stocks (and bonds), it will take some time to unwind the same positions that accounted for a good part of the extraordinary returns of the broker dealers, private equity honchos, and the rest of the masters of the universe on their way to ungodly prosperity and riches.

Forget about the "noise" coming about "derivative losses" as a result of the mark to market of positions that theoretically are hedging business risks. These allow the company to report rather stable "spread" margins on its on balance sheet mortgage spread business. That, and the guarantee of mortgages, is the essence of the business model, for which they have operated the same way for twenty years. The difference between the late nineties and the early part of this decade (besides the reasonable (and merited for the most part) contraction in valuation is the Freddie has to provide values for derivatives for which there is no secondary market (and hence no real way to assess value). Margins have shrunk in the business, and Freddie's business model is now a mid to high teens ROE business (operating), and not a mid twenties ROE business. That, in part is due to the forced retention of capital and reduced leverage (hence lower Return on Equity).

But there is a greatly increased chance that as a result of the rise in rates and reduced refinancings, the annuity stream of revenues is improving in security and stability, hence enhancing the long-term value of the underlying credit and equity. At a discount to the price/book of the peer financial group, and a more dependable revenue stream than banks, broker-dealers which would you rather own (or short)? At Freddie there were perhaps a few rogue traders (profitable) and some bad controls. For that they have to appear at senate hearings. At Goldman, they are called superstars and go to head the Treasury department.

It's clear that the relative value versus the S&P financial sector is now somewhat enhanced by virtue of its own dismal performance. (Hence I believe his tactical call.) It's a twisted way of seeing opportunities through the lens of hedge fund investors, who, for the most part, are happy to pick at an idea if it provides some relative performance through to the March quarter. And, as investment opportunities go, its as likely as any financial for a short-term rebound; bonds are a bit oversold; banks have given up substantial ground since late December, and the yield is now above 2% and competes with the S&P yield.

What struck me was the analyst's conviction that the real story was the growth in "private loans" (30% potential and worth $30 of the $53 a share!!!!). In my humble opinion, giving credit to a stock trading at this unusually high premium/book on the basis of "growth" in private loans is tantamount to "credit suicide". Forget HR5, forget MonteCarlo (simulation) unless you are going there for blackjack, and forget Modelware for now. Even his base-case scenario for 2010 of 29% ROE would deserve a price/book of closer to 2.5 to 3x (depending on yield curve shifts) and ROE assumptions beyond 2010.