We had a small position in E*Trade which we initiated last week, in part due to agreeing with some of the long-term conclusions put forth by Bill Miller at Legg Mason in his 3Q letter to shareholders (.pdf).
E*Trade was doing what many were doing in the mortgage business. Based on a credit score alone you could easily get a mortgage with no documentation, no appraisal (other than a supposed "drive by") and very low fees.
E*Trade has been in crisis mode before and one of our larger clients bought a huge position. His analysis suggested that the replacement value alone for their technology platform was close to the total market capitalization at the time.
The problem now is that it is impossible to know to what extent the value of E*Trade could be impaired by the risk in the banking business. When Enron collapsed, a day of research would show that the company actually had no real assets to use to support a stock price. In our view, E*Trade has clear value in their platform, their customers and capabilities. In fact, we don’t think there is any way E*Trade is going to disappear but there could well be a re-capitalization and/or merger with another player.
On the question of customer panic and business impact, we think there will be some. Trolling the online reactions, there are clearly many individual investors who will switch their accounts to other brokers like TD Ameritrade and possibly shift their banking to places like ING or even regular full service banks. This is true even though there really isn’t any risk for most account holders but many people get emotional about what they read in the newspaper. Unfortunately having "possible bankruptcy" all over the news and watching the stock plummet to $3 creates alarm and concern that will probably cause customer and asset shrinkage in the short term.
Research 2.0 acquired a substantial position in E*Trade stock on Tuesday. It’s probably not going to go up in a straight line and the immediate 40% rise will certainly lead to some near-term profit taking. However, it’s likely that we will continue to own some position in ETFC even after today. If the company can get through the crisis as an independent the stock could certainly be worth $10 to $15. If the problems are not surmountable the company will be absorbed but equity holders can’t be certain to profit from these levels due to the fact that additional capital infusions might be needed.
Disclosure: Long ETFC
~ Kris Tuttle for Research 2.0