Fund Manager: Access to Credit Is Key to Recovery

Thursday, 24 Jun 2010 03:19 PM

 

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It's an old idea with a new twist: Banking is about the return on your money, and the return of your money.

Dave Ellison, chief investment officer of The FBR Equity Funds, remembers hearing it early in his career. "It's probably one of the things that's most important to remember," he says, "and now we're all working on the 'of' part and it's not working out so well."

Ellison, who has specialized in financial stocks since 1985, is the portfolio manager of FBR Small Cap Financial Fund (FBRSX) and FBR Large Cap Financial Fund (FBRFX). He says banks are still paying the price for lowering their lending standards during the housing boom.

He shared his thoughts on financial services companies in a recent interview with The Associated Press.

Q: We're seeing a mix of positive and negative signs regarding the economic recovery. Where's your head at in terms of the big picture?

A: My head is drooped. If you look at the big picture you can find many good things and many bad things. Of course now it seems like there are more bad than there are good, because the economy has seemed like it was going up at a good rate, now it's slowed.

Housing sales boomed, and then they leveled off. Car sales boomed, and then they leveled off. Unemployment hasn't gotten better. So the improvement has slowed to a point where it's almost unnoticeable now.

I think underneath it all if you look at the companies, talk to the companies, there's a tremendous amount of work being done. They're grinding through foreclosures, reorganizing or resetting the loan policies.

The crisis hit, and so I tend to say, "let's get into the mud." Let's see what's going on, and let's buy the companies that are working through the issues with the appropriate speed and the appropriate safety and soundness. And if the economy does stay the same, these companies will get a little better because they're working through their troubles. If the economy gets worse they're probably in better shape because they've started to heal.

Q: What should an average investor do?

A: There are times you need to listen to what people are saying and times you need to watch what people are doing. And this is a time you have to watch what people are doing — because if you listen, it's not a happy time.

My advice would be to find a manager who is experienced, who has a track record, and stay with that. I wouldn't try to buy one financial stock or two financial stocks. You need to take the group hug approach. Because there are many things that are wrong — many types of loans that are bad, many things that regulators are trying to do. But this also means there are many ways to make money in this recovery.

Q: You manage both a small-cap and a large-cap financial fund. What are the key distinctions between them?

A: The small cap fund is more complicated because there are different types of companies. The larger financial companies have been aided more thoroughly and more significantly by the government, and that has helped them to be ahead of the little guys.

They also have a lot of non-loan related income, such as investment banking, sales and trading. You know JP Morgan may make half of its money on lending money, while the little guys make 100 percent of their money on lending money. So the larger banks are able to use the other 50 percent to mark those loans down sooner and get back to normalcy. Which is why you see the bigger companies have higher valuations. You look at Wells Fargo, JP Morgan, they're all trading well above book value. And you don't see that with the smaller guys because they haven't had the time to recover yet.

Q: How do you categorize the companies in the small-cap fund?

A: I look at the smaller groups as sort of four buckets, and they aren't necessarily mutually exclusive. You have those that are well run, that haven't had a lot of troubles and are now feeding on the FDIC's yard sale. They're buying their troubled neighbors for very little.

The second bucket would be those who have had credit issues that are significant that they're working through. And the valuations are such that if you can see your way clear to the end of the ditch, the stock has a lot of upside because earnings have a lot of upside.

The third group would be the second group in worse shape. Now you're taking more risk on regulatory changes, so they're more risky but then the upside becomes very large.

And then the fourth group would be those that are tangentially related, the homebuilders, the real estate investment trusts, the property insurers, the commercial real estate brokers — that kind of stuff.

Q: With so many small banks failing in the last few years, what lessons did you learn?

A: The overriding lesson is that there are four things that drive the industry. It's credit, interest rates, regulatory changes and accounting changes. And they drive profitability, drive sustainability, drive the risk level, etc.

But the thing that really creates a loss of wealth on a permanent basis, or allows you to recover wealth, is credit, the cycle of credit. It's not rates, it's not the other three.

Putting it simply, when credit starts to go bad, get out. When credit starts to improve, get back in.

Q: So interest rates aren't the most essential element?

A: Everyone always worries about rates, but that's been the one thing that's good. At the moment, I think rates are too low. I think the biggest mistake was driving the rates too low.

To keep the math simple, if you've got a million dollars in the bank and you're earning 1 percent, that's $10,000. If rates are 3 percent then you're making $30,000, plus social security and maybe some other money — so it's possible to earn a living. But with such low rates it's as if I'm earning nothing. So it's forcing people either to save more or spend less. At the same time the government is encouraging us to spend, saying they want us to go out and buy a car.

But people say "I can't" because they don't want to eat into principal. Because if I eat into principal and end up with no money in 10 years, "Are you going to come and bail me out?" I don't think so.

And everybody can't live in a trailer park 100 miles south of Orlando. There's just not enough land for that.

© Copyright 2014 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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