Buffett,Dreman and Financials

Posted by alexg

Wow, What a way for Mr. Buffett to end the year with a couple of hits. First, Buffett purchases conglomerate Marmon Holdings for $4.5 Billion. The size of the acquisition makes it a Buffett play all along. An easy way to find out who is doing the investments for Berkshire is looking at the size of the deals. Warren Buffett’s investments are usually in billions of dollars, whereas Lou Simpon and others make investments range in the millions (i.e. Carmax).

After acquiring Marmon Holdings, Buffett acquired a re-insurer from AIG financial and started his own bond insuring business. Apparently, the bond insurer will start doing business in New York and expand throughout the country.

On the other hand, David Dreman’s new article came out earlier in the week. Being a contrarian, he gave out a list of financials that should perform well in the coming years. Also, he does mention that the “worst might have been over.” Below is the list of banks being recommended. All have adequate size and attractive dividend yields.

Bank of America (BAC)
Wachovia (WB)
Citigroup (C)
KeyCorp (KEY)
JP Morgan (JPM)

Along with the above names, David Dreman gave another list in which the banks are more volatile but might provide better returns.

Washington Mutual (WM)
Freddie and Fannie (FRE) & (FNM)

Being a student of Dreman, its satisfying knowing he is looking in the same location as I am. Although,I do have different picks than the above list, its great knowing we are fishing in the same lake. Currently, financials represent the majority of the Garcia Value Fund with 31% invested in the financial sector. My financials include American Express (AXP), US Bancorp (USB) , Wells Fargo (WFC), American Insurance Group (AIG),E-Trade Financial (ETFC), Moody’s Corp (MCO) and Capital One Financial (COF).

American Express has been beaten down for subprime fears and fears that consumer spending is slowing. I found this interesting as American Express has a great business clientele and little if any exposure to subprime. It currently trades at about 13 times forward earning which is amazing considering the moat the company has. Patient investors buying in the low 50’s will be rewarded 3-5 years from now.

US Bancorp (USB) and Wells Fargo (WFC) are both conservative banks with great management and great histories. Both banks have little sub prime exposure but for some reason are beaten down. Both banks also trade at lower valuations than their historical averages and post consistent ROE around 20%, which is above the industry average of 15%.

American Insurance Group (AIG) is another business trading at a discount. The big insurer stated its subprime exposure is manageable and re-affirmed the company’s growth of 10-12% for the next 5 years. Yet, the stock is trading below $60 with forward P/E of 8! Analyst have AIG earning $6.20/share this year. Assuming management is able to maintain a conservative growth rate of 8% for the next 5 years we can do a quick back of the envelope valuation using simple math.

2008 : $6.70 EPS
2009 : $7.23
2010 : $7.81
2011 : $8.44
2012 : $9.10

using a P/E of 10 on 2012 earnings we arrive at a $91 stock. Demanding my standard 34% margin of safety, the stock is a buy below $60. The stock currently trades at about $58.
I also have Moody’s (MCO) and Capital One Financial (COF) on my financials list. Both businesses follow the same idea that in 3 years these businesses will be more valuable than what the street is valuing them today.
Now time to comment on E-trade Financial (ETFC)*sigh*. The worst performer in the Garcia Value Fund and also the riskiest stock in the portfolio. The main thesis behind E-Trade is that the company will get rid of its subprime mess and stick to its retail operations. So far so good. The company is trying to make progress by launching a customer “win back” campaign. The street is valuing the whole business at roughly $1.6 billion . I think the business is worth more. Obviously, this is going to be a wild ride as management turns things around but hopefully being patient will result in a great investment as it has been a drag on the Garcia Value Fund.
In an earlier post, I mentioned I was going to read Ben Graham’s The Intelligent Investor. Well, change of heart. I read it twice in 07′ and decided it would be more interesting reading something else. So I decided of digging into my David Dreman collection. Which book will I re-read ? Undecided.
Finally, I would like to wish everyone a happy and safe New Year. 2007 has been an incredible year for me as I met a personal goal. 2008 will be better. God bless.

-Alex Garcia

Disclaimer: I own shares of US Bancorp (USB)