Agora Financial’s Rude Awakening

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Laguna Beach, California

• Financials vs. refiners – are we close to a bottom in either?
• What the price of oil spells for refiners…one dollar at a time,
• What the insiders are buying and plenty more below…

Eric Fry, reporting from Laguna Beach, California…

One year from today, would you be better off for having purchased refining stocks or financial stocks? Both types of stocks are cheaper now than they were six months ago. Both types of stocks might get cheaper still. But why bother with the richly valued shares of a hyper-leveraged, cash-flow-challenged finance company when you could purchase the lowly valued shares of a cash-flow-positive quasi-monopoly?

We examine this question in today’s column…

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Calling the Bottom
By Eric J. Fry

Forget baseball, the new American pastime is a little game known as, “Calling the Bottom.” Ever since the credit crisis splashed onto the front pages of the nation’s newspapers, swarms of overly eager investors have tried to call the bottom of the crisis, while also trying to call the bottom of the housing collapse and the finance sector selloff. No one has won the game yet.

In fact, every participant who has dared to call the bottom has had his bottom handed back to him by Mr. Market. Since hitting record highs last October, the major U.S. stock averages have all slumped by about 20%. The indices that track financial stocks have tumbled at least twice as much. In six of the last eight months, the Amex Securities Broker/Dealer Index (XBD) has fallen. But throughout this miserable eight month slide, wave after wave of investors have tried to call the bottom.

Some of the earliest bottom-callers were deep-pocketed institutional folks and Sovereign Wealth Funds. These misguided investors provided billions of dollars of financing to beleaguered financial institutions…

Remember when Bank of America spent $2 billion last August to buy part of Countrywide Financial, or when the Abu Dhabi Investment Authority spent $7.5 billion last November to prop up Citigroup, or when Warburg Pincus spent $1 billion last December to breathe new life into MBIA, or when TPG provided a $7 billion bailout last April for Washington Mutual?

Each of these “sweetheart deals” has turned very, very sour. And yet, the bottom-callers keep trying to call the bottom, while continuing to toss their billions into a bottomless abyss. Bill Miller, the legendary manager of the Legg Mason Value Trust, tossed billions of dollars into the finance-sector abyss during the first three months of the year, causing his long-suffering shareholders to suffer a bit longer.

While Bill was busy loading up on the fallen angels of the finance sector, his mutual fund delivered absolutely hellish returns. Maybe Miller suffers from an excess of confidence and conviction. In the first quarter, Miller added to only eleven of his top 35 holdings. Eight of the eleven were finance companies like Freddie Mac, AIG, Wachovia and Countrywide Financial (now part of Bank of America). No wonder that Miller’s famous fund has tumbled 28% year-to-date and 36% since last October.

Eventually, of course, one lucky bottom-caller will actually call the bottom – not because he is brilliant, but just because he is lucky. Perhaps that lucky bottom-caller was the guy or gal who called the bottom yesterday afternoon at 12:43 Eastern Time. That’s when the Dow Jones Industrial Average kissed the lows of the day – and of the last two years – at 11,183.92, before reversing course and charging 200 points higher.

By late in the trading session a procession of bottom-callers appeared on CNBC to cheer the stock market’s sparkling intraday recovery as proof that “the bottom is in,” especially for the beaten-down financial sector.

Perhaps the bottom-callers are right this time. Your editors here at the Rude Awakening are agnostic. The stock market certainly deserves a bounce. But we would not be tempted to place a big bet on an enduring bounce.

Instead, we would turn our attention to the oil-refining sector and ask a question: If the bottom is in, why not buy refining stocks instead of financial stocks? In other words, why not invest in cheap companies that gush cash, rather than expensive companies that consume cash?

Let’s take a peek at a couple of eyebrow-raising comparisons. The S&P Refining Index trades for about six times this year’s earnings. The XBD Index trades for infinity times earnings, thanks to the finance sector’s multibillion dollar loses.

Looking ahead, however, the gimlet-eyed analysts of Wall Street expect earnings in the refining sector to retreat, while earnings in the finance sector recover. Based on analyst estimates, therefore, the refining sector trades for nine times next year’s earnings, while the finance sector trades for 28 times next year’s earnings.

Nine times real earnings seems like a much better value than 28 times the fantasy earnings that the finance sector spits out. Which brings us to eyebrow-raising data-point number two: Since the stock market peaked last October, the shares of refining companies have tumbled even more than the shares of finance companies. The S&P Refining Index is down a whopping 47% since last October, compared to a 40% drop for the XBD Index.

Perhaps both indices deserve such scorn, but the refining sector would seem to deserve it less than the financials. Even with today’s thin refining margins, the refining sector continues to produce robust cash flow. The finance sector produces robust losses. However, the eager sellers of refining stocks would be quick to point out that refining margins have been contracting as the price of oil has been climbing. They would also point out that falling demand for gasoline could cause refining margins to narrow even more. Both of these fears have merit.

But these fears obscure two important positives. First, the “bad” refining margins of today are still pretty darn good for many refineries. Second, oil prices might actually fall one day, thereby boosting margins. A little bit of margin expansion goes a long way in the refining sector, as the nearby chart
illustrates.

Nevertheless, despite the awesome earnings power of the refining sector, and the fact that refining margins are sitting smack in the middle of their two-year average (and well above their five-year average), oil-refining stocks are getting the boot from many portfolios.

But here’s where our story takes an interesting turn…Refinery company insiders are BUYING. “Refinery executives are buying more of their own stock than at any time since 2000,” Bloomberg News reports. “Executives at 10 refining companies snapped up $2 million of their shares last month, twice what they sold, according to data from the Washington Service.”

Refining company insiders are not the only conspicuous buyers of refining stocks. Some of the world’s most successful hedge funds have also been loading up recently. “Caxton Associates LLC, Citadel Investment Group LLC and Renaissance Technologies Corp., which oversee $64 billion in hedge-fund assets, also boosted bets that the shares will rebound,” according to Bloomberg.

Refinery stocks are not a “buy” just because company insiders and leading hedge fund managers are loading up on them. But they are probably less of a “sell.”

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[Rude Endnote: After dropping to a two-year low yesterday, the Dow recovered somewhat to post a 32-point gain. It begins today’s trading on 11,382.26. The S&P and Nasdaq moved in similar fashion to end the day up 0.38% and 0.52% respectively.

Gold cooled off after rocketing back into the mid $900s during the week. The yellow metal trades around $936 while oil remains above the $140 mark at a stubborn $141.30.

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com