Over the past 10 years, Citi’s debt to capitalization ratio has often been more than double or triple Stifel’s. This served Citi fairly well while times were good and credit was easy to obtain. During 2007, Citi increased the dept to capital ratio while Stifel decreased their ratio. Citi’s stock declined while Stifel’s increased.

A high debt to capital ratio is just one sign of Citi’s precarious financial position just as a very low ratio was a sign of Stifel’s strength, but in times of tightening credit and assett deflation it seems to me that the ratio takes on more significance compared to other quantitative factors. I know this is probably a very “apples to oranges” and unfair comparison as the two companies differ greatly in size and scope, but I still think the comparison can serve as a lesson that financial strength is of paramount concern in times of crisis.

Alice stepping through the looking glass

At some point this year I feel that this country stepped through the looking glass.

In Alice’s case, outcomes preceded events, cakes were passed out before being cut, and destinations were reached by walking in the opposite direction. In the case of the U.S., companies apparently strong are in reality weak, Bear Stearns got tossed to the wolves (apparently no one forgot it had refused to play ball back during the LTCM crisis), we have the Fed handing out money in exchange for trash, investors and traders have suffered through arbitrary rule changes, investment banks have morphed into commercial banks, the world’s largest insurer looks close to failure, GM maybe doesn’t have enough money to make it past December, American Express will become a bank holding company, and so on.

To use another metaphor, perhaps America’s economy really is like a Tom Hanks romantic comedy… The Money Pit.

At the time this article was published, the markets were still feeling the effects of the tech bubble burst. The S&P 500 was down about 32% ytd and down about 49% from the last peak. I believe that some of Kahn’s picks from 2002 are back in the same position they once were. The same stocks might also be suitable for purchase for the same or similar reasons. So here are some select quotes from the ‘02 interview and my short comments.

Irving, for instance, is a nuclear-power proponent, arguing that it will continue to play a vital role in electricity generation around the world. This led the Kahns to an investment in USEC, the leading supplier of enriched uranium to the nuclear industry. The formerly government-owned USEC now trades under 7, below its book value of more than $11 a share.

USEC (USU) eventually rose to the lower 20s by mid 2007. Right now, USEC trades at 4.05, which is far below its current book value of approximately $12 a share. Its trading at a deeper discount that it was over six years ago.

Irving also likes Seaboard, a thinly traded conglomerate run by the secretive Bresky family that trades at about 220 a share, a little more than half its book value of $363 a share. Seaboard has a large hog operation in rural Oklahoma and also owns Seaboard Marine, one of the largest cargo operators in the Caribbean and South America. The company amounts to a Cuba play because it’s poised to benefit if U.S. trade relations with Cuba are normalized.

“You have to think of Seaboard as an investment in a private company and not pay attention to the stock quote,” Tom says, adding that he thinks the company is worth at least double its current price.

It turned out that Seaboard (SEB) was worth way more than double its price. Seaboard appreciated rapidly, reaching a price of 1,800 in 2005. Seaboard eventually peaked at around 2,700 in 2007 and is now trading at 1,036 with a price to book ratio of 0.89.

Alan [Kahn] is partial to American National Insurance, a low-profile Texas life insurer whose thinly traded shares are around 70, a discount to their book value of $110. “American National is a wonderful statistical bargain,” he says. The stock trades at 14 times projected 2002 profit and yields 3.5%. Alan thinks the controlling Moody family eventually will sell it. “This is a stock that could double or triple overnight, but they aren’t going to tell you ahead of time when that will happen,” he observes.

Right now, American National (ANAT) is trading at 67 with a book value of 127. That’s a 52% discount.

I hope these old ideas are helpful for the present. As always, do your own due diligence.

Low leverage and an excellent balance sheet translates into financial strength during crises

Low leverage for a financial institution does not necessarily translate into unprofitability relative to its competitors. As long as excellent employees and managers are acquired and retained, business can expand at reasonable rates while strong capital positions will be beneficial in the inevitable periods of financial turmoil.

Take for example Stifel Fianancial (SF), a full-service regional brokerage and investment banking firm that is up about 27% YTD. Looking at their financial ratios, its not hard to imagine why they are doing so well in this environment.

• Stifel Financial, the holding company, has a Tier-one capital ratio of 49%, which is 12 times the required level; For comparison, Citigroup’s Tier-one capital ratio is approximately 9%
• Stifel Nicolaus, the broker-dealer, has a net capital ratio of 37%, 17 times the required level
• Stifel Financial’s total capital ratio is 3 to 1…. The major New York investment banks’ capital ratio, on average, has been 30 to 1…. In other words, the large firms are ten times more leveraged than Stifel

In the 2007 shareholder’s letter, Chairman, President, and CEO, Ron Kruszewski begins with a quote from Warrent Buffett: “It’s easy to put on leverage but not as easy to take it off.” It seems to me that Stifel has done quite well simply by not employing the insane amounts of leverage like other investment banks. I’m willing to bet that Stifel will continue to do quite well as a result of their seemingly prudent nature. I look forward to reading the 2008 shareholder letter.

The following quotes are excerpted from an article entitled “Banking With Tisch” first published on October 6, 1986 in James Grant’s Interest Rate Observer. Just some food for thought. A lot of what was said 20 years ago can still be said today.

Thomas J. Tisch gives some advice to bank-stock investors:

First, never buy a bank at twice book. Number two, don’t trust any bank with a superior earnings record. Number three, you’re buying a pig in a poke because assets are inherently unanalyzable. So buy enough comfort and coverage.

On the “winning features” of the banking business:

First off, you can grow as fast as your ingenuity will allow you to. Number two, you never have capital expenditures that far exceed your depreciation. Number three, I’ve never read about a strike against a bank. And number four, the Bank of New York and the Bank of Boston have paid cash dividends every year since you-can-look-it-up. Sow how bad a business can it be?

On the unattractive features of banks:

Then there are the contra rules, [such as the inability to earn exponential rates of return except through recklessness or fraud]. Also, bankers don’t own stock in their own banks. And banks put their customers on their boards of directors.… Another thing: A really smart person says to himself at a certain point—and this is part of the problem of it being so easy to enter the business—that your pricing is set by the stupidest person in the market.

So what type of strategy would one use in a volatile market in an economy that’s headed straight for some type of recession? I would love to adhere to a value investing strategy, but I feel that the time frame of the competition is too short. I also have decided to make a conscious effort to invest in the same manner as I would with real money. Thus, in this situation I have chosen to adhere to an risk-arbitrage strategy. I feel this gives me a lot of safety with a decent amount of upside. Right now I’m invested fully in four stocks that in my estimation will be acquired at their respective announced prices. The stocks are CVP, BUD, ABI, and ROH.

Given the fact that these acquisitions weren’t yanked during the awful month of October, I’m pretty confident that these acquisitions will take place. And if there’s any more market downside left in the near- to mid-term, I feel I will be better protected than my competitors. But judging from their own portfolios, they also seem to have made some good picks that bring safety and upside potential. It will be interesting to see how this plays out.

I have not researched any of these stocks. Do your own due diligence if you wish to trade. This is merely a starting point for those interested in the investing style of Graham and Dodd.

I recently became a shareholder of Fairholme, coincidentally on the same day as Buffett’s most recent editorial in the New York Times. Now is the time to be greedy. Berkowitz repeats this Buffett mantra every time I have seen him interviewed and I fervently believe in his abilities to produce excellent long-term results for me.

The second guy is XL Capital’s (XL) Chairman, Brian M. O’Hara, who had to sell approximately 80% of his XL common shares on October 9th in order to meet a margin loan call.

It’s good that these guys had strong faith in the value of their companies, but when that faith is backed up with margin in this type of market environment, it often does no one any good.