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You know U.S. financial stocks are dirt cheap when Charles Lahr starts buying them. And that's what he's doing.
Lahr is the manager of Mutual Financial Services A (TFSIX), a deep-value fund that finished 2007 with more than 70% of its assets invested outside the United States. Citing compelling values created by the collapse of credit last year, Lahr says, "Twelve months and 18 months and 36 months from now, I expect our fund to have far more exposure to U.S. financials."
Derek Rollingson, the manager of Icon Financial (ICFSX), another top-performing fund in this group, says: "On average, in the financial sector you are getting $1.26 (in assets) for every dollar you invest. In thrifts and mortgages, you're getting $1.39."
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Investors score their greatest profits when they buy groups that are deeply out of favor. Contrary to academic theory, which holds that stocks are correctly valued all the time, emotion often leads investors to drive stock prices to extremes.
And right now, mortgage lenders are considered so toxic that even many dedicated value-driven investors won't touch them.
So it may soon be time to buy. But would you pick a deeply damaged lender such as Countrywide Financial (CFC, news, msgs), down 80% in a year? Or a giant like Citigroup (C, news, msgs), down 50% yet almost certainly too big to fail?
"If somebody wants to bet a dollar on whether a given bank can survive and thrive, I might be willing to make a bet like that," says Wallace Weitz, the manager of Weitz Partners Value (WPVLX), a diversified fund whose biggest financial stake is in Berkshire Hathaway (BRK.B), the insurance conglomerate run by Warren Buffett.
But when it comes to serious investing, they are on what Warren calls the 'too hard' (to figure out) pile," he says.
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I couldn't begin to figure that out either, which is why I would approach this sector via an actively managed mutual fund. Managers who have demonstrated great skill in finding the group's best names include Lahr and Rollingson, as well as Jeff Arricale of T. Rowe Price Financial Services (PRISX).
I also couldn't predict when financial stocks will find a bottom. But to paraphrase Lahr, I think that in 36 months they'll be a lot higher than they are now and that their gains will greatly exceed those of the overall market.
Picking up the pieces
Certainly financials have already gone through their own bear market. From their peak in May 2007, they had tumbled 33% by Jan. 18, as measured by the financial portion of the S&P 500 Index ($INX). They rebounded 16% over the next two weeks but since have fallen back. As of Feb. 19, they were 29.5% below their 2007 peak. The overall market has fallen half as much from its peak in October.Sector index funds have absorbed the full force of this rout. As of Feb. 19, Select Sector SPDR-Financial (XLF), which tracks the S&P Financials Index, had tumbled 27.2% in the previous 12 months. Active managers were able to avoid at least some of the damage. Both the Mutual and the T. Rowe Price funds were down 22% in the same period, and Icon was down 18.8%.
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The Mutual funds describe themselves as deep value, but that's an understatement. They get involved in distressed debt, merger arbitrage and other esoteric special situations, as well as individual stock picking. Lahr is particularly skilled in researching foreign equities. In addition to managing the financial-services fund, he also manages Mutual Discovery A (TEDIX), a world-stock fund, and he formerly managed Mutual European A (TEMIX).
"In 2003 we were 90% invested in the United States, and we owned many of the most successful direct-subprime originators," Lahr says. "We noticed in 2005 that significant capital was coming into the market, and we began seeing shoddy underwriting."
The fund began exiting that space and switched more assets to foreign, especially European, stocks.
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