Sunday, February 17, 2008 12 comments ++[ CLICK TO COMMENT ]++

Bill Miller 4Q 2007 Commentary

Bill Miller published the 4th quarter commentary and it is always an interesting read. He is having a tough couple of years and he says it is somewhat similar to 1989 and 1990. Here are some excerpts...

Are we in 1990?

The past two years are a lot like 1989 and
1990, and I think there is a reasonable probability
the next few years will look like what followed
those years.

The late 1980s saw a merger boom similar to what
we have experienced the past few years and a
housing boom as well. In 1989, though, the merger
boom came to a halt with the failure of the buyout
of United Airlines to be completed. The buyout
boom had been fueled by financial innovation.
Then it was so-called junk bonds..Now it is subprime loans
repackaged into structured financial products...

By 1990, housing was in freefall, the savings and
loans were going bankrupt (as the mortgage companies
did in 2007), financial stocks were collapsing,
oil prices were soaring in 1990 due to a war in
the Middle East, the economy tipped over into
recession, and the government had to create the
Resolution Trust Corporation to stop the hemorrhaging
in the real estate finance markets. Eerily
similar to today, the situation began to stabilize
when Citibank got financing from investors from
the Middle East.

He seems to think the current period is similar to the 1990 period. That thought has also run through my mind but given the unprecedented run-up in house prices, I'm not sure how likely the the future will resemble anything like the early 90's. The housing recovery may take a lot longer than in 1990 and this can hurt financial and real-estate stocks for much longer. But the argument in favour of a quick recovery is the fact that the correction in real-estate-related assets have been very steep.

I think the market is in for a period of what the Greeks
refer to as enantiodromia, the tendency of things to
swing to the other side. This is not a forecast, but rather
a reflection on valuation.

All of the poorest performing parts of the market,
housing, financials, and the consumer sector—with the
exception of consumer staples—are at valuation levels
last seen in late 1990 and early 1991, an exceptionally
propitious time to have bought them. The rest of the
market is not expensive, but valuations cannot compare
to those in these depressed sectors.

Bonds, on the other hand, specifically government
bonds...are very
expensive...The 10-year Treasury trades at almost 30x
earnings, compared to about 14 times for the S&P 500.
The two-year Treasury yields under 2%, and is thus
valued at over 50x earnings!...

Even more compelling are
financials, where you can get dividend yields about double
that of Treasuries, which only adds to their allure, with
them trading at price-to-book value ratios last seen at the
last big bottom in financials.

I share Bill Miller's view that US stocks are neither expensive nor cheap, and the beaten-down sectors like financials and consumer discretionary (especially anything to do with real estate) seem to have low valuations. The big risk for investors (especially foreign ones) is the potential for further US$ decline.

I tend to go for risky stuff (maybe I should change this strategy) but one can find relatively cheap stuff in the struggling sectors. There are companies that can easily go bankrupt; and there are others who are unlikely to go bankrupt. For example, some financial industries like bond insurers (eg. ABK, MBI) and mortgage lenders (eg. CFC) are risky, but large money center banks (eg. BAC, C) or investment banks (eg. MER) are safer. Similarly, homebuilders (eg. PHM) are risky but building material suppliers (eg. USG) are safer. Some of the established retailers like Home Depot and Sears may battle their way through any economic problems but the smaller, niche, players are risky. I'm not recommending any of these (simply giving some examples) and none of this means that you won't lose money one way or another. However it does mean that buying an established financial company with a decent dividend yield and long-term history seems attractive.

I think enantiodromia has already begun. What took us
into this malaise will be what takes us out. Housing stocks
peaked in the summer of 2005 and were the first group to
start down. Now housing stocks are one of the few areas
in the market that are up for the year. They were among
the best performing groups in 1991, and could repeat that
this year. Financials appear to have bottomed, and the
consumer space will get relief from lower interest rates.
Oil prices have come down, and oil and oil service stocks
are underperforming in the early going.

Clearly a bullish comment on the beaten-down sectors. I'm not sure if this is a bit too early...

Investors seem to be obsessed just now over the question
of whether we will go into recession or not, a particularly
pointless inquiry. The stocks that perform poorly entering
a recession are already trading at recession levels. If
we go into recession, we will come out of it. In any case,
we have had only two recessions in the past 25 years, and
they totaled 17 months. As long-term investors, we position
portfolios for the 95% of the time the economy is
growing, not the unforecastable 5% when it is not.

I believe equity valuations in general are attractive now,
and I believe they are compelling in those areas of the
market that have performed poorly over the past few
years. Traders and those with short attention spans may
still be fearful, but long-term investors should be well
rewarded by taking advantage of the opportunities in
today’s stock market.

Needless to say, doing anything now is definitely a big call and could make the difference between a disaster or huge success. Even if you are a long-term or medium-term investor, housing is scary because the run-up in prices and the demand was unprecedented in modern US history. The fact anything heavily tied to housing is cyclical multiplies the damage from a mistake.

On Potential Countrywide Financial Takeover

Legg Mason Capital Management (LMCM) is the largest
shareholder of Countrywide Financial (CFC), holding
about 11.8% of the company’s shares outstanding as of
December 31, 2007.

We were quite surprised by the decision to sell the
company at close to a seven-year low in the stock price,
and agreeing to a bid that amounts to only 30% of book
value and under 3x consensus earnings for 2009
. What
makes the decision puzzling is that the company was seeing
solid deposit growth, has no apparent capital
problems, was not forced by the regulators to seek a
merger partner, and is in sufficiently sound condition to
have declared its regular quarterly dividend at the end of
January. Subsequent to the decision to sell, the Federal
Reserve cut interest rates sharply. The reduction in rates
is quite beneficial to CFC by reducing its costs of deposits,
and by setting off a wave of refinancings that should
significantly increase its loan production.

I was surprised with the Countrywide decision as well. No doubt mortgage lenders have run into massive problems, with many declaring bankruptcy. However, except for some wild, unsubtantiated, rumours of imminent bankruptcy, CFC seemed to be strong enough to survive the downturn. I don't have a position in CFC and haven't followed it closely enough, but the deal looked to me as if insiders were looking for an exit strategy more than anything. Whatever the case may be, it is up to the shareholders to accept or reject the deal. It looks like Bill Miller is adding to his position:

We petitioned the Office of Thrift Supervision for
permission to increase our holdings in CFC to up to 25%
of the shares outstanding. That permission was granted
on January 18, and we (LMCM) have increased our holdings
to about 86 million shares, representing 14.9% of the
company’s shares outstanding...

We have asked CFC’s Board to eliminate the poison pill
(or at the least provide us with an exemption from it) as it
plainly is unnecessary since the company has already
agreed to be acquired by BAC. Eliminating it would
allow us to acquire additional shares, should we decide to
do so.

We have asked other companies to allow us to exceed pill
thresholds, and those requests have been routinely
granted, as we are long-term patient shareholders, not
activists or acquirers. We fully expect CFC’s Board to do
the same.

Bill Miller views the takeover as offering CFC shareholders a put option on their company:

It is important to understand that CFC’s Board has effectively
negotiated a put option contract with BAC. Shareholders
now have the right to put the company to BAC
for 0.1822 shares of that company. They may elect not to
do so, in which case the company will remain independent.

Given the turmoil in the mortgage and credit markets, and
the failure of hundreds of mortgage originators, some of
whom were public, this provides protection to CFC
owners from a worst-case outcome should the housing,
mortgage, and economic situation worsen dramatically.
On the other hand, should the actions of the Federal
Reserve and the economic stimulus package lead to a
gradually improving situation, CFC owners can turn down
the deal, should they believe that is in their best interests.

I don't think Bill Miller is hedging his position (i.e. not shorting BAC stock as risk arbitrage players would) so this is basically a bullish bet on housing. I suspect Miller will be happy to own BAC shares if CFC accepts the buyout so this looks attractive to him.

On Potential Yahoo! Takeover

LMCM is YHOO’s second-largest shareholder,
owning over 80 million shares. Subsequent to the
deal being announced, we have met with Steve Ballmer,
MSFT’s CEO, and spoken with Jerry Yang, CEO of

That said, we think it will be hard for
YHOO to come up with alternatives that deliver more
value than MSFT will ultimately be willing to pay.

I don't follow these companies well enough to have a strong opinion. My feeling is that Yahoo is struggling but it has a strong brand and display advertising. Their problem is that they are having a hard time monetizing their strong brand. To make matters worse, Yahoo is good at display advertising but what is popular with customers is context-sensitive text advertising. The problem with these tech companies is that even though they have huge barriers to entry (online mass advertising is locked up between the three, Google, Yahoo, and MSN), their valuations are high. Yahoo's TTM and forward P/Es are 63 and 54, respectively (growth companies should technically not have depressed earnings). It's awefully hard to satisfy the required growth rates for such high valuations even if you are one of the top 3.

It has been reported that MSFT has been
discussing a combination with YHOO for well over a
year, and that it had been prepared to pay over $40 per
share previously. We have no way of knowing whether
those reports are accurate or not.

Our own valuation work puts the value of YHOO in the
range of those reported numbers, though, and we think
MSFT will need to enhance its offer if it wants to
complete a deal. YHOO shares were recently trading at a
four-year low, and the stock averaged above the current
offer price for all of 2004.

I feel like Bill Miller is a bit too optimistic here. Yes, Microsoft is being opportunistic by offering a price off the 52 week low. But Yahoo doesn't seem to have anything going for it. I also don't think Microsoft needs this deal as much as some make it out to be. There are major integration risks if Microsoft buys Yahoo. Unlike prior purchases, Yahoo is massive and there is room for big culture conflicts, not to mention issues with technology integration issues. Lastly, with such a high valuation being placed on Yahoo by the market, I'm not sure how easy it will be for Microsoft to satisfy market expectations in the future.


12 Response to Bill Miller 4Q 2007 Commentary

February 17, 2008 at 9:43 PM

Recent update Ambac


February 17, 2008 at 9:44 PM

Ambac in Talks to Split Itself Up
February 17, 2008 7:18 p.m.

Ambac Financial Group Inc. is in discussions to effectively split itself up in a move aimed at ensuring that municipal bonds backed by Ambac retain high credit ratings, according to a person familiar with the situation.

A deal could fall apart because of the complexities in such a move, this person said. Bond insurers in recent weeks have become ground zero in the global credit crisis because the companies contractually have agreed to stand behind billions of dollars in securities underpinned by U.S. subprime mortgage loans.

A halving of Ambac would create one unit that insures municipal debt and one that would cover rapidly diminishing securities tied to the mortgages in a structure that effectively creates a so-called "good bank" and "bad bank." Bond insurers generate revenue by promising to cover bond payments on debt issued by a range of entities, including local governments. Bond insurers now are under pressure, though, because they also agreed to guarantee payments on mortgage debt or securities to banks, brokers and investors.

Ratings companies now are poised to further cut credit ratings on bond insurers because of those guarantees. Ratings downgrades can have chain reactions and lead to increased borrowing costs for municipalities and write-downs for banks that own debt backed by the insurance providers. To avert financial chaos, regulators in New York, including state insurance superintendent Eric Dinallo and Gov. Eliot Spitzer have pressured the companies to find solutions or else face regulatory action.

Ambac is one of two bond insurers considering an effective break-up. FGIC Corp. on Friday notified Mr. Dinallo's office, the New York State Insurance Department, that it is pursuing an effective break-up. But according to people familiar with the situation, FGIC's plan came as a surprise to a consortium of banks that had been in early discussions to shore up FGIC's capital. Talks between the two sides be prolonged and litigation may be one outcome. Ambac's plan is much further along and an announcement could be made this week.

But the plan to split Ambac is complex and has required tens of hours in recent days. While a "good bank-bad bank" model has existed for decades, there isn't a playbook for halving a bond insurer. A number of issues remain to be resolved, said a person familiar with the situation.

An Ambac spokesman wasn't immediately available for comment. Ambac is based in New York and is the second largest U.S. bond insurer behind MBIA Inc. FGIC ranks third.

Write to Carrick Mollenkamp at, Karen Richardson at and Liam Pleven at

February 17, 2008 at 10:00 PM

The article says "Ambac's plan is much further along and an announcement could be made this week."

You said earlier -

SIV -It's hard to say anything since it is all hypothetical. My feeling--and it's only a feeling without any solid facts--is that a combined entity is stronger and will be able to handle potential losses better. Assuming hte legal issues are handled (by the state), the only way this split can work is if, as Michael Callen pointed out, the investors willing to invest in the muni side may have materially different risk profile from the structured product side. In other words, if you can attract capital at VERY LOW COST on the muni side then you can give almost all the existing capital to the structured product side. But one has to be sure that investors are lined up before any split is seriously considered."

Do you think Ambac has lined up those investors? Maybe Ross going to the muni side? Banks to both sides?

What do you think?

February 18, 2008 at 1:35 AM

I still don't like this split idea from a shareholder point of view--but it depends on the actual specifics. I really hope management isn't acting for itself. Run-off looks better than split to me. There is a high risk that shareholders can end up with nothing. But to repeat again, it depends on the actual plan.

In my eyes, for the split to actually make sense:

(i) The state has to provide legal cover. This is still a big unknown because even a state like New York can lose billions if the structured policyholders successfully sue. If the state tries to pass the buck to the monoline then it is instant bankruptcy so the legal issue has to be clear.

(ii) If nearly all the capital is kept with the non-muni company then the cost of new capital for the muni bond business needs to be low. I can see capital costs being low but just not sure how low. If the cost is too high then shareholders may end up being wiped out completely.

(iii) The new muni bond business must not only get a AAA rating but have customer support. Who knows how muni bond buyers will look at this new entity.

Finally, none of this really helps the markets; but it can help the muni bond side. Already, you have the market pricing in higher default risk across the world.

Even if the impact on shareholders is identical, my concern is that the non-muni business will be extremely weak with a split. It might just go into run-off instantaneously (depending on how the rating agencies look at that).

Just some random thoughts...

To answer your question on whether Ambac has someone lined up, we can be almost certain that no one will want to provide additional capital to the structured product side. But I think it will be easy to raise capital for the muni bond side. So, yes, Ambac likely has someone if the structured product risk can be isolated. Some analysts still think a split is unlikely (video not exactly recent) and I kind of feel the same thing...

February 18, 2008 at 1:48 AM

Not that this really helps our case now but the short interest on Ambac has been steadily increasing and is around 40% of the float. And this is with the stock price around $10... This doesn't mean that Ambac won't go bankrupt but if it doesn't, then...

February 18, 2008 at 11:19 AM

I'm probably way off the mark but Ambac's talk, if it's true, becomes the latest move in a very curious chess game. Callen seems to be a straight shooter so I'm hoping management is not looking out for itself. As a PR move, saying they might but not sure if they can, it's clever - shows the company is willing to take that extra step for it's muni clients, doing the right thing, etc. blah blah blah. It may also push WB's offer into deep background.

Another point is given the enormous financial and legal complexities involved, Ambac may have just bought itself a ton of time here. That these rumors are circulating before a possible downgrade as opposed to FGIC's announcement after the downgrade seems to me to put the ratings agencies squarely behind the 8 ball. With the US gov't, Spitzer, Dinallo, and every city and town across America watching, if the agencies were to levy a downgrade now and roil the markets, forget it, they would be toast. Which may explain why Moody's has been fairly sanguine lately.

We have to remember that Callen said this was something "they MIGHT have to consider". But that was probably based on continued deterioration in ratings.

As shareholders, it is all very nerve wracking. As an observer, it is interesting to watch the little guy throw a little gasoline on the fire.

As you say, there is a ton of short interest (for MBI it is approx 56%) so who knows what can happen.

Europe is flying today. The only comment I hear is "oversold" but...

February 18, 2008 at 11:36 AM

What do you think of this post?


February 18, 2008 at 6:24 PM

This is the Cramer interview with Spitzer from 2/15. I still wonder how Cramer managed to keep a straight face, especially when he scolds the laizess faire irresponsibility of Bush & Bernanke and promotes Spitzer's socialist agenda!


February 18, 2008 at 7:01 PM

Cramer is a short-term trader and he often flip flops depending on the situation. I don't have access to his show (I'm in Canada nad dont' want to pay for CNBC :) ) but I see him trashing a CEO one month and then praising him a few months later.

I think the upcoming week may be quite wild. It can potentially end up being like the first few weeks of the year when monoline stocks plunged 70% in a few days, only to rally 100% (from the low price). I can see the sentiment going either way.

I read that post that you linked to... and... well... I agree with the original poster. His main point is that no one really knows what the losses will be. I have felt the same. I mean, you can literally pick a number between $5 billion and $400 billion (for the full industry). This unknown element is what makes this an intriguing investment.

I disagree with the poster in that I believe that we'll know the ultimate outcome by the end of this year. Even though the subprime products can last up to 30 years, we will know if the company will be insolvent based on teh default rates. If the default rates and losses, along with loss recovery, doesn't stabilize or decline, the bond insurers will be insolvent. We will have a good idea about the 2006 and to some degree the 2007 vintages by the end of this year. The default rate curve, as you may recall from some charts, is parabolic so the worst will happen within a few years--not 15 years from now.

The problem I see right now is that there is a lot of emphasis on retaining AAA rating. That's needed but it's almost as if the government will do anything to keep that. Well, from a shareholder point of view, keeping the rating is one choice (run-off is another; along with asset sales (sort of what Buffett was looking for)). The government wants the rating for their own muni problems. But Ambac only needs it to write new business. The concern I have is that shareholder interests may be tossed aside in the name of retaining the rating.

Having said that, Eric Dinnolo seems like a good guy who is working together with the monolines. I think he knows the severity of the situation and how a mistake can bring the whole thing down. So things may not be as crazy as the media, shorts, and others make it out to be.

As long as book value is pretty high (it's around $20 now), I'm reasonably confident with this investment. The government can hurt shareholders but it'll be tough for them to do so if the book value is over a billion dollars, the stock is trading at a market cap above $1 billion, and the monolines haven't defaulted on any payments or are insolvent. If book value drops a lot (which basically means you took a big loss) then it is closer to death (although, a lot of the book value decline is due to mark-to-market losses and that may or may not turn out to be the reality).

February 18, 2008 at 8:50 PM

Pre-emptive rights offering?

Selected cuts / paste from tonights WSJ news...

Ambac Financial Group Inc. is discussing a plan to raise at least $2 billion in much-needed capital to help the world's second-biggest bond insurer retain its top-notch credit rating, according to people familiar with the matter.

The extra cash, to be raised by selling shares to existing investors at a discount, would likely be a prelude to a trickier and lengthier move: splitting itself into two businesses.

"It may sound politically convenient to separate out the muni business, but it's going to invite a raft of lawsuits," says Sean Egan, managing director at research firm Egan-Jones Ratings Co. Mr. Egan recommends that bond insurers set up a trust along the lines of the asbestos industry that will cover future claims at certain set rates.

If Ambac's banks agree to "backstop," or buy up any unsubscribed shares in the offering, they would be providing a form of contingent capital that could persuade rating agencies to preserve Ambac's high ratings. Convincing banks to commit this capital remains a hurdle, according to one person familiar with the matter. The banking group includes Citigroup Inc. and UBS AG. Additional money has been sought from other banks, this person said.

February 18, 2008 at 9:41 PM

Rights offering, with shareholders being given first dibs, is cool with me.

February 18, 2008 at 10:04 PM

Well, there are a lot of rumours, with most of them contradictory to each other...

I don't think Ambac will consider a split if it raises $2 billion. MBIA is pretty adament about not splitting (you can be sure that they are being influenced by Warburg Pincus and others) and Ambac will be in a similar situation.

A $2billion rights offering will be extremely expensive but the situation right is slightly better than when the stock price was at $5 (that was when they were considering the initial capital raising plan). Ambac's book value is around $2 billion and its market cap is around $1 billion.

Societe Generele issued a deeply discounted rights offering recently and as long as shareholders are offered a chance to participate, the blow won't be as severe as if it were a private transaction.

I think they still need to unload some of their muni bonds (via reinsurance). Buffett's price is ridiculous but if they can find someone else or get a better price, it can work...

One looming question is whether $2b is enough to satisfy the rating agencies. When I invested in Ambac originally, my expectation was for Ambac to raise around $1.5 billion. I thought that would be enough for the time being. That obviously never happened and I am not sure what the rating agencies require right now.

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