There are a lot of fingers being pointed as people try to decide who was at fault in the global financial meltdown of 2008. The complex problems hit a crescendo in September 2008, when banks found themselves unable to make loans. Many blame lax financial regulation and consumers, who, along with the U.S. government, borrowed like there was no tomorrow. Then there were the lenders who carelessly made loans to subprime borrowers with poor credit.
Like many other value investors, Chris Davis, co-manager of Selected American Shares, says his performance was hurt by plunging financial stocks such as AIG, Wachovia and Merrill Lynch. "We mistakenly assessed the deterioration in their cultures," he says. "At any leveraged financial firm, culture is critical and it starts at the top. The chief executive officer must serve as the ultimate chief risk officer."
Going forward, however, Davis is on the lookout for "opportunities amid the chaos." He's focused on companies' financial strength and "franchise value." The business model of financial companies is not obsolete, he says. And he expects large banks and financial institutions to register returns on equity in line with historical averages because their business models are still in demand.
Davis is also investing in companies he considers global leaders because they have strong balance sheets and reasonable pricing power. He likes oil, natural gas, coal, turbine power, power plants and timber companies.
Muni Bonds in Turmoil
Meanwhile, municipal bonds have been out-yielding comparable Treasury bonds by a wide margin. But there is a greater danger of defaults. Investors are squeamish because states and cities are running large budget shortfalls. There is also a risk that some issuers may call their bonds.
Alex Grant, manager of the RS Tax-Exempt Fund, says now is the time to buy good credit because "historical spreads are at the widest ever." He stresses that national municipal bond funds are lower-risk than state-specific funds but don't sacrifice yield. And investors have minimal exposure to credit default/mortgage issues. But investors need to do their homework because insurance ratings are flawed.
Another bond manager, David MacEwen, co-manager of the American Century Diversified Bond Fund, was on the defense in 2008, when his portfolio avoided asset-backed subprime mortgage loans. He also shortened the duration of the fund. The portfolio was overweighted in Treasury securities and he used default swaps to cushion losses during the financial meltdown.
Now, though, he's maintaining a neutral duration of 5.75 because the yield curve has steepened. The fund has nearly 14% in 'AAA' rated corporate bonds and 37% in high-quality mortgage pass- through securities and collateralized mortgage obligations. He also invested in 'AAA' rated municipal bonds because of their historically high yields. MacEwen, however, is underweight in Treasurys.
"We added value with sector rotation," he says. "We used credit default swaps for protection with financial bonds and it worked. Today, you have to be very careful about credit selection, and bond covenants have been more important in security selection."
MacEwen's biggest concern is future inflation that could result from the U.S. fiscal stimulus package and the devaluation of the U.S. currency. As a result, he is prepared to use inflation hedge strategies in the portfolio.