Friday, July 3, 2009

Tilson Talks Mortgage Default

How do you determine which financial sector company will survive at the end of the day?

Basically, we analyze their balance sheet and try to come up with a range of estimates for the likely losses that they are going to take. And we think the losses are going to be huge in general, so our numbers tend to be much more bearish than most Wall Street analysts', for example. Then we compare that to the equity, the loss reserves and--very importantly--the earnings power of the business, and we try and find situations ... in most cases they either have to have the balance sheet strength or the earnings power to earn their way out of trouble.

And then, assuming that we think that they can make it through the period of losses that we anticipate for the next two years, we then look to see, you know, what's the normalized earning power of this company, you know, three or four years from now. When they get back to a more normal level, then we put a multiple on that, and we try to put a value on what the stock will be worth when it comes back to "normal."

We wrote a book with an entire chapter on Wells Fargo ( WFC - news - people ) and an entire chapter on American Express ( AXP - news - people ), which are two good examples of companies that we think are going to face hideous losses and do not currently have enough equity and loss reserves on the their balance sheet to cover all of the losses, which is why many people are short those stocks. We are long [on] them, because what we think the bears are missing is--in these two particular companies--is the earning power of these two businesses. Wells Fargo and American Express are earning a lot of money, and they can use those earnings to offset losses. So we think basically that there a few blue chip companies, Wells Fargo and American Express being the two that we own, that will be able to earn their way out, outrun their losses because of their high earnings, and we think both of them are $50 stocks in the normal environment, and so we bought a lot of them at $10, we sold half our position at $25, but we continue to hold them at today's levels.

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