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Searching Out the Optimal Portfolio of “Revelation” Stocks

Investment Thesis for GFI Group, Goldman Sachs (GFIG, GS)

Posted on | September 21, 2008 Time: 2:25 am |

GFI Group (GFIG) and Goldman Sachs (GS) were two late-day additions to the Secular Trends Portfolio on Thursday, getting the fund into Financials quicker than expected with a 4% stake, and overall the portfolio sits at modest 25% equity exposure. What are the odds of ramping a new portfolio during the most volatile market period in years? The crowds were fleeing for the exits, and as confusing as it all was, there were so many valuable lessons at least partially exposed, just begging you to grasp them.

I was wary of adding any Financials exposure until there was better visibility into the sector’s survivability, but Goldman and GFI both fell to levels that were simply too compelling to ignore as fear overtook all logic midway through the Thursday session.

For those that weren’t witness to the mid-day events, Morgan Stanley and Goldman had both dropped about 40% intra-day; even stodgy State Street Corp. (STT) dropped 45% even though they had zero exposure to the derivative assets that caused the meltdowns at Lehman, Bear, and Merrill. There was a run on money market assets as banks & institutional clients rushed to get liquidity anywhere they could…this caused the fear-based run on State Street, which incidentally made up nearly all its losses by the end of the day.

One of the most accurate barometers of fear was plastered over the television; you could literally see it in the faces of Wall St. veterans, the ones that make a living out of keeping a cool head. With about 2 1/2 hours left in the trading day, news broke of the planned Treasury mega-fund to buy up mortage assets from institutions that deperately needed to unload them. Goldman had already dipped below $90 for a few minutes, and GFI was below $3.50 per share.

I wasn’t able to time my purchases that precisely, but I am quite happy with picking up GFIG at $4.68 and Goldman at $114.68…as of Friday’s close they stood at $6.11 and $129.80, respectively. At this point on Saturday I’d say we have about 30% of the details we need before a reasonable attempt can be made to evaluate the earnings(read:losses) consequences for investment banks, commercial banks, and for that matter everything else in the financial sector…any everyone that needs to borrow money.

If the mortgage-baset assets get real pricing in the market, expect to see one more big round of losses from the known offenders; many have been hiding their Level III assets in a dark corner, and a posted price will produce major writedowns. Goldman may see some effect, but in truth they are more leveraged to the strength of the commodity and hedge fund markets. It’s still a big risk, but I prefer that devil at this point.

GFI Group Background & Thesis

Not many folks outside of the brokerage industry have ever heard of GFI group, which acts as an inter-dealer broker for many financial products, mainly derivatives on everything from basic debt & equity securites to more complex credit-default swaps, forex, freight, and even weather. The company also sells data services and analytics wrapped in some novel software products, but these are currently very small contributors to the top line. It’s basically a company filled with brokers that trade OTC contracts with other brokers and institutions. Because many OTC markets are unregulated frontiers, the spreads they earn on trades need underlying volatility to be overly profitable. Volatiliy has not been in short supply this year, and were it not for the dramatic deleveraging of the credit markets GFIG’s stock might be heading to the moon.

Instead the stock has been crushed this year after previously showing a relatively steady upward trend. The underlying growth in the majority of their markets is still there, but 2008 has highlighted the #1 problem with GFI’s business model. It’s all about people, human brokers that either make it rain or…hop ship en masse to a competitor, which happened this summer when 22 of its brokers were lured away to French firm Compagnie Financière Tradition.

To say that GFI was pissed would be an understatement; they tried to file a lawsuit to gain some damages but those suits rarely do more than make a PR statement. But what’s done is done, and the same goes for the frozen markets for CDSs and credit-based derivatives. The bad news seems fully integrated into the stock price, as GFI now trades for about 6x trailing earnings.

I wrote an overly bullish piece on the company in early 2007, when underlying growth in hedge fund assets was peaking and volatility was high as the early stages of the massive credit unwind was just beginning. I didn’t have enough foresight to see how the company would be affected by the end game that we saw this past week. It doesn’t matter if you earn great spreads on trade if your client base shrinks by 60% in a matter of months.

The overall risk/reward scenario still stands at a (very theoretical) 3/1 Earnings to Price Leverage so long as the bottom doesn’t completely fall out of derivatives - including the regulated, reasonable hedging type. There’s enough margin of safety to make feel good about giving this company a chance.

To be honest, I have no idea how near-term earnings will pan out, and I will be reading the next quarterly report with both earnestness and curiousity. But most of their markets should still see solid double-digit growth in 2008, and the company has announced very limited exposure to Lehman and AIG directly. They have an extremely under-levered balance sheet, and roughly $500 million in equity, quite tidy compared to their $720 million market cap.

This 2% position is a little bit spicier than most will be in the portfolio, but the secular trends of derivatives growth is not something I’m willing to bet against. I believe in a trends of a modern economy that can develop an insurance policy for anything and everything (Kenneth Arrow has great thoughts on this), and derivatives are where most of those policies will be created and traded. GFI should benefit nicely from this secular trend.

Goldman Thesis - A Much Shorter Read!

These guys are (sorry - guys and gals), on the whole, the smartest folks on Wall Street. It’s not based on the performance of one single person, it’s just the stats talking. The numbers prove them to be the best-run company in the industry, and I never thought I’d get a chance to see the price below $140. It hopefully proves to be the best price I could ever, ever get.

At five times earnings, frankly it had better be or we’re in much bigger trouble than even I think..and I’ve been a bear for so long now that I’m actually thankful the whole messy, bloated, mortage whale has washed ashore. As time passes, people will realize that Goldman is still the best at making, flipping, merging, and otherwise atom-colliding companies together.  And in the global marketplace, that’s an absolutely essential function - one that needs to be done with sharpest knives in the proverbial drawer.

I promise I’ll get some charts and performance up on the Secular Trends page soon. It’s been a great, if not wearying, first week for the portfolio.

Ryan Barnes

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Category: Financials, Investing Philosophy, Secular Trends Portfolio
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