Equities love risk

The stock market seems to indicate investors are in love with risk again. The overall stock market is richly valued at more than 24 times earnings, paying a cash dividend yield of less than 1.8%. I'm not saying this is a top, but it's nothing like a bottom valuation. At the bottom, stocks trade around 7-10 times earnings and  yield 6% or more.

Yet Treasury bonds yesterday showed a flight from risk. Long-dated Treasuries sold off yesterday, pushing yields dramatically higher...

Carlyle's financial services group also includes James Burr, who used to work for Wachovia, and Randal Quarles, former undersecretary at the U.S. Treasury. I don't know about you, but if I were staffing up a new money management operation, executives from one of the biggest bank disasters and former government employees wouldn't be high on my list of candidates.

Carlyle had trouble raising money for the fund and had to ask investors for more time last fall. The new fund has already spent 30% of its capital on investments in three companies.

I've found two small bank stocks, both of which are participating in a special government guarantee program. Under the program, banks first buy the assets of failed banks for around $0.75-$0.77 on the dollar (this happened in two recent deals). Then, the government guarantee assures those assets will never be worth less than about $0.91-$0.92 on the dollar.

So there's a guaranteed pre-tax value creation of as much as $0.15 per dollar embedded in each of these transactions. It's free money, thrown at an elite group of banks hand-picked by the federal government.

These special little bank stocks are trading for right around book value, which tells me the market doesn't see the huge avalanche of profits headed their way over the next several years. At these prices, you're getting all the assets for fair value, and the future earnings power of the assets nearly free.

And in each one of these deals, the acquiring bank also gets the failed bank's deposits, by simply paying a small premium. In the deals I've seen recently, the premium has been just 1%. So for example, you'd pay $101 million for $100 million of deposits. And according to bank regulations, you can lend out $1 billion on that $100 million.

The small deposit premium paid doesn't come anywhere near to offsetting the huge discount the acquirer gets on the failed bank's loans and foreclosed real estate. So in some cases, it's as though hundreds of millions in earnings power was given to the acquiring bank, free of charge.

But there's a trick to buying into this elite group of bank stocks that profit from government-guarantee programs. You have to find a bank small enough that a small-sized acquisition can increase its earnings power dramatically. Nearly all of the banks that will fail in the next few years will be small. If a big bank acquires a small failed bank, it doesn't boost the big bank's earnings enough.

This is why I also like the idea of shorting one of the big banks that's buying failed banks. The new deposits and the government guarantees won't be enough to keep this behemoth from having real problems on its own bad loans over the next couple of years.

You've also got to find small banks with plenty of excess capital. One of the banks I found has more than three times the statutory requirements for a "well-capitalized" bank. It's one of the safest banks in the country. And if it keeps buying failed bank assets and deposits via the government's guarantee program, it's going to be a much larger bank in a few years. I think investors who buy now will double or triple their money within the next three years (perhaps sooner).

I've found two small banks, both of which I'm going to recommend in the next issue of Extreme Value. A potential third one popped onto my radar screen late last night.

Greece's Titan Cement Company wants to build a cement plant in Wilmington, North Carolina, promising hundreds of jobs. There's even an abandoned cement plant it could take over in Wilmington.

But the state of North Carolina has dragged out an environmental review of the property for two years – two years. That's two years when hundreds of people might have been working.

There's also the usual opposition from faint-hearted latte-sippers who say the environmental damage will cost more in the long run. Meanwhile, New Hanover County, where Wilmington is, has an unemployment rate of 10.5%, and the U.S. has lost 6 million manufacturing jobs over the last 10 years.

Ferris comment: I love catfish. We used to catch them in the Gunpowder River when I was a kid. We caught and ate a lot of eels, too, which are even better. Much as I like catfish, though, I'm not sure I want to be on the other side of your long gold/short catfish trade.

Most of the ills of the world have been caused by well-meaning people who ignored the principle of individual freedom, except as applied to themselves, and who were obsessed with fanatical zeal to improve the lot of mankind-in-the-mass through some pet formula of their own. . . .

The harm done by ordinary criminals, murderers, gangsters, and thieves is negligible in comparison with the agony inflicted upon human beings by the professional "do-gooders," who attempt to set themselves up as gods on earth and who would ruthlessly force their views on all others--with the abiding assurance that the end justifies the means. By Henry Grady Weaver in the book The Mainspring of Human Progress pages 40-41.

"Here is another one from a former FBI agent, Dan Smoot in January 29, 1968:

England was killed by an idea; the idea that the weak, indolent, and profligate must be supported by the strong, industrious, and frugal – to the degree that tax consumers will have a living standard comparable to that of taxpayers; the idea that government exists for the purpose of plundering those who work to give the product of their labor to those who do not work.

The economic and social cannibalism produced by this communist-socialist idea will destroy any society which adopts it and clings to it as a basic principle – any society." – Paid-up subscriber Garth Brinkerhoff

"For anyone who might be interested the tax sale auction is always the last Monday of August which would be 8/30 and is held at the courthouse if space allows. If not it is then held at the fairgrounds. No deposit is required, a blank check or a credit card is acceptable when registering. You can get additional details by calling our tax collector, Joe Tucker at 228/769-3072. The properties are published 2 weeks before the sale in The Mississippi Press. Please come, you will have fun and, make some easy money." – Paid-up subscriber M. Spalding