Iron Capital Insights

  • Iron Capital Insights
  • October 22, 2009
  • Chuck Osborne

Fragile

Everything was going so nicely, then it dropped off a cliff. Yesterday the market was heading for nice gain in response to a blowout quarter from Wells Fargo among other positive earnings reports. Thus far 76% of the S&P 500 companies that have reported have beaten expectations for Q3 earnings.

Then out of nowhere, we got hit by two bombshells. First Richard Bove of Rochdale Securities downgraded Wells because he didn’t like where their blowout earnings –$0.61 per share vs. estimates of $0.39 per share – were coming from.  Wells’ stock went down a little more than 5%.

The second bombshell came from our pay czar. Earlier in the day, reports suggested that the grand czar of compensation would not really be cutting the amount of compensation as much as the structure, attempting to tie compensation more to long-term corporate success vs. annual bonus. Guess again – total compensation cut 50% and salaries cut 90%.

The first shock received most of the credit for tanking the market, but I believe it is the second headline that deserves more attention. The downgrading of Wells Fargo after a fantastic quarter is certainly bold, but we don’t put much credence in analyst predictions. As Bloomberg pointed out in August, if an investor with a $10,000 portfolio had taken all Wall Street analyst advice in March of this year – meaning they bought all the stocks rated buy, and sold short all the stocks rated sell – they would not only have lost everything but also would now owe $6,000. This during the steepest market rally in more than 70 years.

If your time horizon is a few weeks or months, now may be a good time to sell Wells Fargo. However, if your time horizon is three years, you may want to consider that the current Wells Fargo, after the Wachovia merger, is selling for less than the old Wells Fargo did for most of 2008. After running up from a low of $7.80 to the $30 range there may be some pull-back, but longer term Wells Fargo will be one of the two strongest banks in the country. Not a bad place to be.

The second story has staying power. No one is going to come to the defense of executives at Bank of America, Citi, or AIG. If they do, the angry mob will certainly tear them apart. However, there are two very important questions we should be asking. First, is this justice or is this revenge? The end result of the two can often be very similar, but the difference is huge. How something is done is often as important, if not more important, than what is done. One could argue that had the government not stepped in, these firms would have failed and these executives would have received a 100% pay cut. Then that person might be accused of suggesting that a truly free market is more just than, say, the rule of a czar.

The second question we should be asking is one that comes from David McCullough’s biography of John Adams. Adams stopped at a tavern while traveling and overheard the locals discussing British actions regarding taxation. One man said to the rest, “…if Parliament can take away Mr. Hancock’s wharf and Mr. Row’s wharf, then they can take away your barn and my house.” Where will the pay czar stop? If he stops here, then I don’t have a problem with it. These firms essentially have become wards of the state, so the state arguably should have some say in what pay structures look like. The concern in the market is that he won’t stop, in which case no one will care until it impacts them, and then it will be too late.

This uncertainty is starting to look like the end of the rally. At the very least this rally is becoming fragile, and we remain cautious.

Chuck Osborne, CFA
Managing Director