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Three Reasons Why Investing in Common Stock May Be a Terrible Idea


Market may be overestimating the benefits of so-called "solvency."

I don't know about other readers, but I think Minyan James Kostohryz has been a great addition to the Buzz & Banter. And whether I agree or disagree with him, I find that his pieces always make me think.

And that was again the case yesterday, when he wrote that companies issue stock when they have to, when they'd be stupid not to, and to address solvency - even when it dilutes existing shareholders. I guess I lump this third case into the first one - when they have to. And that stock prices rise on this action doesn't surprise me at all. In fact, as James sets out, they should. Risk has been removed.

And if you rewind the tape, I would suggest that when Citigroup (C) announced that it was swapping $81 billion in preferred stock back on February 27th, when its common stock was trading at roughly a dollar, solvency risk, not just for Citi but for most of our largest banks was effectively taken off the table by our banking regulators.

And I would note, too, that a few weeks before Citi's announcement, Freeport McMoran (FCX) started the ball rolling, issuing common stock to address looming maturing debt. And given the market's positive reaction to both Freeport and Citi's news, this was then followed by issues by Alcoa (AA) in March and any number of REITs. And I would put Ford's (F) stock for debt exchange in the same category. The market rewarded firms for trading stock for potential insolvency.

But 3 observations:

1. From my perspective, you want to be an owner of common after, not before, the "solvency" trade occurs. And while you may miss the immediate "pop" on the news, from a risk/reward perspective, I think your odds of success are much better, as enterprise values should rise when solvency risk is reduced and investors turn their attention once again to future earnings potential.

2. Given how dour the market's mood was back in March, I think investors may, to James' point, have overestimated the risk of insolvency. But I would argue that we may now be overestimating its benefits of its "elimination."

And in that regard, I would highlight insider sales at Alcoa, and a second common stock offering by Simon Property Group (SPG). (And I give my "2-timing" award to SPG for issuing common stock both because it had to and because it was stupid not to, in a span of less than 45 days. (I suppose 100% appreciation will do that to you.)

But from my perspective we are celebrating survival to excess. And when I look at forward earnings projection and stock valuations I see much more risk than potential reward.

3. In the case of our largest financial institutions, I believe there is an enormous difference between solvency and a good common stock investment. Freddie Mac (FRE), Fannie Mae (FNM) and AIG (AIG) are all still "solvent," at least from a technical perspective. And I have no doubt, given the linkages among our largest financial institutions that even the worst of them will be kept "solvent" by the regulators.

But based on the existing precedence at the agencies and AIG, common shareholders -- and, I would offer, preferred shareholders and debt-holders -- need to recognize that only positive earnings and liquidity should form the basis for a financial services sector investment.

And in that regard, vis-a-vis the banks, I still have my doubts.

That's not to say, and to another great point made by James yesterday, there can't/won't be a euphoric melt-up along the way.
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