The Gannon Report

As you know, financial markets in the United States and in a number of other industrialized countries have been under considerable strain since late last summer. Heightened investor concerns about the credit quality of mortgages, especially sub-prime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for the economy, have also roiled the financial markets in recent months.
- Federal Reserve Chairman Ben S. Bernanke before the Senate Banking Committee on 2/14/08

Chairman Bernanke's words weren't much of a Valentine for investors hoping for rosier news about the economy. If anything, his remarks constituted a variation on the theme that subprime fallout continues to unfold in a dramatic, if not destructive, way. The housing bubble has burst, and as a result the  economic conditions that inflated the credit bubble have seemingly changed for good. In addition, economic growth is slowing, credit conditions have tightened, and many non-commodity asset prices have fallen, with the Federal Reserve easing aggressively to offset further downside risks.

From our perspective, the post credit bubble environment is going to be quite difficult. The days of easy credit are long gone, which is especially troublesome for companies who need access to credit to finance their growth.  Quality companies with solid balance sheets and low leverage will most likely have a distinct advantage over firms with weaker balance sheets in gaining access to the credit markets during this period. We believe that balance sheet focus, specifically on companies with low leverage, should be an enormous benefit in this environment. Rather than concentrating primarily on long-term debt, we search for companies whose balance sheets show low leverage. We measure leverage more broadly by looking at the ratio of assets to stockholder equity.  Using this method allows us to note changes in long- and short-term debt, as well as in accounts receivable. This exercise is particularly critical in the current period, as tightening credit conditions are affecting all areas of borrowing.  This type of examination paints what we believe is a more complete picture of a company's financial well being. Financially strong companies are better positioned to grow over the long-term and navigate any short term squalls.

In general, our concerns over balance sheet and valuation quality have led us to mostly avoid, or at least underweight, certain industries within the financial sectors over the past few years, such as banking and specialty finance.  Now, even amid considerable share price declines, our preference for companies with little leverage on their balance sheets has continued to keep us on the sidelines in many financial areas, at least for the moment.  Of course, certain businesses within the finance industry remain of interest, such as investment management, but these areas have been mostly untouched by subprime contagion. Meanwhile, it has been nearly impossible for us to establish a thorough understanding of downside risk for many other financial companies due to our ongoing concerns about their balance sheets.

Stay tuned…
FDG