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One Man’s Junk Is Another Man’s Treasure

Rational, unemotional investors create an orderly and efficient securities market. But sometimes fear takes over, buyers stop buying and the market malfunctions.

For daring investors, that’s when opportunities abound.

While many people ran from the carnage of the 2007-2008 credit crisis, some of the “smart money” wielded by institutional investors took advantage of the situation. If an investor can understand why certain markets are in flux and anticipate conditions that will restore order, he or she can realize outstanding returns. We have seen these opportunities before. However, buying an asset that most of the world is selling takes conviction and patience.

At the inception of the North American Free Trade Agreement (NAFTA) in 1994, the outlook for Mexico’s economy seemed bright. However, in short order, Mexican imports rose and exports declined, contributing to a growing current account deficit. Political tensions mounted, and interest rates on government debt increased dramatically, forcing the Mexican government to devalue the peso. Following that, Mexico was unable to maintain its exchange rate peg to the U.S. dollar, and the peso plummeted to a lower, market-driven rate.

Despite these conditions, Mexico was in fact a good long-term bet. The country was still sitting on substantial oil reserves, and letting its currency float was a smart economic reform. The United States and the International Monetary Fund (IMF) also provided $50 billion in loans. Nonetheless, many people lost confidence in Mexico and subsequently wrote it off as a viable place to invest. Mexican stocks dropped 42 percent in 1994 as measured by the MSCI Mexico Index.

But investors who bought Mexican stocks following 1994’s substantial decline were nicely rewarded. From Jan. 1, 1995, through March 31, 2008, Mexican stocks beat the S&P 500. The MSCI Mexico index returned 13 percent yearly, while more diversified Latin American funds returned 14 to 15 percent annually. The S&P 500 returned 10 percent annually over the same period.

The summer of 1997 is often remembered for the Asian financial contagion that swept from country to country. Over the previous decade, many Asian countries, including Thailand, Malaysia and South Korea, grew their economies at extraordinary rates, mostly through exports. This growth enabled governments to invest heavily in infrastructure and industrial assets. However, in early 1997, when two major Thai companies defaulted on their debt obligations, the Thai stock and currency markets went into tailspins. Lax financial oversight made matters worse. The major Thailand stock index, SET, declined more than 57 percent in 1997. Following Thailand’s financial collapse, other Southeast Asian countries saw their currencies devalued and their stock markets decline.

In 1997, the T. Rowe Price New Asia Fund, a diversified Asia-Pacific fund (excluding Japan), lost 37 percent. While Asian currencies and stock markets were declining, infrastructure improvements made during the boom years remained in place to help these countries recover. The IMF also organized a financial response that included $118 billion in loan commitments to Indonesia, Korea and Thailand, with assurances that financial sector supervision and financial risk management would improve.

In the years following the Southeast Asian crisis, investors experienced healthy returns in these once-battered economies. An investment in the T. Rowe Price New Asia Fund on Jan. 1, 1998, would have returned 14 percent annually, on average, through March 31, 2008, compared with the 4 percent annual return earned by the S&P 500 over the same period.

A common Internet bubble slogan was “clicks, not bricks,” referring to the advantage of having an online store in lieu of physical commercial space. In late 1999, Amazon.com’s market value ($25 billion) was more than 16 times greater than that of its direct competitor, Barnes & Noble ($1.5 billion). Nonetheless, revenue at Barnes & Noble was twice that of Amazon.com. Because of the clicks-not-bricks mentality, real estate securities, which own mostly commercial property, declined. In 1998, real estate stocks, as represented by the Dow Jones Wilshire REIT index, lost 17 percent. Well, as we all know, reality wins in the end. An investor who bought real estate securities following this decline was well rewarded. From Jan. 1, 1999, through March 31, 2008, real estate securities returned 13 percent annually, on average. The S&P 500 returned 2 percent annually over the same period.

Going short is another way to take advantage of non-functioning markets, but this is not for the faint of heart. Short-sellers profit from declining prices, but risk unlimited losses in the process, because even irrational market movements may persist longer than expected. Still, some well-known short-sellers capitalized on recent bubbles. One is hedge fund manager John Paulson, whose special credit funds increased 590 and 350 percent in 2007 after he bet on a subprime implosion. Paulson’s success came because, along with identifying the opportunity to short subprime, he figured out a way to implement his strategy successfully.

There are two ways to take advantage of market opportunities. The first, employed in all Palisades Hudson portfolios, is to regularly rebalance to a target asset allocation. This forces investors to periodically buy what has underperformed and sell what has outperformed. A second strategy is opportunistic investing. This requires some flexibility in asset allocation. We do not have a continuous allocation to special opportunities, because these situations are not constant. Therefore, we consider them for our clients when unusual events occur.

Today’s crises are in financial stocks, residential mortgage securities and certain types of loan instruments. Financial stocks declined 19 percent last year and were off an additional 14 percent through May. Opportunity? Some big investors think so. Earlier this year, as financial companies such as Citigroup and Merrill Lynch required capital infusions, a few institutional investors provided capital when most others would not. These investors, such as Korea Investment Corporation, Kuwait Investment Authority and the New Jersey Division of Investment, received attractive terms for accepting risk that others shunned.

Residential mortgage securities, tainted as they are, now may offer good value. Some of these investments offer 15 percent return potential, even when assuming a high default rate and a low recovery rate. A special situations investment partnership we entered last fall is a buyer. One deal is a joint venture with an independent mortgage products provider, in which the partnership has acquired pools of distressed subprime residential mortgages. The investment capitalizes on the extensive experience of the mortgage provider to perform due diligence and evaluate each prospective loan pool before acquisition.

Certain bank loan instruments also offer attractive yields after a recent investor sell-off of such debt. These non-investment-grade debt instruments are higher than stocks and bonds in the capital structure, increasing the likelihood of a full return of principal even if a corporation restructures. These loan values declined in early 2008 because (among other reasons) banks were trying to sell, but no one was looking to buy. The underlying companies that issued the loans were not necessarily in any financial trouble. But the banks, which at one point last year held $250 billion of these unsold securities on their balance sheets, desperately needed to sell.

Sniffing an opportunity, Apollo Management, TPG and The Blackstone Group in April acquired $12 billion of these leveraged loans and bonds from Citigroup as it sought to reduce its exposure to non-investment-grade debt. The triumvirate paid approximately 90 cents on the dollar for these loans. As the leveraged loan pipeline clears, loan market prices will return to a normal level.

Experience tells us that crisis creates opportunity for those with strong wills and appetites for risk. The right managers will know how to exploit these opportunities.

ReKeithen D. Miller contributed to this story.

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.