Author: Mark Holder, Stone Fox Capital
Covestor model: Opportunistic Arbitrage
Prior to its collapse on October 25-28, MF Global (MF) appeared to be an excellent candidate to take market share in the financial sector. MF was already a respectable commodities trader and primary broker dealer. On top of that, it hired prominent figure John Corzine with experience at both Goldman Sachs (GS) and the political arena to expand into the investment banking sector.
The combination provided a catalyst for a what could have been a game changer. Unfortunately, the concept completely collapsed as MF couldn’t handle the high leverage of European sovereign debt. I believe this debt will eventually payoff as expected, but it unfortunately scared the market into a panic. Lesson revisited: perception trumps reality – at least in the short run.
On Monday 10/24 I wrote about the thesis for buying into MF prior to the earnings report, and even after.
At the time, the trade seemed to have a good risk/reward thesis. The stock had already been cut to half of book value. Unfortunately, it didn’t work out for investors.
As mentioned in my original write up, only half a position (actually closer to a third) was purchased, as the risk was extremely high. This greatly reduced the exposure even in the case of the collapse.
The Jefferies (JEF) news last week further highlights this concept of perception versus reality. It came to light that JEF has exposure to European debt, and investors panicked. It doesn’t appear to matter whether the debt is from Italy or Greece, or whether it matures in six months or six years, or whether JEF has short positions to hedge the longs. The market doesn’t appear to care. In this environment, European debt of this sort is deemed worthless – though most of the countries involved won’t ever come close to defaulting.
This leads us back to our trade made last week. MF was plunging based on what appeared to me to be overstated fears. Sure, MF had a ton of leverage. Sure, MF had exposure to debt from Italy, Spain and Portugal. The debt, though, has an average maturity of 12 months. Anybody expect Italy or Spain to blowup in the next year? Greece was worse off 12 months ago than Italy is now and the Geek debt hasn’t defaulted yet. Close, but not yet.
The Opportunistic Arbitrage model is very risky and these trades don’t always pay off. This might go down as the quickest blowup in my investment career. Yet, by limiting position size it didn’t have a major impact to the model. It still gained 47% in October, and as of end of day 11/3 has gained 3.4% in November so far (details here).
Ultimately, the outcome was unfortunate, but nothing devastating. Other blowups will occur in this model, but the key remains to stay diversified so that any one such event doesn’t destroy the model.
Disclosure: No remaining positions
