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Edgewood Management Company

VIEW FROM EDGEWOOD



ECONOMENTS

Edgewood Management LLC
October 3, 2008

The View from Edgewood

We are looking forward to the moment when we can write about something other than the credit crisis and stratospheric oil prices, but it looks like that time will not be for a while. Most analysts, including us, thought that the financial sector would be stabilized by now. While we still believe that the low point was the Bear Stearns bailout in March, the group still seems to be oozing bad news. The equity prices of many large financial institutions are down over 50% and some have seen another round of declines in the last two weeks. An ETF that tracks the S&P 500 financial sector is down 25% so far this year. Some large institutions like Merrill Lynch and Citigroup may have to raise additional capital after feeling confident three months ago that they had finished shoring up their balance sheets. In contrast some other large banks have painfully digested most of their bad loans and have at least stabilized their portfolios. The larger question is the long term prognosis for investment and commercial banks. How much increased regulation will be forthcoming and how will it affect the banks ability to take risks to produce interesting returns? We have serious questions whether many of these institutions will be called growth stocks for quite a while.

In the not too distant future our grandchildren will read about this period as an historic turning point in the economic history of our country. The upheavals in the financial system, the disappearance of commercial banks, investment banks and insurance companies that seemed rock solid, have produced a stunning amount of change. Until recently the Treasury Secretary, Henry Paulson and the Chairman of the Federal Reserve, Ben Bernanke have been fighting individual fires. While the Bear Stearns rescue in March seemed large at the time, in September alone the nationalization of Fannie Mae and Freddie Mac was followed quickly by the failure of Lehman Brothers and the government loan to the insurance company AIG. After the Lehman bankruptcy the Treasury decided it needed a strategic response.

The events of the last fifteen months have reminded us that much of the financial system is based on a rather tenuous trust that takes a long time to create and a short period to disrupt. There is little doubt that trust in the system needs to be rebuilt, how long that takes depends on how quickly the banking system can be stabilized. The Paulson plan has been called a bailout of Wall Street. We see it as a bailout of the U.S. economy, by investing in what have become illiquid securities. Commercial banks need to find a value for the mortgage issues they have on their balance sheets. The Treasury plan should establish a market price and allow banks to convert these frozen assets to liquid capital. This will allow banks to begin lending again; to other banks, to businesses and to individuals. The fiction that somehow this is solely a Wall Street problem is being rapidly dissipated as the unemployment rate rises and Main Street sees business activity slow.

Ben Bernanke is one of the foremost economic historians on the Depression and he is fully aware of the mistakes that took an economic slowdown in 1929 and created an economic disaster by 1931. He responded a year ago by beginning to aggressively cut interest rates. The Federal Reserve on several occasions has provided excess liquidity to the financial system; these are opposite to the actions taken in 1930-1933. There is still an excellent chance that the policy actions of the Federal Reserve and the Treasury will help us avoid a deep recession.

The financial landscape will be changed not just by the liquidation and consolidation of large institutions, but the inevitable changes in regulation that are to come. The change in government next year will usher in years of hearings, subpoenas, indictments and regulatory overhaul. Democratic or Republican administration, the public will demand its pound of flesh for what is perceived as excessive greed in the financial sector that led to a painful recession in the economy.

After struggling for the first eight months of the year the ground fell out from underneath the stock market in September. A combination of part four of the credit contraction saga and increasing signs that the economy is slowing dramatically led to a decline in commodity prices. A strong possibility of an increase in hedge fund liquidations began a surge in stock sales that intensified as the month’s events in the financial industry played out. The stocks being sold were in most cases the largest and most liquid and those that had been the best performers to that point in the year. We expect that when the market reverses, stocks with consistent growth rates and available liquidity will be the first to rally.

Our portfolio sustained its share of damage in the late September selling. We have made some changes: lowering our financial services exposure a bit more and taking advantage of the steep decline in Monsanto to begin a position. We believe that during earnings reporting season, which begins a bit later in October, the majority of our portfolio companies will report in line better earnings. Their forecasts for the next six months will be very important. They are all highly profitable, cash flow positive, generating healthy free cash flow, and with strong balance sheets. In this environment with almost frozen credit markets they have a great deal of financial flexibility. Our portfolio companies should be able to show solid growth barring a deep recession and that will make them additionally attractive in what could be a slow growth environment over the next several years.


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