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By Jason Stipp | 10-13-2011 11:12 AM

Forester: Why Europe Is Contagious

Forester Value manager Tom Forester on how Europe's woes could become America's headwinds, and how he's positioning his portfolio in response.

Stipp: Another concern that's obviously buffeting the market back-and-forth is the ongoing drama that's unfolding in Europe. When you look at the European situation, is that a concern for you as far as even domestic holdings here in the U.S.? Should investors really have this keenly on their radar?

Forester: Very much it's a concern for us. My concern was always, if the global banks get in trouble, then all bets are off, and you are seeing the global banks getting in trouble.

You've got a Europe where it's different than the United States. In the United States, you've got one Federal Reserve that if there was a bank in California or a bank in New York that gets in trouble, you've got one group that's going to take care of it; in Europe, you don't. You've got 17 countries or whatever they're up to now, the main countries, and they all have to kind of agree on what you have going forward.

So, you've got a Greece issue, which kind of had a band-aid put on it last year, and now that band-aid has come off. The issue isn't really Greece, because Greece is only 2% of the economy. If that goes away, it's not the end of the world for Europe. But the problem is that, the German and the French banks all own the Greek paper. Back in July, in the private talks that you never see in the media, but you just hear rumors about, the talk was that they would take a 21% haircut on the sovereign debt. Now that talk is up to 50% and there are rumors of 60% or 70%.

So, the problem is, you've got very leveraged French and German banks, which really kind of control the growth, if you will, of Europe, that are very exposed to this. So, as you start ratcheting up the haircut that they have take on this debt, that creates losses for them, it lowers their capital, and then, you have to either raise new capital or shrink the balance sheet. If you shrink the balance sheet, there's a lot of people out there who aren't going to be getting debt. It will get made up somehow, but you're going to raise the cost of all debt, or people just aren't going to get it--it's one of those two.

I was speaking to the CEO of BNP, which is Banque Nationale de Paris, a few weeks ago, and their plan is to shrink the balance sheet. So, they're looking at a 5% shrinkage on their overall assets. So, $2 trillion in assets, they'll probably shrink it about $100 billion. And ... you like to see banks growing, that's monetary policy, that's what we're trying to get done in this country, so imagine if all our banks were trying to shrink 5%. You'd probably see GDP down, probably 3%.

So it's a big issue over there, and then bringing it back to the states, all our global banks do business with them, and so they are counterparties, if you will. So there's contagion risk there with us.

The other side, though, is that these guys right now are really having trouble getting U.S. dollar funding, and so the money markets have shut off a lot of the European banks, and so they are in a position right now, they don't want to sell equity because there is huge dilution, because they are trading at about 60% of book. So they don't want to dilute their current shareholders. So what they're trying to do is shrink their balance sheets, and the problem they are having is with dollar ... liabilities, so they end up selling dollar assets, and those assets tend to be prime mortgages. There's a new index out call PrimeX from the Markit group, they used to have the subprime mortgage indexes as well. So it's a new one, that's been falling recently. And the idea, some theories are that that's the European banks selling off U.S. assets to offset the loss of U.S. funding, and so that's how it impacts us and the assets in our country.

Stipp: So it sounds like also, from what you're saying, that the impact is beyond banks at this point if there's less lending. That's a headwind to economic growth generally. So when you think about that in terms of your portfolio, are you trying to get some sort of explicit positions based on what you're seeing in Europe? Are you just thinking generally this could be a big slowdown and I want to position for what could be a broad slowdown?

Forester: We have been expecting a slowdown. We think that the impact of Europe raises that bar. We think there will be even more. Because now if you didn't have a lot of debt with the European sovereign countries, they could take on debt, handle this problem, we move on. No problem. The problem is that most of these countries have at least a 120% debt to GDP. Germany I think is 80%. France is 80% to 100% range, and so there's not a lot of headroom for these guys. At about 100% or 120%, people say no more, as you can see in Spain and Italy, and your rates start going through the roof, and now you don't want new debt because it's too expensive to pay the interest on.

So it's difficult for them to deal with this, and so what they end up having to do is cut their budget. Well cutting government spending, obviously slows things down, so you get a slowdown in Europe. If you look at Alcoa, which just reported earnings yesterday, one of the soft spots was Europe, because it's slowing down. That impacts a lot of the global companies here. In our portfolio, we will probably have some headwinds with some of our global names. That's an impact on the U.S. But you're also starting to get a slowdown here in the U.S. as well.

Stipp: So, it sounds like the fundamental issue of potential slower growth or possibly no growth in some cases in earnings, but what about the valuations? So as you're looking out there in the market, as you are looking at the companies in your own portfolio, are these concerns priced in or do we also have price risk that we need to worry about?

Forester: Well, we think that stocks right now are fairly valued. We don't think that they are exceedingly cheap, where it can take a big drop in earnings, but we think they are reasonable at this point. And so ... then you start looking at, OK, where do you think earnings are going to go? So far, we will see this quarter, we will see where people guide, but Alcoa came in light. JP Morgan announced a $0.10 beat today, but they had $0.29 of a debt valuation, you know, a thing that they added so. I don't really count that, so I look at that as they missed, and indeed the stock was down 5%.

So, we think that you're going to see headwinds in earnings, so that makes us cautious. So, we're going to be a bit more defensive with the portfolio when that happens. So, right now, the S&P has about maybe 15% in ... financials, we're about 7% financials. So, we are underweight. If you look at the value index, it's more like 20%, so we're very underweight there. We only have one bank in there left that we've hung on to; it's U.S. Bank, which is one of the higher-quality names from a credit standpoint.

So, we've tried to reduce our exposure to the highly leveraged side of financials, which are the banks, and move into more shorter-term property/casualty guys, which don't have as much credit risk, don't have as much interest rate risk implied in them.

Stipp: What about your cash stake. Has that moved at all, has it gone up if you have some concerns out there?

Forester: We have raised cash in the beginning of August. We raised it up another 5%, so we are up to like 23% cash right now. We've also added some puts, which provide good downside protection if there is a large move down. At the same time, if there's a big move up, those tend to roll-off pretty fast, so you don't lose too much on that.

So, we think it's a good way to protect downside, protect capital, but at the same time participate quite well on the upside if the markets take off.

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