Wolf: A Tremendous Safety Net on Citi Stock

Ryan Leggio: Let's switch gears a little bit to another sector that's been in the news and those are the financial institutions--a lot of the big banks and smaller more regional banks have reported earnings over the last two weeks. You own a lot of different banks now, like a Citigroup, which you didn't own a year ago when a lot of your funds were kind of out of the financial sector. Can you give us your take on one, recent earnings: Are these good or bad? And two, how you're valuing these institutions now?

Joe Wolf: Sure. In order to own a financial you really need three things. First of all, you need a view on the trend in fundamentals, for us to own a financial; number two is that you need to be able to frame up downside, which is a function of framing up the draconian down case as it relates to the balance sheets; and number three is you need to have attractive valuations.

We've had that third bucket for a number of years. These companies have looked inexpensive; the problem is that we haven't had any visibility on one or two. In the last year or so, we've gained conviction that number one: fundamentals are going to be improving very materially for this sector. The balance of power has shifted from the borrower to the lender. You see on a company specific basis, companies doing the right thing. A lot of new management teams. A lot of cost-cutting. A lot of closing down of underperforming businesses, running off of bad businesses, etc. Return on invested capital is going to be improving very materially for this sector, and no doubt about it, in our opinion, credit is turning. If you look at any of the leading indicators of credit, we are in the process of healing, and so fundamentals to us in the last year have started to improve.

And number two; there has been a lot of capital raised in this industry, and so from a downside standpoint, we are now able to ring-fence the potential problems within these institutions and still be in a liquidity-strength position. The balance sheets are fine even under the stress-tested assumptions.

And so really for us it's not about just cheap valuations, it's about improving returns, being able to frame the downside. In the last 12 months, we've been able to get there, and they've gone from essentially owning no banks to now a fairly significant weighting in the spread-based businesses.

Leggio: And this is a long-term type of investment thesis for you. You're not looking for Citigroup to double in the next six months. I mean you're really betting on the business improving over the next couple of years.

Wolf: Yeah, our obsession is around understanding business value, and we always say that if you get the business right eventually you'll get the stock right. When you look at any type of normalized environment, normalized ROEs, normalized loan growth, etc, I mean these are assets that are worth two times plus what we're paying for them.

If you look at Citigroup, under our stress-case-tested scenario, you still probably have a book value of let's call it $6.50, on a $4 stock with a business that will have a trajectory upward in terms of returns: you just have a tremendous safety net here. We don't spend a lot of time on the upside, because if we're buying structurally improving businesses, and we've put our purchase price very close to our entry price – our safety net very close to our entry price, we're not going to lose very much money, and if we're buying a structurally improving business, in a lot of respects the upside will take care of itself.