BARRON'S: Banking On Ag And Gas: Wake Up! The Economic Recovery Is Real, Says Th

An Interview With Jeff Gendell

The economy is in full recovery, the market is acting rational and all is

right with the world in the view of Gendell, the man behind the curtain at

Tontine Associates and the $600 million it manages in two hedge funds, Tontine

Partners and Tontine Financial Partners. Seeing things that others plainly miss

or misinterpret is a hallmark of this Wall Street wizard, the former head of

equity investing at Odyssey Partners, where he worked for much of the 'Nineties

before opening his own shop in 1997. It's the reason Gendell delivers strong,

market-beating returns year in and year out. His Tontine Financial Fund finished 2001 up 40.4% after fees and is up 33% after fees so far this year. Tontine

Partners gained 21% in 2001 and is off 6% this year, hurt by lackluster

performance among his favorite group, the homebuilders. When we rang him up a

few weeks ago, he graciously put aside the latest issue of Render Magazine and

the latest news on recycling animal fats and bones to talk to us. For what's on

his mind, please read on.

-- Sandra Ward

Barron's: You're extremely bullish. Why?

Gendell: This recovery, in my view, is no different than any other recovery.

If you have been asleep for the last five years, wake up. If I told you that

interest rates were 1 1/4%, GDP growth is 3% to 4%, the CRB (Commodity Research

Bureau Index) is rising to new highs and inflation is 2%, you would probably say

the market multiple is 30 or 40. I have never seen so many people whining about

a recovery with GDP growth at 3% to 4%.

Q: So why is the stock market still stumbling?

A: There are two things that are happening: One, this market has become the

Ohio Art Market.

Q: As in the company that makes the Etch-a-Sketch? Explain that.

A: The Etch-a-Sketch analogy is based on the fact that there is a lot of

marginal trading being done on a day-to-day basis by people that go to bed at

night without any ideas in their head. They are blank screens, and the first

story they hear is the story of the day and they trade on it. Everybody keeps

focusing on bad news everyday. They don't realize that all the recoveries in the

past 22 years -- since I've been in the business -- have all looked like this.

It takes 5 or 6 months before anybody believes the recovery is real. The other

problem, and it makes this recession a little bit different from others, is that

it is hitting people east of the Hudson -- and the Northeast is where the money

is managed and the media is based, and so things seem worse than they are.

Q: So the market is stronger than it seems?

A: The market is acting in a very, very rational way. It reminds me a lot of

1982. In 1982, you had a big move in August that no one believed the whole way

up, a 30% or so rally that started the great bull market.

I'm not going to say this is the great bull market, but this could be the bull

market that is the opposite of the last bull market. In 1982, oil prices were

high, interest rates were high and you started a whole reversal of probably 13

years of higher commodity prices and higher interest rates. Now, interest rates

are troughing. Commodity prices are probably going to move up higher. You see

new highs in the CRB. Contrary to popular belief, you have a lot of commodities

that are very capacity-constrained. And these aren't everyday commodities that

analysts talk about.

Q: Such as?

A: Agricultural commodities. Grains and worldwide commodities. Cocoa and

coffee have all doubled in price this year. All the analysts that followed these

kinds of commodities were fired 10 years ago, so no one is noticing.

This could be a wonderful period for the hinterlands of the United States. We

love the agricultural business. We would be very long all the ag companies right

now. The market caps on the companies we are looking at are so small I can't

really talk about them here. But some of the bigger companies, like Deere and

Agco, have done very, very well despite a very weak stock market. There are a

lot of equipment companies that have done surprisingly well, companies like

Valmont Industries, which makes irrigation equipment.

As corn prices go up and as grain prices go up, not only will companies do

better but people are going to be surprised by how much this could help to

reduce the government deficit -- because the transfer prices are not going to be

nearly what people expect going forward.

Q: Transfer prices?

A: Subsidies. If corn doesn't hit a certain price, if soybeans don't hit a

certain price, if wheat doesn't hit a certain price, the farmers get a subsidy.

As a way to take advantage of the agriculture trend, we've been buying shares in

all of the $500 million-to-$1 billion banks in Iowa and South Dakota.

Unemployment is shockingly low in those states and this is after a 5-year

downturn in the agricultural sector. It might be because everybody left, but the

Iowa banks are very, very well managed.

If prices go to where we think they will go in the ag business, you are going

to start seeing loan demand. You are going to start to seeing margins improving.

It's similar to what we did 1 1/2 to 2 years ago: When coal prices went up we

bought all the banks in West Virginia and that turned out to be a great thing to

do.

Q: Are you seeing business spending picking up?

A: We have the advantage of talking to numerous small banks every week. These

people are in the middle of Kentucky, Nebraska, wherever. They are probably more

bullish on the economy than they've been in two years. A lot of these guys

started turning negative in the fourth quarter of 1999 and the first quarter of

2000, primarily because they saw the boom in spending stopping, the whole

technology boom slowing down.

Q: How would small banks be on the cusp of that?

A: The people we talk to are less affected by tech spending in its entirety,

but a lot of their businesses were capital constrained as a result of the

fallout in tech. Now the Fed is out there increasing money, and after a couple

of years of no spending, all of a sudden these companies are spending, because

the GDP continues growing at 3%. Everybody talks about Cisco all day long, but

Citigroup's earnings this year will be basically the same as Cisco's revenues.

To me, Cisco is an irrelevant company in relation to GDP. It is something

everybody talks incessantly about, whether its quarter is going to be up, down

or whether its order flow is up or down. The whole economy is really big, who

cares how big the telecom sector is? If the telecom sector drops 50% nobody

would really notice it on a revenue basis, especially if the rest of the economy

is growing at 3%, because it is such a small segment of the economy.

Small banks are seeing signs of improvement because unemployment is still low

and that is probably the No. 1 impact. If you are somewhere in South Carolina

where unemployment has been 9 to 9 1/2% and all of a sudden it starts falling to

8 to 8 1/2%, you start noticing the difference.

Q: Has it been that dramatic?

A: In a lot of the country, yes. There again, if the unemployment rate in this

recession peaks at 6%, that is going to be the lowest peak of unemployment

basically in any recession in this country's history. There are signs that

employment is picking up. There are also a lot of signs that companies are still

cutting back people. But if you look at who is cutting back, the Lucents, the

Cornings and so forth, they are cutting back fives and tens of thousands of

people in a sector that probably grew to a level it shouldn't have in the first

place. These people will find jobs, they are just going to have to lower their

expectations on the kinds of jobs they look for. Many people are employed;

people are fairly confident. The decline in the confidence numbers is really

connected to the stock market falling and world terrorism, and it has less to do

with the economy.

Q: Are you still betting on energy stocks?

A: One of our big disappointments this year has been our energy stocks. When

we talked a year ago, I told you we expected to see natural-gas prices over

$3.75 mcf [thousand cubic feet], and here they've been over $4 for the last 5

months. It seems no one is really paying attention, or they think the higher

prices are the result of dislocation in the energy market stemming from Enron.

Everybody is pointing to Iraq, pointing to this or that and saying that prices

are going to come down, but production is down year-over-year and if we're in a

recovery mode for the next 2-3 years, we are going to see pretty strong growth

in consumption.

You want to be long natural gas. Clearly terrorism is a risk here, and clearly

Iraq is a risk here for the whole market. But if the Iraq situation settles

down, oil prices are probably going to go down. We were long some of the

refiners earlier this year and we just gave up on that because they didn't have

the liquidity, and people just didn't care.

In this Ohio Art Market, you want to own these things a month before they

happen. When the Iraq situation settles out and they punish all energy stocks,

the refiners will probably be our first sector to go back into. Until then, we

want to be long gas, but there are not that many names to own with that much

leverage. We own the very small ones, but we are also still long Apache and

Chesapeake Energy.

Overall, our gas names have been somewhat disappointing, but you have to be

very patient on the price performance, because people won't really realize what

is going on until the quarterly earnings are released.

Q: What about coal, which you've also liked in the past?

A: We've reduced our coal holdings once again. Coal is a fabulous 5-year

story. Since that's the case, we can wait three years before we buy them. We

reduced our position in the summer when we realized that even with gas at $4

mcf, people were not going to care. It is kind of like when I turn on Brady

Bunch reruns for my kids and they look at me and say `Dad, it's really not that

funny.' We are sitting here cheery that gas is over $4 mcf and the market looks

at us and says, `so what?' The gas companies are all going to beat their

earnings estimates, but the market doesn't care.

We have also started focusing on oil-service companies, realizing production

is down in the gas sector and that all the companies are surprisingly cautious

on drilling because of the Iraq uncertainty. They've also become more cautious,

hoping to dispel the idea they aren't good allocators of capital. In the old

days, they never saw an oil well they didn't like. And they would have been more

than happy to drill a wild-cat well 18,000 feet deep. Now they are all being

very, very cautious. They are all hedging more. Many more have sold forward than

in the past. You still want to own all of them, because nobody has hedged out a

great portion of the gas. You are going to see massive debt paydowns in this

group. And, again, gas is going to be a lot higher than people expect.

Q: So what do you own?

A: We didn't really want to be that smart, so we bought the Oil Service HOLDRs

Trust, the OIH, which is an exchange-traded fund and is an easier way of playing

it. It is a fairly liquid way for a firm as small as us to play the sector. This

way, we don't have to worry about the Halliburton asbestos situation. We don't

have to worry about Schlumberger's high-tech business versus their oil-service

business. [Last week, Schlumberger said it would take a $3.17 billion charge to

writedown its technology business.] We don't have to worry about offshore

drilling versus onshore drilling. All we know is that there is going to be a lot

more drilling in the next 24 months for gas and that prices are going to stay

over $4 mcf. In the next 36 months or so money will start to be directed to

those companies and industries that have been underfunded for the past 20 years.

Another way to play natural gas is again through small banks, much as we're

doing with the agricultural sector. Two years ago when we talked, I mentioned

Iberiabank, which is a very well-run bank in New Iberia, Louisiana.

If gas prices go up, there are going to be more oil-service jobs. There will

be more income for people that live there. You are starting to see deposits go

up at all the banks there; these are not people who play the stock market.

Iberia is a $1.6 billion bank and will earn about $3.30 a share next year. It's

not a steal here at $38 a share, but it's still very cheap at less than 12 times

2003 earnings and it's big enough for people to buy. A lot of the bank stocks we

own have under $500 million in assets and market caps of under $100 million.

Iberia just agreed to buy Acadiana Bancshares of Lafayette, a $325 million bank

that's bought back 60% of its stock the past four years. My whole point is that

you can take one town like Lafayette, where you can find four different banks,

all well run and deposits rising at all four, and find tremendous merger

opportunities.

Q: That's a nice segue to talk about financial stocks. What do you make of the

HSBC-Household deal?

A: The biggest impact, one that will be monumental, is that $20 billion of

debt will likely disappear from the bond market if HSBC takes Household

International's debt onto its balance sheet. Why pay 4% to 5% for money when you

can earn 1 1/2% on it. So the deal does two things: It allows HSBC to make a

tremendous spread on its deposits by buying Household's assets and it takes the

pressure off the bank to make new loans. This purchase alone probably gives them

one to two years of asset growth. The capital discipline in the banking industry

is greatly underestimated. Something that's gone unrecognized is that the second

and third quarter of this year were the two of the most profitable quarters in

history for banks in this country by wide, wide margins. Last quarter, the

return on assets for commercial banks rose to 1.37%, up from basically 1.2% a

year ago.

Q: So why will HSBC-Household be monumental for the bond market?

A: When the deal is completed it will result in a major, major turn in the

corporate market. All of a sudden, a $20 billion-plus borrower in the bond

market disappears forever. This will be as monumental an event as maybe the Penn

Square or Bank of New England bankruptcies in terms of marking a bottom. Spreads

of double-BB rated companies over Treasuries are at record levels. When this

acquisition is completed you are going to see those spreads tighten

dramatically.

The big trade to be made is buying strong double-BB credits and shorting

Treasuries, because there is an economic recovery and you are going to have a

corporate bond market that just feels better, and people are going to be willing

to take more risk in bonds. You will also see other banks go into the market and

buy other commercial lenders -- companies that can add to their capacity at very

low cost.

Q: What's the time frame for the turn in the bond market?

A: It will play out over the next 90 days, because the HSBC-Household deal

should be completed somewhere between March or April. We should get a sense of

whether the regulators are inclined to approve it in the next 30 to 60 days. A

lot of people are speculating the deal falls through, though I think it will

happen. We bought a lot of shares in both companies after the deal was announced

because it seemed people didn't understand its value. We own more Household

because it trades at a huge discount to its deal price. We expect the arbitrage

gap to close dramatically. When people realize what the earnings growth at Hong

Kong Shanghai will be as a result of buying Household, HSBC shares will trade at

much higher levels once the deal goes through.

Q: What kind of impact is Eliot Spitzer likely to have on the banks and

brokers?

A: The Eliot Spitzer investigation is probably the best thing that ever

happened to the brokerage industry. It will be the most positive thing for the

brokerage industry since 1974, when they ended fixed commissions. It gives the

brokers a reason to cut a lot of their people and therefore a way to cut

expenses.

Usually when politicians get involved, it has an effect different from the

intended consequences. I am not saying what he is doing is right or wrong,

because there's clearly been a lot of wrongdoing going on with the whole

underwriting process. But the flip side of this is that it is going to keep a

lot of people from going into the brokerage business. The whole compliance issue

is going to be mind boggling. You'll see an incredible number of people leave

the business, a lot of small regional research firms, for instance.

The compliance and regulatory aspect is going to be so onerous. We see this in

our small banks. At small banks, the $100 million to $200 million banks in

Nowheresville, all of a sudden their board members, who are 75 years old and

have been on the board for 40 years, are at risk in signing off on their

financials. Consolidation in the whole financial-services industry will

accelerate here because of this. We've already started seeing it among the small

banks. This has been a banner year for small bank consolidation. You are going

to start seeing companies like Citigroup, as soon as they get out of this

regulatory bind, buying up retail banks because banking spreads are terrific and

I think there are a lot more willing sellers.

Q: What about on the brokerage side?

A: You'll start to see companies getting out of the brokerage business.

Prudential has made it known that they want to figure a way to monetize their

brokerage division. And Canadian Imperial Bank of Commerce is selling its

Oppenheimer brokerage to Fahnestock Viner Holdings. The brokerage consolidation

will take place.

Q: Are you still a big fan of the homebuilders?

A: About 40% of our fund is in housing stocks, up from about 25% last year, so

we've made a big commitment to them. Centex is the cheapest stock in the S&P

500. The stock is going to earn $9 a share and has the best management, and it's

trading at 5 times earnings. Why would I buy another stock?

The big builders are crushing their competition even more than I would have

expected with their higher credit ratings. Other homebuilders can't compete and

you will see continued massive consolidation. But clearly, the next move has to

come from the companies themselves. Centex is far and away our favorite stock

and we expect it will get so frustrated with its stock price that it will decide

that buying back its stock at 5 times earnings is better than building new

homes. When you start to see more aggressive buybacks from any of them, I would

buy them. We also own Pulte, KB Home and Ryland.

Q: Are you short anything?

A: We are short gold stocks. We think they have little value. We think the

asset values are below the stock-market values. If you look at a company like

Newmont Mining, with gold at $310 an ounce, there is really no positive cash

flow.

Q: Thanks, Jeff.

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