What to Do When You Can't Analyze a Company
By Graham Summers
August 8, 2007

Gail Seneca just got taken to the cleaners.

Seneca is the founder and chairman of Luminent Mortgage Capital (LUM), a Maryland-based, mortgage-backed REIT. She founded the company in 2003. From 2003 to 2007, she served as LUM's CEO.

Simply put, no one on earth knows more about LUM's business than Gail Seneca.

So if you saw Seneca loading up on shares of LUM's stock, you'd think big gains were on the way. At least that's what I thought when I saw Seneca purchase $126,000 worth in May 2007.

Seneca's purchases occurred at around $7 a share, bringing her total holdings to more than $4 million of LUM's stock.

And in the last two days, Seneca has lost $3.6 million. On Tuesday, LUM discontinued its dividend and warned that it may not be able to cover its margin calls. Shares fell 90% on the news.

Seneca is just the latest in a string of insiders and other savvy investors who have gotten cleaned out by the collapse of the mortgage lending industry. That all of these people lost money just offers more proof that the lending industry is so opaque even corporate insiders don't know how much the assets they own are worth.

Consider hedge fund legend David Einhorn.

Since 1996, Einhorn has shown investors an average annual return of 28%. But even his investment acumen and connections didn't stop him from losing more than $102 million on subprime lender New Century's stock. Einhorn wasn't an outside investor either. He served on New Century's board of directors!

The credit and lending industries have never been particularly transparent – for one thing, just how do they calculate our FICO scores? Over the last 16 years, loans of various degrees of risk have been packaged and repackaged into derivatives and derivatives of derivatives until it's virtually impossible to gauge what the assets are worth these days.

And that's making analysis of companies that own these assets impossible.

When the people who run these businesses are losing their shirts by buying their own stock, you know the cards are stacked against the ordinary investor. How are you or I to accurately and safely invest in these companies when the people who founded them don't even know what their businesses are really worth?

The answer is, we can't.

Analysis is useless if a company's assets experience a massive downgrade. Standard and Poor's recently cut the credit rating on 418 mortgage-backed securities worth an estimated $3.8 billion from AAA to BBB. In an instant, any analysis of the companies owning these securities was rendered moot. It's as if you bought a car that was certified as mint condition and then had it break down the moment you got it off the lot.

Insiders aren't the only ones getting it wrong. Investing legends David Dreman, Arnold Schneider, Wally Weitz, Brian Rogers, Richard Pzena, Charles Brandes, and others have all seen their holdings in mortgage-lending stocks evaporate.

Simply put, when the insiders get it wrong and the legends get it wrong, it's best to stay away from the sector completely. My advice is to avoid any and all businesses involved in lending right now. The rewards aren't worth the risk. Everyone including the people who run these companies is getting taken to the cleaners. Preserve your capital and wait until the fireworks are over.

Good trading,

Graham