More on DFR

Ugly -- so the secular value investor decides to buy more DFR and within 24 hours he has already lost $1 per share or about 7%. The portfolio had a few other uglies like AB, Genvec (biotech), UEPS, Navteq and the energy related stocks. Bright spots included Asia, some of the lower beta stocks (FDS, LH, EPD, PEP, TECH, etc) and Illumina -- just got upgraded on Monday and reported after the close (next post). Overall, the portfolio was flat with the S&P 500 -- meaning down 2%, which means its still outperforming by 2.3% for the year.

DFR is a bet on management -- their ability to differentiate credit risks so that the portfolio is able to produce the kind of dividend income that will get the stock moving towards $30. Today they announced the dividend for this quarter will be 42 cents -- 3rd quarter in a row at that level but I am guessing they are waiting for high yield debt/loans to get more attractive before boosting their exposure to alternative assets and they are waiting for the deal to buy the management company to close before raising the dividend.

Was I early in buying more DFR? You betcha! Will I be vindicated in the future -- I expect to be but I expect the stock could see more pain before it gets better.

Right now DFR has about 25% of its equity invested in alternative assets -- mostly higher yielding areas like CDO's and high yield bonds. The management company's status as a manager of CDO's -- that's what makes up about 80% of their assets under management provides the source for the deals that DFR participates in. The goal for DFR's alternative assets is to reach 50% of equity or about 20% of assets. Once that happens the ROE potential will be higher and therefore the dividend potential is higher too.

Deerfield has a track record of managing credit risks that is very impressive -- I am betting that continues. If they suffer credit losses in either the mortgage portfolio or the alternative asset side, the dividend will be vulnerable and the stock will keep dropping. A rise in credit losses could also offset the expected increase in income from the higher percentage of equity invested in alternative assets -- meaning DFR's portfolio could complete the shift to 50% of equity being in alernatives and yet due to credit losses the firm could see the dividend remain at 42 cents. I do not believe that is likely.

One reason I like the deal to buy the management company is the potential for growth from new products -- Deerfield capital management develops a new fixed income product; they use the new product in the REIT -- the REIT provides seed money to build a track record for a new product. Over time the management company markets the performance of the new product and is able to grow client assets under management. This way the combined firm has a growth path to go along with the high yield.

DFR's stock is dropping in line with other financials -- including the banks, brokers and other credit related financials. To me that means the stock is not assuming a worse result -- there are no company specific issues that have led investors to question the company's future any more than they are questioning the future of all credit related entities. While today was ugly, I still believe the future is higher -- $20's.