Kyle Bass, David Tepper: Play ‘Less Bad’ Assets

In an environment of collapsing commodity prices, IMF sex scandals, U.S. government shutdowns (and associated budget deals and “not-deals”), and the recent death of Osama bin Laden, one may expect the global investing community to take an uncertainty-driven hiatus from the markets—at least for the time being.

Wall Street sign
Wall Street sign

Fortunately, Kyle Bass and David Tepper provide at least one good reason, and at least one corresponding method, for investors to stay in the game.

Recently, hedge fund magnates Mr. Bass and Mr. Tepper, the respective heads of Hayman Capital and Appaloosa Management, separately initiated bets on “less bad” assets—those assets which may be expected to see some cyclical improvement from a low base—as opposed to investing in those assets/markets which boast positive or favorable fundamentals, irrespective of outlying factors.

The release of Appaloosa’s most recent 13F on Monday revealed that in the first quarter 2011 (as of March 31, 2011) Tepper’s fund entered into 14 new positions, purchasing stakes in several refining equities, specifically in: Valero Energy , CVR Energy, Frontier Oil, Tesoro, and Holly Corp. , and in five homebuilders, including DR Horton, PulteGroup Inc., KB Home, Beazer Homes USA, Ryland Group.

Provided the 13F information and irrespective of whether Appaloosa currently holds the aforementioned positions, Tepper’s routinely macro-focused logic may seem rather obvious: buy the refiners (in 2011) to benefit from a cyclical recovery in US refining margins, despite lousy historical refining fundamentals; buy the homebuilders after lousy February housing data, as February’s extremely weak data —existing home sales and single family housing starts and permits were down 10 percent—rendered subsequent housing data disappointments increasingly unlikely (as investors became somewhat accustomed to low levels).

Separately, speaking from the SALT Conference in Las Vegas this past Thursday, Bass told CNBC that he’s betting on the preferred stock of Fannie Mae and Freddie Mac—the same two government-owned mortgage entities he has repeatedly criticized in the past.

In fact, less than 18 months ago on January 13, 2010 Bass gave the following testimony to the Financial Crisis Inquiry Commission:

“With $5.5 trillion of outstanding debt and Mortgage Backed Securities Guarantees, the quasi-public or now in-conservatorship Fannie and Freddie have obligations that approach the total amount of government-issued bonds the US currently has outstanding. There are so many things that went wrong or are wrong at these so-called GSEs that I am not sure where to start.”

Despite his negative view of the GSEs themselves, Bass said last week that he sees preferred stock in Fannie and Freddie, then trading at just $0.08 on the dollar, as a potential “eight- to ten- bagger.”

He explained that the GSEs are currently “profiting” before interest payments of 10 percent on the debt they owe to the US government; additionally, big tax-related assets could eventually be brought back on to the GSE’s balance sheets, and the GSE’s mortgage fees (for guaranteeing mortgages) should rise from 20 basis points to 60 basis points in the next few years.

(Translation: It’s unlikely that the government will ultimately bankrupt Fannie or Freddie— primarily due to the sheer magnitude of the GSEs, if nothing else—and the preferred Fannie and Freddie shares may ultimately be worth far more than their current value)

Some may attribute Bass’s and Tepper’s recent bets to the uncertain nature of today’s global marketplace, and to a lack of any definitively positive or constructive macroeconomic views whatsoever.

Others may categorize Bass’s and Tepper’s recent activities as mere functions of opportunity, and being “in the right place at the right time.”

Either way, the hedge fund managers’ focus on cyclical improvement underscores a broad-based, versatile method for investors with “best of the worst”-type outlooks seeking “less bad” bets.

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