The Smart Money buys Citigroup (C)

Citigroup (C), that once great financial supermarket, has fallen on tough times. So tough, in fact, that the company lost more than 90% of its value over the past couple of years. According to analyst estimates, this once great behemoth of the financial world is expected to earn just 2 cents per share this year, or just 2% of what the company made in 2005.

However, if you believe in following the “smart money” then now is a good time to pay attention.

Given the outlook described above, why are a select group of very smart hedge fund managers piling into the stock? The first real revelation that Citi was on the radar of big name fund managers was the announcement by John Paulson of Paulson & Co. that his fund held a position of over 500 million shares in the company. Paulson is famous for betting against the credit markets and various financial institutions, landing over $15 billion in profit and winning the prodigious award of “trade of the century”. The trade, by the way, was the subject of a very interesting book, The Greatest Trade Ever Made, by Gregory Zuckerman.

Paulson is not the only one who is betting big on Citigroup. Eric Mindich, another well-known hedge fund manager who runs Eton Park Capital Management LP, bought 138 million shares making Citigroup the largest holding in his fund. George Soros, of Quantum Fund fame, has just under 100 million shares in his pocket. Third Point LLC, run by Daniel Loeb, owns 25 million.

The big whammy, however, came just recently when Bruce Berkowitz of Fairholme Funds disclosed a massive position in the company. Berkowitz was recently named Morningstar’s Equity Fund Manager of the Decade, and has built up a tremendous record over that time, outperforming the S&P by 14% on an annualized basis since 1999. Berkowitz has bought 214 million shares valued at over $700 million. In a recent interview with Morningstar, Berkowitz explain his thesis behind the decision:

“In the U.S., this was not a bankruptcy, but it’s gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books. After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There’s been huge capital injections by the government. There’s been a massive amount of dilution to old shareholders. And you’re starting to see some stability, the beginnings. It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt. At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio. So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans”.

As far as the numbers and results go Citigroup is still very much a mess. It lost $7.6 billion in the fourth quarter mainly due to costs related to the exit of the U.S. government. The full year loss was just under $10 billion, compared to $21 billion in profits as recently as 2006. It was, however, a big turnaround from a $30 billion loss in 2008.

I often like to obtain investment ideas based on what those who have been immensely successful for long periods of time are up to. The quarterly SEC filings are a good place to look for such ideas. It’s very rare for so many big-name hedge fund managers to all be buying the same stock at the same time. What’s interesting to note as well is that they are all doing so with different investment approaches: Paulson is a trader, Soros is a hypothesizer and Berkowitz is a value investor.

It’s always important, however, to remember to do your own research when it comes to buying stocks. My personal feeling is that Citigroup is ingrained in the American and world financial system and is not going to disappear. In saying that there is a large speculative part to this equation which is why I myself do not own Citigroup shares (not at the time of writing, anyway!). Some analysts have also put forth their ideas that Citi may at some stage be broken up, the theory being that the company’s individual parts are worth more than the whole. Again, speculation.

From an expected value point of view, the reason in my mind these managers are buying Citi stock is as follows: Even though the probability of the value of the company declining is high, the low probability event of an increase in the price results in a much higher payoff. Simply put, as an approximation, there is an 80% chance Citi will decline by 20%, but there is a 20% chance the stock could double. In that case the expected value of the trade, given a stock price of $3.44, is (0.80 x - $0.68 + 0.20 x $3.44) positive $0.15.

And that, friends, is why we are seeing such big buying in Citigroup shares!