In a recent edition of Value Investor Insight, GoldenTree Asset Management's Steven Tananbaum and Kevin Feder described an opportunity to profit from Principal Financial Group's (PFG) exposure to a weakening commercial real estate market. Excerpts follow:

You invest at all levels of the capital structure – are you limiting equity downside by avoiding equities altogether?

Steven Tananbaum: A lot of our risk management is just portfolio management – we move our weightings in various asset classes around based on the opportunity and risk we see in each. We currently have about 10% of assets in equities, which is on the low side. We think in various sectors of the credit markets – like bank debt and some asset-backed securities – you’re getting 75% of the return potential of equities, with twice the protection against downside. We also are an equal-opportunity short seller. We’ll do single-name shorts and index shorts, in equity and credit markets. Often we’ll do paired trades across asset classes. Right now, for example, the bond market is saying something materially different than the stock market about the prospects for monoline insurer Assured Guaranty [AGO]. The bond market seems to believe there’s no business there, while the stock market says there is. We’re long $2 worth of the bond and short $1 of the stock.

How often do your short ideas involve potential fraud?

ST: Rarely. That’s a function of there being many more companies whose business models aren’t working than those engaged in fraud. We’re much more likely to find opportunity when industry structures are changing for the worse or earnings expectations have gotten unrealistic.

In the recent public disputes between short sellers and companies, those who short are typically made out to be the bad guys. Do you think that’s fair?

ST: Short sellers play a valuable role. There are obviously cases where people may try to start rumors more than anything else, but that’s as true on the long side as on the short side. Markets work better when both sides of the trade are heard.

I’d add that in almost every case I can think of when a company has taken on short sellers in a public way, bad things have ended up happening to the company. Prem Watsa at Fairfax Financial is the only example I know where that didn’t happen.

Are there particular sectors in which you’re finding attractive shorts today?

ST: Frankly, most of our shorts have been doing so well that they’re not nearly as attractive as when we put them on. We started several months ago shorting gaming stocks, for example, as companies were significantly increasing supply in the face of headwinds on consumer spending. We don’t think the story is over, but those are already off quite a bit.

One financial short that’s interesting even though the shares have traded off is Principal Financial Group (PFG). It’s the premier 401(k) asset manager and also has a large book of life and health insurance, but the primary story is its exposure to commercial real estate. We think that could be one of the next areas to get hit.

Kevin Feder: We generally look for stocks that are overvalued versus their peer group and for which we can explain in one line why we’re short. Here, as Steve said, it’s the company’s exposure to commercial real estate. About one-quarter of total assets under management are in commercial real estate, commercial mortgages and securitized commercial mortgages. We don’t necessarily think it’s all going to blow, but we would expect enough credit issues that the company will have a difficult time growing assets at the rate implied in the stock price. Overall, Principal’s investment portfolio screens the worst against peers in terms of exposure to problem credit areas. The company also has the least excess capital, after having made more than $2 billion in share repurchases over the past three years. If asset quality deteriorates too much, in order to maintain its AA-rating, Principal would probably be one of the first life insurers to have to raise capital. That would not get a warm reception from the market.

We also don’t think the market fully recognizes Principal’s equity-market sensitivity. The fee-based 401(k) revenue is great, but those fees are tied to assets and obviously go down as asset values decline. We estimate that a 10% down move in the market translates into a 5% earnings hit for the company.

How expensive are the shares, now around $42.50, relative to peers?

KF: The stock trades at about 1.8x book value, compared to insurance-industry comps of 1.3x. It should trade at a premium because of the asset-management business, but not that much of one. At 1.5x book, the shares would trade at $35-36.

The X factor for many financials is how far the residential meltdown spreads. It’s already spreading to credit cards, but commercial real estate hasn’t cracked at all. If that happens, there will be a whole new wave of problems for a lot more companies than just Principal.

Overall, what will signal to you that the worst may be over for equities?

ST: The most important variable is the direction of home prices. As long as home prices have not found a bottom the banking system will remain destabilized, which will prevent the economy from recovering. The price of oil is the second most important variable, but I expect it to correct as the U.S. and European economies slow. It hasn't happened yet, but I believe it will.

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