Skip to main content

For a guy investing in the eyes of not one but two storms, Walid Kassem is showing an awful lot of calm.

Kassem is portfolio manager for the $112 million

( MDFNX)Merrill Lynch Global Financial Services fund, a sector fund laden with shares of property and casualty insurers and mortgage companies. And despite the turmoil surrounding Hurricane Katrina, as well as the uproar over the so-called housing bubble, Kassem says he is quite comfortable with his current holdings and has no immediate plans to shake things up.

Considering his fund's performance so far this year, it's hard to question his composure despite the turbulence. So far this year, his fund has returned 7.5%, which is 10 percentage points better than the sector as represented by the

Financial Select Sector SPDR



asked Kassem about the future of financial stocks in the wake of Katrina and in the face of a potential housing shakeout.

You run your fund far differently than the typical financial services sector fund manager. What is your strategy?

We have three areas of concentration. One is the emerging markets, especially South Korea. The second is mortgage banking in the U.S. and U.K., and the third area of concentration is the property and casualty stocks with an emphasis on those based in Bermuda. Out of these three groups, the emerging markets stocks have done quite well, which probably accounts for the bulk of our outperformance this year.

I don't see many huge money-center banks like Citigroup (C) and J.P. Morgan Chase (JPM) dominating your portfolio, which is usually the norm for your type of fund. Are you just not bullish on the mega-banks?

Actually, I tend to be bullish on all financials including money-center banks, but I concentrate on mortgage companies and property and casualty insurers, because I believe they have the best prospects for the group.

What is your exposure to Katrina? How worried are you about it?

I have a mix of property insurers like

RenaissanceRe Holdings

Scroll to Continue

TheStreet Recommends



PXRE Group

( PXT), as well as casualty or mixed insurance like



. The property insurers have been affected, there is no doubt about it.

In a case like this, you weigh two things against each other. On the negative side, you have the direct impact of the catastrophe in terms of the money that has to be paid out to victims. On the positive side, you have the increased premiums for future years. The net effect of these two elements tends to be positive.

That may be true, but the damage estimates just seem to keep on rising in the aftermath of Katrina. What kind of uncertainty does this bring to insurance stocks?

One big question that has not been answered yet is whether the hurricane damage in Louisiana will include flood damage. You can argue that the flood was caused by the hurricane, but then you could also argue that the flood damage was not directly caused by the hurricane. If it's judged to be caused by the hurricane, then insurers will have to pay for flood damage, and it would be a much bigger amount.

But it still won't shake my thesis. The historic pattern for catastrophes has been that increases in prices makes up for short-term losses. The attacks of Sept. 11, for example, had a very high human cost and a high cost to insurers. But insurance companies actually did well in terms of stock performance afterwards. So while it is not something to wish for, it does happen. Therefore, it can be positive for some stocks.

What about your heavy weighting in mortgage companies amid all the discussion of a housing bubble? Does this unnerve you at all?

When it comes to mortgage companies, I take a similar, long-term present-value perspective. Mortgage banking is consolidating. There are economies of scale in terms of gathering applications. We are seeing that there are a number of specialists growing rapidly and taking market share at the expense of traditional issuers of mortgages, which are regional banks. So despite the fact that we have seen the peak in mortgage issuance, they are still doing quite well because of the increase in market share. My two favorites in my fund are

American Home Mortgage

( AHM), a primary mortgage issuer, and

New Century Financial


, which specializes in the subprime market.

What about the threat of higher interest rates popping the housing bubble?

Once again, I emphasize that I look at the long term. The setting of interest rates for mortgages is an economic and not a mathematical phenomenon. Companies that issue mortgages are looking for certain profit targets that pay them for taking the risk of holding the mortgages. So it really does not matter too much what the yield curve looks like, because the issuers of mortgages and the holders of mortgages have certain profit targets in mind. The economics of the mortgage business is such that it is quite profitable, especially the companies that are growing market share.

When people talk about a housing bubble, they are worried about default risk, or in other words, that people won't be able to pay their mortgages. On the other hand, there is a worry that the yield curve is flat, so mortgage holders and issuers won't be able to profit. But the reality is that it's one side or the other. Either the economy is doing well and we have to worry about interest rates, or the economy is not doing well and we have to be concerned about people not being able to repay their mortgages.

Well, which one is it?

I think it is neither. I think the economy is doing well, and the losses on mortgages are always extremely small. In the case of

Freddie Mac

( FRE), I think it is in the neighborhood of one basis point. And that's the way it should be, because people don't want to lose their homes. They will do whatever it takes to pay their mortgages.

Getting back to the money-center banks, in order to take the overall market higher, don't you need these big guys to pitch in? I mean, financials make up close to 20% of the S&P 500, but they have been flat this year while energy has been the leader.

You can take two points of view. If you want to invest in the sector as a whole, then you cannot ignore the very large stocks like Citibank,

Bank of America





. On the other hand, if your purpose is to invest profitably in financials, then you have a choice, which is what I am doing. You don't have to invest in stocks which you don't think have as much upside as others.

But what is holding them back?

The simple concern is that their net margins are narrowing and that they have a large dependence on mortgages and real estate. So if you are worried about a real estate bubble, by extension that will affect them. There is also concern that banking is not a high growth industry.

However, in terms of relative attractiveness of financials as a group to other big-cap groups like utilities, I think there is a mispricing here. People have jumped into utilities for the yield, but banks typically have a better return on equity and better growth. They are priced very reasonably and have very attractive yields. So I think that some of the money that has moved into utilities, and to a lesser extent REITs will come back to banks once fears of further


rate hikes die down.