While the news about the economy and the markets continues to be bad, some in the business are taking heart.

Many money managers, in fact, say it could be time to invest in distressed assets, citing a large number of business restructurings, falling profit margins and plummeting stock prices.

Certainly, financial stocks have been hardest hit, decimated by the subprime lending crisis. Ronald Surz, president and chief executive officer of PPCA, a San Clemente, Calif.-based, financial consulting firm, said most premier, large-cap financial companies have been driven down so much, they're now smaller company growth stocks.

The change in investment style affects money managers and analysts' stock picking tactics because financial stocks are no longer a value play, he warns.

"You would think the decrease in prices would have made these companies even deeper values," Surz said, "but earnings deterioration has more than offset the price erosion effect."

From October 2007 through October 2008, his research shows, the market value of the 46 companies that make up the large-cap financial sector declined to $900 billion, down 65%, or $1.7 trillion, from $2.6 trillion. The average capitalization has declined to $48.4 billion from $56.4 billion. Meanwhile, price-to-earnings ratios (P/Es) have increased from 12.3 to 20.2 times earnings.

Surz analyzed 46 stocks that made up the large company finance sector. Today, 18 companies remain large company stocks. They are less affected by the financial crisis than other firms. These stronger outfits, however, should be considered large company growth stocks rather than value stocks due to the simple fact that their stock prices are still high in relation to their declining earnings. Three companies went out of business. Fannie Mae and Freddie Mac are now small company stocks. The remaining 23 companies are mid-cap growth stocks.

But Jeff Arricale, manager of the T. Rowe Price Financial Services Fund, disagrees. His fundamental analysis shows that it's time to buy financially strong companies due to their long-term potential. His largest holdings include asset managers and insurance companies with good balance sheets, such as ACE Ltd., AON Corp. , Bank of America, Goldman Sachs, H&R Block and Lazard Ltd.

"Returns on equity of financial companies are likely to be lower than they have been, and the sector will be small in the future," he said. "Some companies are trading at attractive valuations. We expect companies in this sector to go back to basics. Banks will make well underwritten loans and take in deposits, while other financial institutions will focus on managing money."

Regardless of whether money managers believe financial stocks are growth or value plays, the stocks should be good buy candidates once the financial crisis runs its course. Christopher Walen, an analyst with Institutional Risk Analytics, a Torrance, Calif.- based risk management company, said that well-run banks, such as U.S. Bancorp and Wells Fargo, are good investments.

On the private equity and hedge fund side, a number of managers are snapping up distressed assets. These managers can buy debt of distressed companies and provide financing to companies that can't get it from banks. For example, they might use a "loan to own" strategy," in which they invest in private equity turnarounds and buy into "Section 363 bankruptcies," which are packaged asset sales.

Turner Smith, a principal with Tuckerbrook Alternative Investments, a Stamford, Conn.-based money manager, is investing in private equity players that specialize in turnarounds. He also is investing in hedge funds that purchase bank bridge loans, mortgage-backed securities as well as corporate real estate loans.

"We haven't seen this kind of opportunity in distressed securities in many years," Smith said. "It's going to be a longer period of distress than prior cycles, and timing is important. There are some bright spots that could be very profitable."

Research by Edward Altman, finance professor at New York University, suggested distressed asset investors may be on the right track. An improving economic outlook typically sparks distressed bond returns. The big question is how long the current recession will last.

His study showed a "significant negative correlation between aggregate default rates and recovery rates on corporate bonds. The report, "Analyzing and Expanding Default Recovery Rates," submitted to the International Swaps and Derivatives Association, suggests the same results may hold for bank loan defaults.

(c) 2009 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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