So, we have very recently been a buyer of Jefferies (Ticker: JEF) stock, which anyone following the financial headlines would know has been pummeled in recent months. It was during this evisceration that we took our initial position…and then bought more to establish an average cost of $12 per share for our small cap and all cap strategies.

Let us first agree on what Jefferies is and isn’t, a distinction that will in some ways be the main support for how we can justify buying a broker-dealer/investment bank in this day and age. Jefferies is not a bank holding company and is thus less hamstrung by the cornucopia of the egregious new financial regulations that have come out. In other words, Jefferies is not TBTF—Too Big To Fail. It is not directly impacted by the Volcker rule or the thousands of Basel III proposals. It does not take federally guaranteed money and is thus conceptually governed by the almighty rule of the market, which is a quaint and old school way of going about life. It is mostly not a hedge fund or quasi-hedge fund, although Jefferies has owned and operated investment structures in high yield. Its origins were in market making and to this very day the management team espouses a classic “middle-man” philosophy of simply existing to help customers transact, versus the new model that suggests proprietary position trading is the optimal way to create high returns.

Jefferies’s CEO Richard Handler has followed a business plan that seems to be the exact opposite of the one advanced by nearly every one of its better-known bank/investment bank competitors. He has hoovered up—at a significant upfront expense—the weary and downtrodden expats of dozens of shrinking firms and has built top ten business franchises across a variety of investment banking and advisory, equity and fixed income sectors, both here and abroad. (Privately held Cantor Fitzgerald is also on the same warpath.) This strategy has been backed by the investment firm Leucadia (Ticker: LUK), which has laid out approximately $825mm (based on our count) for what is approximately a 30% equity interest at an average cost of approximately $16 per share. The company also has several hundred million dollars invested in various Jefferies investment funds.

We watched from the sidelines as the Jefferies model soared out of the 2008 ashes and then as the stock get clobbered in 2011 as capital markets have remained rotten nearly across the board. We have recently watched the firm be the center of much unpleasant attention in the aftermath of MF Global’s spectacular flame-out and bankruptcy, as well as the lurching and evolving Euro-Zone crisis, two ongoing events that have produced some tremendously flawed nonsense masquerading as market commentary. Our position is fairly simple and parenthetically can be applied to not just Jefferies. Under a variety of measures of book value, the stock trades at a valuation that we consider inexpensive, especially for a business model that has more than a fighting chance of earning mid-teens returns on equity. We think the world is not going to retreat into a pre-historic era whereby companies can only fund themselves with self-generated cash and/or barter goods, stones and shells. Therefore, there will be a role for those who arrange and distribute capital and credit globally—the classic intermediary businesses. We think the incentives of the Board and management team are as well aligned with the shareholders’ interests as much as can be hoped for in a Wall Street entity. Accordingly, assuming that we return to some form of normalcy in financial markets, we think we will make a lot of money over the next 2-3 years from present levels.

The world is not without risk of course. The biggest risk in any financial business model—and we do not kid ourselves about it—is a dependence on some level of “market credit.” Recent years have reinforced a 4,000 year old truism: the perception of credit-worthiness is the most fickle of mistresses. So we are utterly aware that everything we are about to say may be totally logical. But as John Corzine recently found out (and we paraphrase Keynes), the market can remain illogical longer than a firm can stay solvent. Regardless of Jefferies’s protestations that it engages in market-making vs. position taking, a continuing squeeze on funding costs and/or actual access to credit due to real or imagined fears (and the difference blurs more over time), will produce sub-standard profitability at best and severe shareholder dilution at worse. To be fair the same can be said about JP Morgan (Ticker: JPM) or any institution that is dependent on the confidence of markets. With this risk in mind, we incorporate this high severity, low probability outcome with a smaller position than “normal.”

Jefferies’s capital base consists of longer-term debt, equity and shorter-term “repo” funding, the latter of which occupies the fear quartile of the investing world. In a perfect world, Jefferies’s trading business is like that of a bookie. The market makers don’t care who wins; they just want people to trade so the house can take a small cut and they endeavor to keep a balanced book between long and short and not retain undue exposure. The “book” is financed by short-term borrowing across a panoply of sources and sound risk management attempts to ensure that available funding is longer-term than the speed at which a firm can buy/sell within the marketplace. A reasonably matched funding base enables a firm like Jefferies to scale up or down dependent upon its appetite or the attractiveness of and volatility in a particular sector. What is crucial to note when investors look at Jefferies’s “leverage” (which finances either 8 or 13 times its capital in trading positions, a reported gross number vs. a management-adjusted number—we stick with the former), is that the firm is not buying $30 billion of Italian bonds, leveraging $3 billion of equity and really hoping the market doesn’t move against the position because it won’t take much to wipe the firm out. Instead, Jefferies attempts to move inventory in and out of positions as rapidly as possible. Of course, every trader has a “lean” when moving inventory and to suggest that a Jefferies trader effortlessly moves inventory without basis risk, designed or otherwise, is silly.

Unsurprisingly, Jefferies’s stock and publicly traded debt has had some miserable days recently when a variety of “fears” received headlines. I do not think anyone can put a specific finger on any specific rumor, but I will toss out my favorite. There is a well-followed, desperately bearish blog entitled Zero Hedge that is clearly making its mark as THE place to espouse end of world conspiracy theories interspaced with interesting and thoughtful pieces. In the midst of MF Global’s bankruptcy week and the fun and games with Europe, the proprietors of this blog clipped a piece of Jefferies’s last SEC filing that showed the company as having $2.7 billion dollars of European debt on the asset side of the balance sheet. On the surface this represented an enormous amount when compared $3.17 billion in shareholder’s equity and thus the blogger immediately jumped to the conclusion that Jefferies is the next MF Global. If the author had bothered to actually read the 10-Q and move a few inches down the same page, this conveniently anonymous person would have also seen $2.6 billion of sovereign debt liabilities, which, combined with the asset, “nets” out to $100mm-ish of conceptual exposure to European follies. Reading a page or two further down, the author would have also noted that 95% of both these assets and liabilities were categorized as Level I and Level II assets, a fact that suggests they were garden-variety European bonds, not complicated and illiquid securities. The categorization also implies that it was very unlikely that Jefferies had gotten itself into a situation in which one side of the book was highly liquid and the other side was illiquid or involved insurmountable counter party questions. Jefferies’s filing is a snap-shot of a day and as the firm has had to demonstrate through the highly unusual step of actually publishing the entire day end trading book, today’s merchandise is often gone tomorrow. Accordingly, the firm dutifully moved out $1 billion of the gross $2.7 billion exposure in two days, just to “show” the market how rapidly a de-risking can be achieved.

The other issue that particular day was that the namesake of the fine firm of Egan-Jones came out with a downgrade of Jefferies to BBB- from BBB and went on CNBC to trumpet his viewpoint. Now I am sure Mr. Egan is a fine family man and a smart guy, but he also runs a 2nd tier (by size not reputation) rating agency and is doing his best to grow his business and support his lifestyle. One very effective way to accomplish that is to flog aggressive opinions in highly volatile situations in a very public venue. In that case, if you are right, you inure massive staying power with great financial tail-winds. If not, you were just another of the 312 opinions asserted that week on TV. Why his assertion that Jefferies needs more capital—an argument that seemed to be predicated on not much more than a gut-feeling that times are tough and more capital is better than less capital—is the “definitive” opinion on the subject is somewhat questionable.

And the same can obviously be said about ours. The world of finance is a miserably complex place these days and no one can claim to have the “the final word” as to the most appropriate mix of business and what balance sheet to support. As Jim Grant has suggested, the best way to “insure” the world of finance behaves appropriately is to make the Board of Directors and management of a bank or a finance company personally liable for the firm’s debts and failure. This was the old Wall Street partnership model and the metaphoric equivalent of ensuring safe driving by dropping all seat belts and airbags and simply putting sharp poles at eye level in the back of every car. Those days are mostly gone and since Jefferies is a public company, it can make shareholders “the stooge” with inappropriately risky activity. We are of the opinion that the nearly 40% insider ownership is on our side and remains cautious during volatile times.

The short-run remains uncertain—in nearly everything these days. When it comes to Jefferies’s stock and that of other firms that find themselves in much less complicated situations, we think investors are being well compensated vis-á-vis current valuations that are indicative of a wholesale unwillingness to look out past the next three months.

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