Some feel bullish about Bear

NEW YORK (Fortune) -- When a deep-pocketed investor scoops up a big stake in an embattled company, it is often seen as a bold vote of confidence that draws in other investors to bet on an imminent recovery. But don't expect that to happen at Bear Stearns (Charts, Fortune 500), after public filings showed Monday that billionaire Joseph Lewis has acquired a 7 percent stake in the battered brokerage.

Lewis' stake is worth around $860 million - a hefty bet that strongly suggests the Bahamas-based British investor believes Bear Stearns will emerge relatively unscathed from the credit crunch and that its stock will trade higher once the market sheds its nervousness. On Monday, the stock rose nearly $2.13, or 2 percent, to close at $107.50, although it's still down 38 percent from its 52-week high.

Bear's new investor could signal a recovery for the battered bank, but some believe it still needs a cash infusion.

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A spokesman for Lewis declined to comment, as did a spokesman for Bear Stearns.

Lewis' purchase has certainly added some bullishness to the debate swirling around Bear. The brokerage's market capitalization is around 1.2 times the value of its shareholders' equity at the end of June - making it look very cheap. However, that low valuation didn't seem to be drawing in many buyers. The fear has been that bond-related losses will decrease the value of the equity in coming quarters, with Bear possibly even announcing big charges on Sept. 20, when it is scheduled to announce fiscal third-quarter earnings.

But the Lewis purchases, which started in late July through a range of investment vehicles that he controls, could be a sign that bargain-hunting investors who like to acquire beaten-up stocks think this is the level to start buying.

"Value-type investors are looking closely at Bear and this move by Lewis is certainly interesting," says Jeff Harte, brokerage analyst at Sandler O'Neill. (Harte rates Bear Stearns a buy.)

Perhaps the most bullish aspect to Lewis' purchase is that it does not put fresh money into Bear; the shares were bought in the secondary market. The message appears to be that Bear doesn't need a cash injection to prop up its balance sheet. That would be a strong retort to the persistent chatter that Bear has been seeking out a strategic buyer to put fresh capital into the company to see it through the credit market storm.

So, why is it hard to get fully behind this interpretation of Lewis' move? First, an equity injection of new money actually makes a lot of sense, especially by a larger bank that might be able to help Bear in more ways than just providing some balance-sheet support during a tough time. In other words, investors may start to get behind Bear only when the company is given new opportunities by a new owner or partner.

"I am convinced they need an equity infusion," says Dick Bove, banks analyst for Punk, Ziegel. (Bove rates Bear a sell.) Bove adds that this could be a positive development if it were made by a large bank in a move that enabled Bear to reach more markets and clients. But Bear execs may balk at selling equity when it is priced at such a low level compared to book value. Equally possible is that potential buyers may have balked at paying Bear's asking price, especially when big losses could soon be reported.

Indeed, the headwinds working against Bear show no signs of abating. The company sold a $2.25 billion bond to raise cash in August with a yield that was very close to that of a junk bond. That issue still trades at a level that is close to junk. It makes little sense for a brokerage, which depends on cheap financing, to keep borrowing at that sort of rate. Indeed, management would come under extreme fire if it tried to place more bonds with that sort of yield - especially when a sizable equity infusion by a large financial firm could allow the company to borrow more cheaply almost immediately.

But any strategic investor putting new money into Bear has to make a bold judgment call about the company. Lewis appears to be in the camp that says Bear is able to do just fine once debt markets start to pick up. And perhaps CEO James Cayne and President Alan Schwartz have the abilities to turn the bank around. Schwartz, after all, is very well regarded on Wall Street.

The other viewpoint is that in the boom period of the last five years, Bear made a big mistake that will be hard to undo, even if market conditions ease. The great miscalculation was that it increased its leverage but did so without diversifying sufficiently. The evidence for this? In the second quarter, Bear Stearns' assets were 15.5 times its equity, according to a key measure called "adjusted leverage" that is contained in brokerages' financial statements. At the end of 2003, it was much lower at 11 times. True, at 15 times, it is in line with its competitors, but they are more diversified, and thus theoretically have greater ability to navigate downturns in the bond market.

Of course, Bear may announce a strategic investor at any time - and a run-up in the meantime would make Lewis look very smart. But the fact that we've not seen any big equity infusion yet is a strong sign that prospective buyers think Bear is still not cheap enough.