Long-Term Value in Freddie Mac
What a difference a day makes for mortgage giant Freddie Mac.
The stock surged 14% on November 28, to $29.42, its largest one-day gain in 19 years. Freddie jumped on news that it will have no problem raising $6 billion of capital in a preferred stock offering to bolster its balance sheet. It also announced that it will halve its $2 per share annual dividend.
Rick Pzena, whose firm, Pzena Investment Management, recently went public, says the mortgage purchaser is still severely undervalued.
Speaking at the annual Value Investing Congress in New York City, Pzena labeled Freddie "the single cheapest stock that I've come across in my career." This isn't because Pzena is bullish on the U.S. housing market (he's not), but because he says Freddie has been unfairly tarnished by the subprime brush that is has afflicted so many mortgage lenders.
Freddie's shares (symbol FRE) traded at $65 as recently as August 22 and plunged to as low as $22.90 on November 26 before rebounding.
Pzena says he considers three questions when analyzing businesses selling at low prices. Is it a good business? Are its problems temporary, rather than permanent? Is it rational to think that earnings will return to historical levels? With Freddie, he says the answer to each is yes.
Pzena says that the quality of Freddie's mortgage portfolio is quite high. The weighted loan-to-value ratio of the mortgages is a conservative 60%. The delinquency rate is rising a bit but is no higher than it would be during a normal credit cycle.
He likens the effect of the current storm in housing on Freddie to the impact of a hurricane on a disaster-insurance company. The insurer takes the hit, raises rates and its stock rises. Freddie is similarly raising rates for its services, such as credit guarantees.
Unlike the case with banks, Pzena concludes that Freddie's accounting is conservative. After doing some calculations, including figuring the expected return on equity on Freddie's mortgage portfolio, he estimates the company's current earnings power is $6.30 per share (analysts, on average, expect the company to earn $1.62 per share in 2008).
So even after the November 28 price spike, the stock sells at less than five times Pzena's estimate of "normal earnings." That, to him, is a bargain for the patient investor.