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The world's largest fixed-income manager, Pimco's Bill Gross, told Bloomberg recently that he "see[s] bubbles everywhere." Talk about an ominous statement for investors. But if his "everywhere" includes the residential real estate market, Gross is sorely mistaken. As I shared recently, the real estate recovery is legitimate. And it's gaining traction, too. However, the way we capitalize on this trend is evolving.

Forget the Usual Suspects

No longer can we expect to book the biggest profits on the most obvious beneficiaries of a housing recovery -- homebuilders. Nor can we bank on "first derivative" opportunities -- companies with obvious ties to an uptick in home sales. I'm talking about home improvement stores like Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW), and building materials suppliers like Lumber Liquidators Holdings (NYSE:LL) and Masco Corporation (NYSE:MAS).

As I told you in late February, these plays are too obvious and overcrowded. Instead, it's time to move our attention to "second derivative" opportunities -- companies that investors don't even remotely think about when it comes to the real estate market, but are nonetheless highly leveraged to the recovery. I can think of no better example than mortgage insurance companies.

Back From the Dead

Mortgage insurance companies cover losses when homeowners, who typically make a down payment of less than 20%, default on their loans. But you know the story: During the go-go days, just about everybody put less than 20% down and then defaulted. As a result, it drove the biggest mortgage insurance providers to the brink. Meanwhile, others -- like PMI Group -- completely crashed and burned on the courthouse steps.

Fast forward to today, though, and we're working through the excesses of the last boom. Case in point: The total share of distressed home sales keeps falling. Take Las Vegas, for example. In September 2011, distressed sales accounted for over 70% of all activity. Now it's almost half that -- and still falling. We're seeing big declines in many other major markets, too.

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The Comeback Is Officially on for Mortgage Insurers

As the real estate market charts a path back to normal conditions, it's a similar story for mortgage insurers. Sure, the bonds of the largest insurers like MGIC Investment (NYSE:MTG) and Radian Group (NYSE:RDN) still carry junk ratings. So we're not in the clear yet. But there are definitive signs that their businesses are coming back to life. Consider the following:

  • In the most recent quarter, Radian reported a 69% jump in new mortgage insurance business. And CEO S.A. Ibrahim sees a "return to operating profitability" on the horizon, too.
  • MGIC reported a 54.7% increase in new insurance business in the first quarter. And its delinquency rates continued to improve, dropping more than two full percentage points in the last year.

Industry-wide data confirms that a recovery is under way, too. Moody's Investors Service says operating income before taxes for the entire mortgage insurance industry more than doubled compared to last year. And Inside Mortgage Finance found that sales of private mortgage insurance rose by almost 80% in the first quarter. This comeback isn’t going unnoticed, either.

Follow the Leader

You'll recall that hedge fund manager John Paulson made a name for himself -- and his firm, Paulson & Co. -- when he famously sold short subprime mortgages in 2007. Basically, he predicted the top in the real estate market and positioned himself to profit from it. A $3.7 billion profit, to be exact.

Today, Paulson is signaling the bottom of the market -- and setting himself up to profit again. As Bloomberg reports, Paulson & Co. and other noteworthy hedge funds are "piling into mortgage insurers." Paulson's hedge fund alone owns 17 million shares of MGIC. He also owns 8 million Radian shares, which he thinks could top $20. That would be 45% higher than the current price.

That's enough profit potential to get my attention. How about you? Bottom line: In a normal environment, mortgage insurers enjoy strong profitability. And we're moving to a more normal market. Or, as Paulson said in a letter to his clients, "Mortgage insurers are all experiencing improving fundamentals ... and should offer considerable upside if recent positive housing trends continue."

As I've demonstrated here many times, all signs point to the positive housing trends continuing. So do your portfolio a favor and follow the leaders into mortgage insurance stocks.

Source: How To Book 45% Gains In The Next Leg Of The Real Estate Recovery