Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) appear to be great turnaround investments. On October 3, 2013 I have written an article about Fannie Mae titled 'Fannie Mae Common Stock: A Once In A Lifetime Asymmetric Bet on Washington's dysfunction'. I particularly argued that contrarian investors should take a close look at the common stock of Fannie Mae -- not the preferred stock. Bill Ackman subsequently bought Fannie Mae's common stock and, just recently, noted bank analyst Dick Bove of Rafferty Capital Markets argued that Fannie Mae could indeed fetch a price of $18 per share.
While I was right in recommending the common stock back in October, I misjudged how quickly investor sentiment can change and I clearly expected much slower price appreciation. My thesis was largely based on the idea that the Treasury and the Federal Housing Finance Agency (FHFA) acted in an unconstitutional manner by placing the GSEs into conservatorship and by sweeping their profits. As such, I expected an instantaneous increase in the value of Fannie Mae's common stock. The net sweep is now challenged in court and a net sweep court ruling will still be a major catalyst for Fannie Mae's share price. On October 3, 2013 I wrote:
The common stock offers an asymmetric bet on a status-quo secondary mortgage market structure. In terms of risk/reward ratio I would put Fannie Mae into the same basket as American International Group, MGIC (NYSE:MTG) and Radian (NYSE:RDN): All of them were pronounced dead but they just defied the odds and made staggering comebacks. Investors purchasing the common stock bet that the sweep agreement will be repealed and both preferred and common stocks gain in instant value. Until the courts have made their decisions with respect to the preferred stock, the common stock is likely to fluctuate erratically. As long as the sweep agreement is in place, I would not recommend speculating on specific earnings announcements. So far, the market has accepted that earnings will be swept over and aren't value accretive to either the preferred or the common. The court's ruling on the preferreds and political inaction are the determining catalysts for Fannie Mae's common stock.
I also still believe that the US mortgage industry will not be fundamentally reformed since Washington is utterly incapable of reaching break-through compromises. The US mortgage market represents a good chunk of the US economy and a major restructuring is unlikely. Fannie Mae and Freddie Mac are here to stay.
Since shareholders have no clarity yet about the legality of the government seizure, uncertainty with respect to the true value of Fannie Mae's common stock is quite high. Uncertainty, however, is always a great indicator of contrarian value since investors get paid for taking risk and not by waiting around until results are delivered (that is, a court ruling).
I think Fannie Mae common shares are still a good BUY even though shares have risen strongly above the $5 mark. SA author David Sims derived an adjusted EPS of $3.94 for Fannie Mae in 2013, which I think can increase substantially over the next years as the recovery in the housing market gains traction. I believe Fannie Mae can achieve $4.50 in recurring EPS (available to common) in 2015/2016. I also think that Fannie Mae, like any other profitable, industry-leading enterprise, could trade at 10x forward earnings which would give the stock a fair value of $45 - if the company is returned to shareholders.
Fannie Mae's share price is up 268% since I aggressively made a case for the common stock back in October 2013 - an outstanding return for a five month holding period. Fannie Mae's common stock has consistently edged higher since the end of February driven by high volume and bullish sentiment.
My fundamental thesis hasn't changed at all: The structure of the US mortgage market isn't going to change - thanks to Congress. Simultaneously, investors face explosive upside potential should the company indeed be returned to shareholders. The risk/reward ratio remains extremely attractive.
While the Relative Strength Index indicates that shares of Fannie Mae are overbought in the short term, momentum is clearly on the side of bullish investors and I wouldn't be surprised if Fannie Mae's share price touches the $10 mark in the near future. Long-term investors, however, are looking at substantially higher share prices - $45 region - should the company be returned to shareholders.
Disclosure: I am long FNMA, RDN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.