The Long Case for Redwood Trust

In a recent edition of Value Investor Insight, investor Wally Weitz explained why he believes the market is mispricing Redwood Trust (RWT).

After enduring much pain with mortgage-REIT Redwood Trust [RWT], you’re still pounding the table for it. Why?

WW: Redwood specializes in analyzing credit risk. They underwrite pools of mortgages down to the individual-loan level. When lenders are fearful, and prices are attractive, they invest aggressively. When underwriting standards are lax and buyers are overpaying for loans, Redwood patiently holds cash. Within their circle of competence, they behave the way Warren Buffett does when he buys stocks or underwrites insurance. Over the past two years, they’ve raised cash and eliminated debt to prepare for a credit and liquidity crisis in which they could invest with the risk/reward equation stacked in their favor. That time has come and they’re taking advantage of it.

How have they been impacted by ongoing troubles in the credit markets?

WW: They haven't had any major problems. In the pools of prime jumbo mortgages they securitize and hold the equity for, they've been right on target with expectations. In the CDOs they've put together, they're somewhat disappointed with three or four of the newer ones. They've disclosed that they could lose $1-2 per share in book value on those investments that are starting to underperform. If the economy and payment experience gets much worse, that of course will create unpleasant surprises, but I believe they're being conservative and honest with themselves about what's going on.

Do they have the liquidity to take full advantage?

WW: At the end of September, they had $300 million in cash out of $1 billion in equity, and they've since raised just over $120 million from the sale of new stock – all of which I expect them to be able to deploy at well above normal returns on equity. Their plan is to spend the money on assets that may not always have the very highest returns in the short run, but that will provide strong cash flows for several years. They are also seeing a lot of one-off distress sales of assets that might yield higher returns, but which might last only a year or two. To take advantage of those, they're raising a separate “opportunity fund” of $250-500 million. What I like about that is that, in keeping with management's sense of fair play, the hedge fund-like fees from this venture will accrue directly to Redwood shareholders.

How are you looking at valuation, with the shares now around $36?

WW: I start with the stated core book value of around $30 per share. Given today’s opportunity set, they should be able to earn over time a 15% return on equity, or $4.50 per share on today's equity. Book value will also increase as they retain the 10% of earnings they don't have to pass through to shareholders, as they sell new stock at a premium to book, and as they earn and retain non-REIT income from the opportunity fund. Overall, I'm assuming 2-4% annual growth over time for the book value. If the market prices the shares for a 12% total return, with 2% book growth, the stock would have to yield 10%. This would indicate a current value of $45. If book grows at 4% (still less than its historical growth rate), the stock would sell on an 8% yield basis, or at about $56. Given the unusually high returns available on new investments today, we would expect some positive surprises in earnings and book-value growth. I realize that I sound like a stopped clock in recommending Redwood again. But I have a very long and successful history with this company and believe they do things the right way. That ultimately should get recognized.

Comments

[BetterInvestor:]

What incredibly bad advice this article has! The article makes a "long case" for RWT, but the author is the SINGLE LARGEST OWNER of the company, which has dropped by more than 50% from its early 2007 high. Ouch!

While the author of this article has been buying RWT, insiders are selling. In the past 3 months insiders have bought 11,758 shares and sold 121,394 shares, a more than 10 to 1 ratio of selling to buying. This data from the Nasdaq web site, go check yourself.

Also disturbing is both the company president and one of the VP's have announced their retirements in the past few months.

One thing I will give RWT is that is has an incredible PR machine. "Yes we have a portfolio of toxic waste mortgage assets," they say, "but the losses will be bourne by the buyers of our CDOs, not us."

But what about lawsuits? What about provisions that let the CDO owners force RWT to buy back some of the mortgages? RWT on its website says it provides "credit enhancement" to 10% of outstanding jumbo mortgages. The majority of jumbo mortgages are in California and Florida. I wonder how long it will be before RWT will have to start "enchancing" those mortgages as foreclosures soar to record highs in those states and our economy enters a recession.

As for the track record of "Value Investor Newsletter", on this very site the newsletter featured suggested going long Indymac Back when it was around $33, and now it is at $5, and FBR at 6.33, which is now at 3.

Sorry, I am not impressed. I am, by the way, an owner of RWT puts, so I am just as biased as Mr Weitz. But unlike him, I have made a lot of money on this stock, because I am short the stock via owning several classes of RWT puts.

2008 Jan 16 01:25 PM

[bogeytrain:]

One thing that has not been reviewed or disclosed yet either is what kind of CDO's are they? (What is the collateral, what are the underpinning referenced obligations, who is the counterparty, what are the attachment points for each CDO, what is the WAL of each deal?) I am interested investor but the lack of disclosure on the CDO is making me pull back.

2008 Jan 16 03:41 PM

[E Nuff Sed:]

Reading this in August when the current stock price is $20 is very instructive. The shorts on alpha are baying for blood and predicting RWT is going down to single digits - a fraction of book value.

As Seth Klarman says, A market downturn is the true test of an investment philosophy.

Wallace Weitz is the portfolio manager of Weitz Value Fund, Weitz Hickory Fund and Weitz Partners Value Fund, which he incepted in 1983. As of 9/30/2007, his Weitz Partners Value Fund has had an annual average total return of 14.5%, and a cumulative return of 2597.7%

Value investing is the discipline of buying securities at a significant
discount from their current underlying values and holding them until more of their value is realized. The element of the bargain is the key to the process.
The greatest challenge for value investors is maintaining the required
discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market over-valuation.

2008 Aug 15 09:43 PM