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

Source: The Long Case for Redwood Trust