Fannie May Just Be Worth the Risk

Includes: FMCC, FNMA
by: Alan Brochstein, CFA

Fannie Mae (FNM) (28.55, $27.8 billion) is a tough company to understand in my opinion. Having been a professional mortgage trader and portfolio manager in a different life, I have followed the company and its sister (or is it brother?) Freddie Mac (FRE) for 22 years. I have viewed them for the past decade as huge hedge funds with a very low funding cost, and I continue perceive that to be the case. The challenge, in my opinion, is that mark-to-model accounting prevails at both firms. Even tougher than understanding the company is investing in it.

I shorted the stock last summer as I perceived that the credit quality of their massive portfolio would deteriorate. If I recall, I sold it at 62 or so, watched it go to a 52-week high a few weeks later of almost 70 and then covered at 57 or so, feeling lucky at the time. It wasn’t exactly my best trade!

Big picture, what was going on then and continues to this day is the trade-off between paying for the sins of the past and enjoying the opportunities of the future. The political situation has improved dramatically over the past nine months, and it seems clear that these Federal Agencies will be a large part of any solution to the housing woes. Meanwhile, though, the focus on credit losses and the need for additional capital has overwhelmed investor sentiment, and I believe that the pendulum is about to swing the other way. Hence, the eye-catching title.

As you may be aware, I had been very bearish from last July until January, at which time I wrote about a range-trade that I expected to develop (The Bear Turns Mildly Bullish). My most recent prognostications in March about the market (Get Ready for the Last Rally and The End of the Bear Market?) discussed a testing of the top of the range, with a likely extension that would include leadership from the beaten-down Financial sector. While it has been somewhat slower to develop than I anticipated, it does appear that we are on track to visit 1410 to 1455 on the S&P 500 and “at least 29” on XLF, the SPDR ETF for the Financials. While not the subject of this article, I could probably go both ways arguing “is the Bear over?” While I believe that it is unlikely that the market will advance from here significantly over the balance of the year, I am less sure that we will make new lows. My expectation is that we will work lower after hitting this interim peak, essentially biding time as we close the year out somewhere between where the market is now and what the lows were. Maybe we get a new low, but I am no longer as confident that we actually do.

So, what could possibly lead me to believe (and bet on) FNM stock could jump as much as 40% soon? It is really a case of not over-thinking the situation but rather incorporating some basic technical analysis, betting against sentiment and smelling an opportunity. As you can see in the chart below, FNM’s decline has been rather extreme:

Not only has the stock fallen 71% peak to trough and obviously underperformed the broad market, but it has actually trailed the entire financial sector by over 30% over the past year. Unlike some other mortally wounded entities, though, this one is part of a duopoly that will ultimately benefit from the environment. In the 20-year chart below, you can see that the company earned at its peak almost $9.

Analysts officially expect the company to earn about $2 per share in 2009, though the range is quite wide ($0.25-$4.25). Rich Pzena, the founder of Pzena Investment Management, stated in a Barron’s article at the end of 2007, that the company has earnings power of $9. Let’s say he is only ½ correct. If so, ultimately the stock should merit at least a 10PE and earn a valuation, then, of $45. Similarly, while the book value is most likely overstated, the multiple is still quite low for an entity that operates as part of a duopoly. Let’s take 50% off of the stated book value and apply a more typical 3X multiple, and we get a price more than 100% in excess of the current one. Longer-term, assuming FNM gets through this mess, there is clearly a lot of value. Part of my interest is that folks may be willing now that we have found some stability to begin to think about that potential. For now, though, the fear is great, as reflected in the high implied volatilities of the options and the high absolute amount of short interest: $1.8 billion. The analysts loved it at 70 and don’t like it any longer – go figure:

To get to the $38-40 short-term target I maintain wouldn’t take a great deal. The PE for 2009 is relatively low for a company whose earnings have imploded. Any CONTINUED rise in expectations should get some multiple expansion. Yes, that is right – the consensus for 2009 has been rising:

So, we have a low valuation and poor sentiment. Technically, a 38% retracement from the peak of 70.57 to the trough of 18.25 is 38.24, while a 50% retracement would yield 44.41. The 200dma is at 46. So, we could have a monster rally in FNM and it would still be in a bear trend. Chart resistance appears to be 38-40. I think that this is a time to take some risk – the mortgage credit story is well played out, and it appears that the market may have been a bit too punitive on the GSEs.

Disclosure: Long FNM