Why This Hedge Fund Analyst Owns Fannie and Freddie

Includes: BBW, FMCC, FNMA, IP
by: Behind the Spread

Jeff Borack is one of the dozen investors who debut at kaChing, a site offering a trade mirroring service to any investors willing to take the risk. He's currently working as a research analyst at Marathon Partners.

In our interview, Jeff gave insight to some of the useful resources he uses for his researches along with the rational behind his ownership of Fannie Mae (FNM) and Freddie Mac (FRE).

Can you give us more on your trading strategies? What helps you deliver the consistent performance you’ve demonstrated at kaChing?

For me, the key to consistency is patience. I look for companies trading at a cheap enough valuation for me to be confident that the business will generate a 15% rate of return on my shares through dividends, share repurchases, and the growth that comes from incremental reinvestment. However, when I don't find companies that I believe are capable of generating significant returns, I wait patiently. The portfolio I've been managing on kaChing has maintained a 20 to 50% cash balance. This reduces my risk exposure to market-wide fluctuations, and it allows me to quickly take advantage of opportunities as they arise. I'm comforted by the knowledge that even if all my stocks went to zero tomorrow, I would still be able to rebuild my portfolio from scratch. But I don't maintain a large cash position by choice.

My ideal situation is to be fully invested with maybe ten or so uncorrelated investments that I could hold as 10% positions each. Since many of my investment ideas have already appreciated in value so much, I'm forced to sell them and continue the hunt. Right now I'm at about 35% cash, and I'm slowly building a position in Build-a-Bear Workshop (NYSE:BBW). When I decided to buy it was still at $5, but in the last two weeks it has risen to about $6.50. At most I would buy another 5%, but we'll have to see how much more it moves away from me.

That being said, I think it's a little early to describe my performance on kaChing as "consistent". Consistency can only be measured in years. If I'm still putting up strong numbers in 2020, I'll be able to tell you for sure what's helped me deliver consistent performance. Even that might be too early.

If I am able to consistently outperform, I'm guessing it will be because I read annual and quarterly reports, proxy statements, conference call transcripts, and sell-side reports until my eyeballs bleed every day. I was only able to sacrifice two years as an unpaid intern because I find the market to be endlessly fascinating. For the first year, I felt like every question I found the answers to raised three more questions. I'm at the point now where every two questions answered only raise one new question.

I still have a lot to learn. With financial markets facing so much uncertainty, I think we're in for a very exciting decade. I have a lot of work to do!

That's certainly a great point. I couldn't agree more. So speaking of learning, what are some of the resources you find valuable and utilize for your learning? Websites?

sumzero.com - A great place for analysts to post research, rate each other's work, and talk about ideas. It's educational, good for networking, and I get a lot of great investment ideas there.

gettextbooks.com - They aggregate price data from all the major online booksellers, and email users when the price of a book I want falls below a threshold. So I've been maintaining a wish list there for about two years, and it funnels me a steady supply of great books at great prices.

I avoid websites like fool.com with the terribly superficial garbage they produce that's clearly designed for search engine optimization. We have a natural bias to seek information that confirms what we already believe. Sites like fool.com play to that weakness by randomly saying good and bad things about every company without any depth to the analysis, and I'm guessing that causes people to be overconfident and to make terrible short-term trades. I designed my blog to be the exact opposite of fool.com.

"Can you share some of your good and bad trades? Given the new age of transparency, I would love to know more about your past trades."

I watch CNBC for about 20 minutes in the morning while I eat breakfast. I see that commercial for Jim Cramer in which he says something like "Oversized dividends can be a big RED FLAG! It’s a reason to worry and not to feel safe, and that means it's time to SELL SELL SELL."

Well, earlier in the year, I saw that International Paper (NYSE:IP) had an unsustainable trailing dividend yield of over 15%, and I couldn't resist buying it. Good thing I did because it tripled in just a few months. If a company is consistently paying dividends for years and all of a sudden can't, it's probably not a long-term problem with the business but a short-term problem with the environment. So I focused my research on International Paper's default risk, decided it wasn't terribly significant, and bought shares. Time was on my side. However in this case, alternative fuel tax credits came to the rescue and boosted share prices industrywide.

I haven't really had any disastrously terrible trades yet, but I know they're right around the corner. I subscribe to the Ralph Vince optimal-f theory of portfolio management, which I expect will lead to a higher long-term rate of return but greater drawdown.

A big position for me right now is FNM, and I'm fully aware of the possibility that shares will end up worthless. I've more than doubled my money on it. I've pulled out my initial investment, and I'm still embarrassed to talk about holding it.

I'm guessing that my natural fear/disgust is part of the reason why FNM is so cheap right now. What it boils down to is that if it goes to zero, it would have been obvious. If it goes to $10, it will be for some reason no one today could have foreseen. So there's a huge social liability to holding shares. I don't want to look like a fool. However, the underlying business has been tremendously profitable over the past 20 years (no one remembers that Jim Collins wrote about it in Good to Great). FNM is an important piece of our economy, and its fate rests entirely in the hands of our government.

Our government wants its money back. It doesn't want to control FNM/FRE. Furthermore, the government has made it extremely difficult for these companies to actually go bankrupt, and it has received massive campaign contributions from these companies in the past. Lastly, the government is partly to blame for the mess by mandating FNM/FRE to make home loans available to those who otherwise might not be able to afford them. Therefore, there are enough positive scenarios to believe that the upside far outweighs the risk. 15% of my kaChing portfolio is in FNM right now, and an even greater percentage of my real money is in it. People probably think I can't sleep at night with so much FNM, but the truth is I couldn't sleep at night until I bought shares.

Disclosure: No Positions