2 Stock Picks For the Subprime Mortgage Crisis

Includes: DFC, HRB
by: Brian Harper, CFA

Often several times a year, whole market sectors find themselves in sudden free fall, gripped by investor panic. Such is the case in the sub-prime industry right now, and to a lesser degree in anything associated, including homebuilders, even the country's largest residential brokerage, Realogy (NYSE:H), which is being priced irrationally.

It happened to the poultry industry last year during the bird flu scare. Chicken prices plummeted as overseas demand was sapped by consumer fear (despite the fact that you can't get bird flu from eating cooked chicken). Chicken prices fell, and poultry stocks dropped precipitously, including diversified giant Tyson (NYSE:TSN), as well as specialized names such as Sanderson Farms (NASDAQ:SAFM), which we still hold.

Since that time, producers cut back on supply, chicken prices have recently rebounded sharply, and consumers returned to eating birds. In the case of SAFM, the stock is up 70% off the low it hit during the scare.

Back to sub-prime. Like many financial companies, you have tremendous leverage employed, and a company's loss assumptions can be inaccurate or in some cases fraudulent. So in the current situation, it's best to stick with more conservative plays.

H&R Block (NYSE:HRB), at $19.70, is presently being deeply discounted as they work on selling their Option One mortgage business. Analysts are now questioning whether the business may end up being worthless; Block has said the business will likely fetch more than its $1.3 billion book value. We think Block is worth at least $28 based on a sum-of-the-parts. The company has a strong balance sheet and the rest of their businesses generate good cash flow.

Delta Financial (DFC) is one of the more conservative of the pure-play sub-prime names. The company eschews riskier loans, issuing primarily fixed versus floating rate mortgages. As a result, their portfolio of loans is much higher quality than the industry average. At $7.60, DFC is selling at 5.6 times estimated 2007 earnings. While the company may experience increased default rates, in the 4th quarter they saw only a modest rise.

Disclosure: We hold shares of HRB and DFC.

H vs. DFC vs. HRB 8 month chart:

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