I have written some bullish articles on Genworth (NYSE:GNW) in the past few months, and my timing has been far less than perfect. However, even though the stock price has plunged from about $5 in December to below $2 per share today, I don't believe the company fundamentals warrant such a decline. I think a number of factors that are not related to the fundamentals and the long-term potential of this company are responsible for much of the damage to this stock. The stock is broken, but the company is not. In late January, I wrote an article titled "Genworth: Why The Path From $2.50 To $10 Appears Realistic". After this article was published, the company released quarterly results, and I suggest investors read Jonathan Booth's article, which analyzes the results and market reaction to these results. One of the comments left on this article was made by Fairlight Capital, which is "a value-focused alternative asset manager based in Greenwich, CT." The comment was:
"Excellent and concise write-up. Agreed that the market has not ingested the full impact of their earnings release. In my opinion this is the cheapest value stock in the US market. Over the coming quarters the earnings picture should become more obvious."
I agree with Fairlight Capital in that Genworth is probably the cheapest value stock in the U.S. market, as it now trades for about 2 times earnings. I also completely agree with Jonathan Booth that many investors in this market do not understand the company or the current strategy being used by its management. Obviously, it is easy to argue that I am the one who doesn't understand. However, I still believe in Genworth as an investment as well as in the strategy its management has deployed. So in the short term, I have been wrong, but it is worth noting that historically, the market has been extremely wrong on how it valued Genworth, as it has mispriced this stock more than once in the past few years. I believe this is the case right now. Because of this, I recently bought more shares, and I am planning to wait for the significant upside I see in this stock. Here are a few points for investors, shorts and shareholders to consider.
First of all, I want to address the macro environment, which is, and has been, extremely poor for stocks. Investor sentiment is unbelievably negative these days, and the CNN "Fear & Greed" Index is around 18, which is a level of "extreme fear". Conversely, extreme greed is indicated when this index is between 80 and 100, and historically, it has paid to buy stocks when there is extreme fear among investors and sell when this index is at high levels. This market is so negative right now that for many stocks it does not matter if you report massive record profits like Apple (NASDAQ:AAPL) or General Motors (NYSE:GM) just did, because those stocks are also trading near 52-week lows and also sport single-digit P/E ratios. The macro environment for financial stocks is even worse, as major firms like Bank of America (NYSE:BAC) and Citigroup (NYSE:C) have seen share prices plunge by nearly 40% just since January 1, 2016. In this environment of extreme fear, it is easy to see why Genworth would also be trading at low levels, but I think the panic in the financial sector and in this stock are completely overdone. In times of extreme fear, bargains are created and opportunities to make huge gains appear.
Stocks often overshoot to the downside and get to levels that make people wonder "What was I thinking selling then or shorting?" or "Why didn't I buy?" - and that is where I think we are at with Genworth. So now let's go through some of the events in the past few months that have been like a perfect storm for the company. In November 2015, this stock was trading at about $5 per share, which was well below the 52-week high of about $9. At that time, it was announced that Genworth would be replaced by Synchrony Financial (NYSE:SYF) in the S&P 500 Index (NYSEARCA:SPY). This move meant that index funds and ETFs had to sell GNW and replace the stock with SYF. Genworth was moved into the S&P Mid Cap 400 Index (MID), but this move was a negative for the stock because there are far more ETFs and funds that track the S&P 500 Index. That led to forced selling of an already beaten-down stock in November and December, which was only further exacerbated by year-end tax-loss selling. After being hit hard by the removal from the S&P 500 Index and significant tax-loss selling, a brutal market correction started in January that punished just about every sector, and especially financial stocks. But wait, there's more. Next came the quarterly earnings report and a round of credit rating downgrades for Genworth.
All of this has taken a brutal toll on the stock and also caused a significant amount of forced margin call selling and triggered stop-loss selling. The shorts have also piled on and contributed to the downward spiral we have seen. There has also been selling of this stock due to the technicals. However, most of these factors are one-time events that are not directly related to the fundamental value of Genworth. Selling based on an index change, technicals, tax-loss selling, forced margin call selling and selling pressure due to a market-wide panic sell-off (particularly in financials) has no real long-term bearing on what this stock is ultimately worth. These short-term events have created a true bargain in Genworth, and I think the future is much brighter than the current share price suggests. I think that the stock now trades at rock-bottom levels. I believe that after the dust settles and the management strategy becomes more clear, this stock will head back to much higher levels - as it has historically done many times in the past. Right now, you can buy 10,000 shares of Genworth for just about $17,000, and I think there is a very strong chance that 10,000 shares could become worth $50,000 or even $100,000 in the next year or two. That is not as crazy as it sounds; remember, 10,000 shares of the company were worth over $50,000 in December and over $90,000 in the past year. I think it is going back to these levels, which is why I continue to buy the stock.
According to Shortsqueeze.com, over 23 million GNW shares are short, and this has contributed to the plunge in the stock. At this point, there is less than $2 left of downside, so if you are short, you better realize that your risk-to-reward ratio is becoming exceedingly small now. I would be especially concerned about being short at this level, because Genworth has a history of handing shorts' mind-blowing losses from these levels. That means the market has a clear track record of getting overly bearish and mispricing this stock down to levels that make no sense when fear, margin call selling and technicals take over. For example, GNW shares fell below $2 on February 1, 2009, but within 4 weeks, they were back to trading well above $2, and just about a year later (in March 2010), GNW was trading over $18 per share. In August 2012, investors got bearish and the market had a pullback that took Genworth to $5 per share. But once again, by March 2014, the shares had surged over 300% and traded for roughly $18. If there is any lesson here, it is to NEVER rule out a major comeback from the low-single digits for the company, and also make sure you sell it whenever it hits $18! If you are short now, you have made a lot of money, as it now trades below $2. But if you stay too long at the party and you turn out to be wrong, the losses could be mind-blowing once again if Genworth trades back into the mid-to-high teens, which it has historically done multiple times.
Let's consider another point, which is that Genworth has faced much tougher times in the past than what it faces today. Does anyone forget the end-of-the-world environment facing our economy in 2008-09, when banks were being taken over by the FDIC, foreclosures reached record highs and Citigroup (C) was trading for just about $1 per share? Mortgage insurance was just about the worst business you could be in back then, and yet, Genworth survived, defied the shorts and turned its mortgage division around to be extremely profitable. I think company management deserves some credit for that, and I also believe they have taken the steps needed for a turnaround in the long-term care division. In fact, this division reported a profit in Q4, and it appears poised for larger profits in 2016. This is because Genworth has won regulatory approvals for significant premium increases that take effect this year, and that could add about $210 million to the bottom line.
Let's address the recent credit downgrades. First of all, I want to point out that credit rating agencies downgraded U.S. government debt a few years ago, and while that initially caused a pullback, it was a huge buying opportunity, as we all know how it has played out since. Secondly, I don't think the recent and slight downgrades will have much impact on the asset value of Genworth, for a couple of reasons. After the recent earnings report, it seems more clear than ever that management is going forward with a breakup of the company. That means the focus should be more about what the assets are worth in a breakup, rather than on viewing this company as if it were going to continue operating as it has been, with too many lines of business.
Here is another big reason why rating downgrades don't matter in terms of long-term fundamentals or what the ultimate breakup value will be for Genworth: If history serves as any guide, past downgrades appear to have been the final capitulation that marked the bottom for this stock, and therefore, were huge contrarian Buy signals. In February 2009, Fitch downgraded the company's credit rating. In February 2009, Standard & Poor's downgraded Genworth's credit rating. In early April 2009, Moody's downgraded its credit rating. These downgrades were right in between the times when GNW shares hit rock-bottom (below $2) in March 2009. These downgrades helped push the stock lower initially, but in hindsight, this marked the capitulation lows for the stock and was an incredible buying opportunity. The extremely negative sentiment against Genworth and financial stocks back then is similar to what we are seeing today. If you bought GNW after the credit rating downgrades in 2009, when it was below $2, you could have sold just about a year later for $18 per share. If you were short the stock at that time, you were delivered mind-blowing losses just because you greedily hoped for a little more downside. In addition, credit agencies also downgraded Genworth in October 2012, and that also coincided with and marked the low of about $5 per share that year. Once again, this credit downgrade was a huge contrarian Buy signal, as Genworth went from about $5 in October 2012 to around $18 in March 2014. Again, shorts that hoped for the worst and wanted more gains received stunning losses of more than 300% by not covering the downgrades made after the credit ratings.
Longs should be asking themselves: Is this really the best time to sell GNW? You really have to be desperate to give up on any future potential for less than $2 right now. If you are short, is this really making sense at just over 2 times earnings? The best-case scenario offers shorts less than $2 worth of upside, but quite possibly several dollars or more of downside.
Now let's review the strategy and options the company has going forward. I think there is a potential opportunity for some type of "white knight" event with Genworth. That could come in the form of an activist or a billionaire value investor like John Paulson, Carl Icahn or Warren Buffet. If someone like this came in and disclosed a significant new stake in Genworth, it could boost confidence and create a major rally in the share price. But even better would be a white knight event, whereby a major insurance company agrees to buy Genworth. I see a huge opportunity for another company to take over Genworth now for a number of reasons. First of all, an acquirer would get a company with book value of about $20 per share for a mere fraction of that price. It would also get a valuable and solidly profitable U.S. mortgage business. Additionally, it would get stakes of nearly 50% in the publicly traded mortgage business in Genworth Canada (MIC:TO), which trades for about $24 per share with a current market cap of about $2.2 billion, as well as in Genworth Australia (GMA:AX), which is also publicly traded with a market cap of nearly $1.5 billion. The icing on the cake would be that an acquirer with a triple A credit rating could refinance Genworth's debt and get much lower rates, which would significantly improve the company's profits. What is ridiculous is that Genworth now has a market cap of about $900 million, which is much less than the market cap of either Genworth Canada or Genworth Australia. Genworth could sell its stake in Genworth Australia and it would have nearly enough money to buy all the outstanding shares in Genworth. If I ran a major insurance company, I would buy Genworth while it trades with a market cap of just around $1 billion. Then, I would sell shares in the Canadian mortgage division for about $1.1 billion to pay for the entire purchase and use my triple A credit rating to refinance the debt and basically see significant cost savings and get (in essence) the rest of Genworth for free.
But I think there is more upside in the long run if the company remains independent. In terms of strategy, I believe that management took a huge charge on the long-term care division back in late 2014 because they felt it was the right thing to do, and also because this would put the company in a position to petition regulators for significant premium increases. That is exactly what happened, and Genworth will start to really see a substantial amount of additional revenue from these approved increases in 2016. The size and impact of these increases was outlined by Genworth as follows:
"Turning to long-term care, we continue to make strong progress in obtaining rate increases to address our legacy LTC blocks and some of the newer blocks. During the quarter, we obtained five additional approvals with an average rate increase of 29% on $9 million of impacted in force premium. Since the end of the third quarter, we have received additional approvals covering approximately $190 million of additional in force premium with an average rate increase of 26%, bringing year-to-date total in force premium impacted close to $700 million with an average rate increase of 29%.
The average premium rate approved and the level of impacted premium achieved through the third quarter of 2015 remains in line with our 2014 ALR margin assumptions. We continue to expect to see a more meaningful benefit to LTC earnings from these actions later in 2016 as the significant increases approved in 2015 are implemented on policy anniversary dates."
This indicates recent premium increases averaging about 29% on roughly $700 million in policies will have a really meaningful benefit for the company in 2016. A 29% average increase on $700 million in policies represents about an extra $210 million annually, which can go to the bottom line in 2016. Genworth has nearly 500 million shares outstanding, so a $210 million addition to the bottom line is equivalent to potentially about 42 cents per share in additional profit. I use the term "addition" because the company reported that this division actually earned a profit of $19 million in the fourth quarter of 2015. In fact, Genworth made money in every single one of its business units in the last quarter of 2015: the U.S. mortgage insurance division had net operating income of $41 million, its Canadian division reported net operating income of $37 million, the Australia division posted a $22 million profit and its fixed annuities division earned $19 million for the quarter. Finally, the life insurance division had a profit of $21 million for the quarter, if you exclude a $194 million charge for deferred acquisition costs, or DAC. The company announced plans to end life insurance sales, and this explains why it would take a DAC charge on this now. I think this charge positions it to sell this policy block to another insurance company. This will raise cash and allow Genworth to exit the life insurance business, and therefore, puts it in a better position to move forward with breaking up the company. It could also sell its remaining stake in the publicly traded mortgage insurance companies in Australia and Canada or spin those assets off to shareholders. Or the Australia and Canadian divisions could remain as part of Genworth. There might be some who doubt Genworth's ability to get approval from regulators to spin off the long-term care division, but with this division having taken a very significant charge in 2014 to boost reserves, with it showing a profit in Q4, and with significant premium increases expected to boost profits further in 2016, these concerns might be baseless.
It seems many investors are looking at the significant reserve charge the company took for long-term care as a huge negative and as if these charges are never-ending. But I think over the long term, this huge charge in 2014 is what allowed Genworth to get premium increases of about $210 million per year going forward. That is going to pay off in the long run. The company has also posted non-recurring charges in the last couple of quarters because it has been positioning itself to get out of the life insurance business. For example, on September 30, 2015, Genworth said it would sell a block of life policies to Protective Life Corp. (NYSE:PL), which would lead to an "after-tax GAAP loss of approximately $275 to $325 million in the third quarter of 2015 primarily related to the write-off of deferred acquisition costs associated with the term life insurance blocks being sold."
Since there have been a string of these non-recurring charges in the past few quarters, it seems many investors are thinking this is a never-ending situation, but historically, that has not been the case. It is clear that Genworth is taking these charges as part of a strategic plan. Without these charges, the company would not have been in a position to seek out huge premium increases for the long-term care division. It also makes sense for it to sell the life blocks and end that line of business in order to reduce costs and raise cash that will help win regulator approval for a spin-off of the long-term care division. All of this makes sense, and CEOs often want to throw the kitchen sink out in the final quarter of the year so that the company is positioned for a solid new year. I think that is what Genworth's CEO has done with Q4 2015. The market is extremely negative and skeptical of any financial stock right now - even ones like Citigroup, which just reported record profits. Naturally, it is going to be skeptical of Genworth after seeing non-recurring charges show up more than once in the past few quarters. I clearly believe these charges have been strategic, and that while it has been painful in the short term, the long-term benefits will reward patient investors. Genworth maintains solid capital positions in all of its operating subsidiaries, and it has strong financials, with about $6.61 billion in cash and just $6.67 billion in debt.
In summary, much of the downdraft in this stock is not based on fundamentals, but rather on index selling, shorts, tax-loss selling, fear, margin call and technical selling. Genworth shares might look "toxic" now, just as they did in 2009 and 2012. However, when the shares looked very "toxic" in the past, the company ended up posting 1,000% plus gains from the lows of 2009 and 300% plus gains from the lows in 2012. As for the bears and the shorts, enjoy this moment of victory while it lasts, and remember that just about every reason you can list for being short or believing in the demise of this company was also believed and said many times earlier in 2008, 2009 and 2012. It has always paid off to buy GNW around current levels, especially at times of significant market stress and when fears are running high. There is always irrational and foolish selling in financial panics - as we have seen now and earlier too with Genworth and many other stocks. When I look at the fundamentals, here is what I see: Genworth has significant (and marketable) assets worth billions of dollars with its stake in Canada and Australia, billions in cash on the balance sheet, a book value of nearly $20 per share, all of its divisions produced an operating profit in Q4. Plus it has credible earnings estimates of about 90 cents per share for 2016, and even more for 2017. For all these reasons, I am bullish.
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Disclosure: I am/we are long GNW.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.