If you glanced at my post this past July 19 titled "Be an Early Investor in Mortgage Insurance Stocks, Ahead of Next Week's Earnings", you were aware that I expected investors to finally get excited about these stocks - MGIC (MTG), Radian (RDN), Essent (ESNT), and National Mortgage (NMIH) - when they delivered good earnings and distributions to shareholders. The mortgage insurers (MIs) certainly delivered. They delivered on Q2 earnings:
Source: Company reports, Yahoo Finance
They delivered on Q2 credit quality:
Source: Company reports
And they largely delivered on increasing their cash returns to shareholders:
- MGIC initiated a $0.24 annual dividend and bought back $25 million of stock during Q2.
- Radian bought back $219 million of stock (5% of its shares) during Q2 and July.
- Essent initiated a $0.60 annual dividend.
- National Mortgage grew too fast to be able to return capital to investors - 41% growth in its insurance in force from a year ago.
Considering that these companies went into Q2 reporting with a paltry average P/E ratio of 8, investors should have gotten at least a little excited, right? Wrong. The stocks are 2.5% lower than the day before the first MI (MGIC) reported earnings.
Am I disappointed by Mr. Market? You bet. Am I giving up? Not a prayer.
Four reasons for my stubbornness:
- Credit quality fundamentals remain excellent.
- The MIs' emerging capital-light business models are freeing up tons of cash for investors.
- Wall Street is under-estimating the earnings power of (1) and (2)
- Valuations are even more embarrassingly low after the earnings reports.
Credit quality fundamentals remain excellent.
Exhibit A is the table above that shows MIs' still-falling loss rates. I feel safer forecasting that claims will be even lower a year from now than that POTUS will insult somebody over the next week. My confidence stems from Exhibits B and C. Exhibit B is the most crucial - an index of U.S. mortgage loan quality:
Source: Urban Institute
Lending standards remain quite conservative. The details of the MIs' Q2 loan standards (presented in detail by each company) verify this trend.
Exhibit C presents the other key for mortgage defaults - the supply and demand for housing. The law of supply and demand says that if supply is in excess, then its price will drop, and if demand is in excess, the price will rise. In housing, the supply/demand balance is measured by a vacancy rate. And Exhibit C shows that vacancies are falling:
Source: Census Bureau
Falling vacancies are a key reason why home prices rose strongly over the past decade. And while home construction activity has been a disappointment for the U.S. economy over the past few years, it is awesome for mortgage credit quality.
The MIs' emerging capital-light business models are freeing up tons of cash for investors.
While accounting earnings are good for investors, transmitting those earnings into cash paid to shareholders is great. Two quick examples:
- The standard homebuilding model is that the builder reinvests a lot of its accounting earnings into land for future construction. For example, while Lennar earned $658 million during the first half of 2019, it spent $1.5 billion in new land, driving a $423 million operating cash flow loss. But competitor NVR doesn't buy and inventory land; it options land to acquire as needed. So its $399 million of first half '19 earnings generated $303 million of operating cash. Lennar's P/E? 9. NVR's P/E? 17.
- Microsoft (NASDAQ:MSFT) has been a cash machine for the past few decades because of its Office software. CEO Steve Ballmer used that cash machine to be a serial acquirer, most of which were spectacular failures. As a result, during his 14-year tenure, Microsoft's stock fell by 35%. (As punishment for his misdeeds, he is a multi-billionaire. Hah!) His replacement Satya Nadella stopping buying companies, instead dramatically increasing the dividend and share buybacks. The stock is now 274% higher.
So, investors like when earnings translate into free cash flow. The MIs are starting to get the concept. Holding a mortgage insurance policy requires capital to back it, so growing the business requires retaining capital. But the MIs are increasingly using reinsurance, which shifts some of their credit risk to other investors in exchange and, therefore, reduces required regulatory capital. For Radian, the use of reinsurance has reduced their regulatory capital requirement by a third. Increasingly, then, the MIs are becoming capital-light. The result is those dividend and stock buyback announcements I noted above. I am confident that these announcements will grow over the next few years.
Wall Street is under-estimating the power of the MIs' low credit risk and capital-light management.
For example, the current Street estimate (re Yahoo Finance) for Radian next year is $3.10 per share, up 6% from this year. I think $3.20+ is more likely. One EPS forecast from a Street analyst I saw is probably representative. He has $3.00 next year, including:
- A $200 million claims provision, up from $144 million this year. Why? Claims payments are still trending down, and while the MIs are forecasting that the number of delinquent loans will start to rise soon, the loss content of those delinquencies is low because of good underwriting. Assuming a flat provision adds $0.20 a share to EPS.
- That Radian will use barely $100 million of his forecasted $625 million in earnings to buy back stock. Crazy. $400 million in buybacks is much more reasonable. The extra $300 million buys back roughly 12 million shares, shrinking Radian's share count by 6%. That adds another $0.20 per share to EPS.
I just got to $3.40 a share. $3.20 should be a breeze.
Valuations are even more embarrassingly low after the Q2 earnings reports.
Since I'm on Radian today, let's review the valuation of this $22.53 stock (August 2 close):
- 7.0 times my $3.20 EPS estimate for 2020. That's only 40% of the market multiple.
- Flipping around the P/E ratio is Radian's earnings yield. It equals 14.2%. Since the great bulk of Radian's earnings are available for shareholder payout, that means Radian is close to a 14% bond. With growth. It might make sense to pass up the German government 10-year bond yielding minus 49 bp to nibble at a little Radian, no?
- Nearly 20% below my estimate of its liquidation value of $27 per share. That's right folks - 20% below shut-the-doors, sell-the-furniture value.
Is my liquidation value crazy? Maybe not, considering that book value, which is nearly all in investment-grade securities, is $18.42. And off the balance sheet is $231 billion of high-quality mortgage insurance in force. Radian says that these policies will generate over $2 billion of income over time. My estimate is $2.8 billion. Taking the present value of those earnings gives me another $8.50 per share.
Seriously, what are you waiting for? Buy an MI stock today. Thank me one day. Maybe not today - the past week proved that - but one day.
Disclosure: I am/we are long MTG RDN ESNT NMIH. 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.