Subprime Mortgage Fears Bring Select Opportunities

12 Mar

Yet another analyst downgraded Countrywide Financial (CFC) today. And the shares are down another 3% on top of being down almost 15% year-to-date. In my view, the decline on the news provides yet another great entry point for long-term investors. Don’t get me wrong, this will be a volatile sector to be exposed to in the near term, but an investment case here need not be predicated on a quick rebound in loan originations.

Despite market perceptions of CFC as a pure play on mortgages, less than half of Countrywide’s earnings are derived from originations. The company is the second-largest loan servicer in the country (after Wells Fargo), with a servicing portfolio of $1.33 trillion, up 17% year over year through February. The servicing fees and interest earned on no-cost escrow accounts in this business give it annuity-like characteristics that are not tied directly to originations. The company’s fast-growing banking division, with $84B in assets, has grown 12% since last year and now provides about one third of CFC’s profits. The insurance and capital markets segments further diversify the business.

At $35, Countrywide trades at 8 times forward earnings, 1.4 times book value, and pays a 1.7% dividend. Management has an enviable track record of growing value for shareholders – over the past 15 years the stock has returned over 18% per annum including its recent poor performance. Based on conservative assumptions, I think the company is likely to have one or two years of flat revenues followed by continued growth as the industry recovers. Countrywide’s origination business will not suffer as greatly as the industry since it continues to take market share. And its financial strength and diversified revenue base give it many options as the industry shakes out the weakest players.

Is the market discounting overly pessimistic views disproportionate with their probability of occurrence? It sure looks that way. As an investor with a long-term perspective, I welcome the misvaluation as an opportunity to add to positions. The stock can still go lower, but the risk-reward balance seems tilted in favor of the patient investor. Outperformance over long periods requires being able to stomach bad news and volatility in the short-term. Once the mortgage industry dust settles, shares will make up for lost time.

I’m not oblivious to the near-term threats to the business. Countrywide has originated many option-ARMs, which are a relatively new product whose long-term viability has not been proven. Exposure to the nonprime market remains a concern, but Countrywide has not been a large player in this space. The company securitizes and sells nearly all of the loans it originates, so an investment in Countrywide carries low balance sheet risk. Though the company holds some residual tranches from CMOs it sells, these comprise only a small portion of company assets.

In aggregate, the potential rewards seem to outweigh the risks. While negative industry sentiment is justified with players such as New Century Financial (NEW), Countrywide’s year-to-date loss has just made its shares more attractive, in my view.

Full disclosure: Long CFC shares personally as well as for clients.


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