Tuesday, September 9, 2008

"Freddie Mac is the Cheapest Stock I've Ever Seen"

So said value investor Richard Pzena1, of Pzena Investment Management, at the 3rd annual Value Investing Congress in New York last November, according to the notes of attendee Amit Chokshi. Chokshi posted the following notes from Pzena's presentation on Seeking Alpha last November 30th (hat tip to commenter "cm1750" on GuruFocus):

* Pzena's talk was entitled 'Evaluating Financials in a State of Panic'
* The only time good businesses sell for cheap prices is during times of distress
* Financial stocks are cheap on a P/B basis against historical multiples
* Freddie Mac (FRE) is the cheapest stock Pzena has 'ever seen':
* Losses are absorbable and GAAP is not useful in evaluating FRE
* Pzena believes the mortgage payment resets that result in higher monthly payments will be handled by borrowers because they will be reluctant to forfeit the equity in their homes
* Fears in the market don’t necessarily impact FRE’s business but are impacting its stock
* FRE Loan to Value = 60% and are mostly in fixed high credit
* Believes FRE will follow similar action to P&C insurance companies
1. Hurricane/natural disaster occurs, P&C insurance companies experience losses, P&C companies raise prices/premiums, P&C stock goes up
2. Housing crisis has occurred, FRE and other industry players will raise fees, tighten credit standards, experience lower losses resulting in strong capital returns and thus improving stock price.

At the time, Freddie Mac (NYSE: FRE) was trading at about $30 per share. Today it closed at 95 cents per share. Off the top of my head, I can't think of a value investor who has made money going long on a financial stock over the last year and a half, but another investor at last November's Value Investing Congress, David Einhorn, has done well shorting Lehman Brothers (NYSE: LEH).

1Richard Pzena went to Wharton with Joel Greenblatt, author of The Little Book That Beats the Market. In that book, Greenblatt appeared to be alluding to Pzena as "the smartest money manager I know" on p.72.


Dennis Mangan said...

Pzena may still have been right but didn't reckon with something that's not normally associated with the U.S.: political risk. Not saying that FRE would ever have recovered, but who would have thought that the government would seize them?

DaveinHackensack said...

There had been talk for years about dealing with the GSEs at the federal level, though I don't recall whether effectively re-nationalizing them was seriously discussed.

That said, the GSEs were political creations to begin with, and that unique status is what made them so profitable for years, being able to borrow at below-market rates due to their implicit government backing. If it weren't for that status, FRE wouldn't have been able to continue to raise debt financing at all in recent months. As it happened, even with that implicit government backing, it was unable to raise additional equity financing.

I guess you could call it "political risk" that the government would finally decide that if it was going to be on the hook for potential losses anyway, it might as well take control of the situation and get an equity stake as well, but what would have been the alternative? The government could have denied any obligation to back FRE's debt and not stepped in with the takeover, in which case FRE would have been unable to borrow at low enough rates to function, and FRE shareholders would have probably been worse off as the company went bust. Or the government could have maintained ambiguity on the question, and FRE shares might have taken another several months to get to their current levels.

The operative risk here seems to have been the credit crunch and the inability of FRE to raise equity capital, not the possibility of government seizure. I say that, of course, with the benefit of 20/20 hindsight. You're right that Pzena's position may have made sense in light of the facts available at the time.