Ripest Grounds for a Spec Play, Part I

 | Mar 23, 2013 | 12:15 PM EDT  | Comments
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Note: This is part one of a three-part series. Part two will appear later on today.

We've got a worst-to-first situation brewing here -- actually three worst-to-first situations. I think every portfolio looking for a decent speculation play has to consider owning a stock in the shipping business, the airlines or the mortgage-insurance space.

The market has thrown a lot of curveballs since 2013 began, but the most difficult to fathom have to be the turns in these most definitively down-and-out industries.

So before I give you some names, let me tell you how I see things shaking out, and why these companies are going to have a terrific 2013.

First, we have to admit that shipping, mortgage-insurance and the airline businesses have been about the worst three industries in the stock market over the last decade. Each has seen players fall by the wayside, and none has generated a rate of return that has made any of them investible.

Second, I have studiously avoided shipping and mortgage-insurance companies since the market's top in 2007. Airlines? I have not recommended them since 1985, with the only exception being Alaska Air (ALK).

But now it's all changed. In this three-part series for the Real Money Open House Weekend, I am going to outline what's changed, why, and how it can be lasting -- along with the best ways to play it.

I'll start by addressing the mortgage industry.

You probably already know that I think the housing sector is not merely coming back; it is roaring back. It is perhaps the most powerful theme out there, able to trump even the knottiest of European monetary or U.S. political problems. Homes are more affordable now than they've been during any time in history -- although we know that won't last if the pricing stays as strong as it has been, a trend that I believe the latest Case-Schiller index will confirm when it's released Tuesday. With expectations calling for the construction of about 1 million new homes, we know more mortgage loans will be written in 2013 than at any time in the last five years.

At the same time, we've seen the huge run-ups in shares of the homebuilders and the suppliers. After the huge quarter Lennar (LEN) had, you could detect how uncomfortable people were paying up here for Toll Brothers (TOL) and PulteGroup (PHM) at these levels.

That's why I think it is time to go down the food chain and own a mortgage insurer. The mortgage-insurances companies, as you might expect from the name, write insurance policies on mortgages that compensate lenders or investors if the borrower defaults on the loan. So let's say you take out a loan to buy a house and put down, for instance, 15%. The bank is required to go to the Federal Housing Administration, or a private player like Radian (RDN), for mortgage insurance -- and that cost is then passed along to the buyer of the house. Any time the down payment on a mortgage is less than 20%, the regulators insist that the bank get mortgage insurance.

During the financial crisis and the recession, the mortgage insurers were some of the biggest losers out there, because they had to pay out endless claims as millions of people defaulted on their mortgages. It was a magnitude of defaults that could never have been imagined in this industry. No significant amount of borrowers had ever defaulted en masse like this, other than in the Great Depression and in a brief period in Texas during the savings-and-loan crisis.

The losses were so bad, and the pain so constant, that PMI -- one of the largest players, and long considered the pristine company in the group -- declared bankruptcy in 2011. For years investors have been worried, justifiably, about the solvency of everybody else in the industry.

Which brings me to Radian. A year ago I thought Radian was going to go under. The stock was trading at $2. Since then it's doubled, though, and doubled again. I believe it's now in the process of doubling once more.

But the mortgage insurers were so toxic for so long that I'm sure many of you readers would want to write Radian off as too dangerous. Don't do that. The industry was in trouble for years and years for the very same reason that it is coming back with a vengeance now: housing. Then, housing had been in free fall; no one was buying new homes, and foreclosures were left for dead. But that's all reversing now, first with the big wave of refinancing -- a major source of mortgage-insurance writing -- and now with the buying of new homes and the sales of existing ones.

In fact, Radian is using the slump to make itself stronger. Just a few years ago, the company was the No. 3 player by market share in the private mortgage-insurance market. Now it is No. 1. The company wrote $37 billion in new insurance in 2012, up 139% from the year before, and it's on a course to vastly exceed that in 2013 as the housing revival picks up steam.

There's another way in which Radian has benefitted from the aftermath of the financial crisis: Banks have dramatically tightened up their underwriting standards, so it's much harder to get a mortgage these days. As a result, the insurance policies Radian has been writing for the last few years are much less likely to blow up in the company's face.

Radian has also been incredibly aggressive at pursuing this profitable new business. Right now, 50% of Radian's risk in force -- that's the key metric the industry uses to measure its credit risk at any given moment -- comes from new insurance written after 2009. These are the safe mortgages to high-quality borrowers. Because Radian is writing so much new business right now, that post-2009 business will represent nearly 75% of Radian's total by the end of the year.

Plus, there's another angle here that I love: the diminution of the competition from the government. The Federal Housing Administration, or FHA, is Radian's largest competitor, with about 15.8% of the total mortgage insurance market. But the FHA isn't a business. It's an agency, and right now its capital position is well below that of the congressionally mandated minimum. That's why the FHA has had to raise prices on its mortgage insurance five times in the last 18 months -- yep, five times! -- and more price hikes are likely to follow in the months to come. In fact, the FHA recently came out to say that its market share will likely revert to the historical norm of somewhere between 8% and 10%. It's setting out to lose market share to Radian! How many companies face that kind of bounty?

Meanwhile, many of the negatives here are being worked out over time, even as the critics remain vociferous in their opposition to the company's improvements.

For years Radian has been winging down its financial-guarantee business, in which it wrote insurance for everything from municipal bonds to complex structured products. The firm stopped writing new policies in this business line back in 2008, and has reduced its exposure in it by more than 60% over the last three years. On top of that, some 35% if Radian's exposure to collateralized debt obligations (CDOs) -- remember those? -- matures at the end of the year.

Now the bears are still very much out in force with Radian, and there are a ton of short-sellers in the name, and about one-quarter of the company's float is held short. Further, back in November, Jonathan Laing -- a very good Barron's writer -- penned a piece entitled "Is Radian a House of Cards." If it is a house of cards, it's a house of cards that has doubled since that article appeared.

Barron's alleged that Radian was under-reserving capital for the policies it wrote, and over-denying claims. However, the regulators have approved the way that Radian has been using its capital. As for denying claims, the firm is just following the standard industry practice of denying anything for which paperwork is wrong or in which the loan might be fraudulent.

Back on Feb. 25, Radian announced a big 30-million-share secondary offering that had to be upsized to 34 million because of great demand. It was priced at $8 a share and closed that day at $8.45. Since then, the stock jumped to $10.50 before pulling back about a quarter of a point to where it went out Friday.

When I recently talked to Sanford Ibrahim, the CEO of Radian -- a Philly company -- I became very comfortable with the idea that this firm could hit profitability perhaps as soon as the second quarter.

I think the next big catalyst for Radian to keep appreciating is in settling delinquencies that are three-plus years old. I think the number is around 20,000 loans, mostly from Countrywide, now a part of Bank of America (BAC). The bull case is that many of these loans were fraudulent from day one and that Radian will not have to pay out on them. While Radian has reserved $30,000 per claim, that bull case says it will settle with BofA for a fraction of that -- say, $10,000 per claim -- and that Radian will therefore increase its statutory capital. The short-sellers are saying that $30,000 is way too low, and that Radian will most likely have to double that.

But a competitor, MGIC (MTG), just settled 9,000 delinquent loans for $5,000 per claim, as opposed to the $70,000-per-claim amount that Countrywide had asserted. If Radian gets that kind of deal -- and I think it can, because it was no better or worse than MGIC -- the stock could appreciate gigantically almost immediately.

There are only four players in this industry: MGIC, AIG (AIG), Genworth (GNW) and Radian. MGIC is getting better, but is not as far along as Radian. Genworth has a lot of other business lines, but it has some questionable investments. AIG's real good, but it has so many other businesses that this can't be that much of a needle mover.

Which is why Radian is the one to buy -- and to buy Monday morning.

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