Two Stories for the Price of One. MGIC/Wayfair Update, and Trump’s Federal Reserve Problem.

Jul 25, 2018 by Gary Gordon

An MGIC and Wayfair update.

This past May 23 I recommended that you buy MGIC (symbol MTG) and sell short Wayfair (symbol W).  I don’t just recommend and run, like some people I know.  Here’s the follow-up.


The day before I wrote MGIC up, the stock sold at $10.70.  Two weeks ago, it was flat with that price, at $10.75.  Yesterday it closed at $12.39, up 15% from my recommendation.  The good news was the second quarter (Q2) earnings report on July 18.  Specifically:
  • MGIC reported $0.49 per share, well over expectations.  Even after excluding a semi-recurring benefit, it earned $0.35 a share, or $1.40 annualized.  The $10.75 stock price was only 7.7 times those earnings, or less than half the valuation of the average traded stock. 
  • The $0.14 per share benefit was a reversal of loss reserves on its mortgage default insurance policies.  MGIC’s delinquent loans have been declining for almost a decade, and Q2 was no exception; they fell 13% from a year prior.  As a result, MGIC has been able to shrink its loss reserves for the past few years.
  • Loans insured from the bad old days prior to 2008 still are 74% of delinquent loans.  Only 1.1% of loans insured since ’08 are in default, half the rate of 1999, during a similarly strong economy.
  • MGIC bought back over 2% of its shares during Q2, a permanent benefit to earnings per share (EPS).  More are planned.
  • Loans insured grew by 7%, or faster than overall GDP growth.  Yet the stock price suggests a declining business.

The recent rise means that MGIC’s stock is not super cheap, just very cheap.  If you bought it, I say hang on to at least $15.  I’m waiting for about $20 to exit.
 


Wayfair’s stock price was $84.66 on May 22.  Today it opened at an astounding $122, up 44%.  Yikes!  I’m not sure another stock did better over that period.  Give me credit for not just being dumb, or even dumber, but the dumbest.

What did Wayfair announce to generate this huge run?  Not a gosh darn thing.  The only recent news that I saw is that furniture is included in the new China tariffs.  Doesn’t seem like a positive for furniture companies, does it.  Wayfair is still expected to lose – yes, you read that right, lose - $0.73 a share for its Q2.  That sounds bad, but not compared to the $0.83 per share loss Wall Street expects Wayfair to sustain the next quarter.  It reports on August 2.

In fact, a Morgan Stanley report on Wayfair expects them to lose money until 2025.  Seven years from now.  How can we reconcile seven years of losses ahead with a $1__ stock price?  The following table shows what investors are implicitly expecting.  The table is built on the facts that stock values are the function of (1) estimated future EPS streams, and (2) an expected percentage investment return (the discount rate, for you MBAs).  The table makes crude estimates for MGIC and Wayfair’s earnings through 2024.  I assume a very modest 3% for MGIC (4-6% is more realistic) and a Morgan Stanley-like outlook for Wayfair.  My assumed investment return is 10%.  Using these assumptions allows me to estimate the value that today’s investors expect investors in 2025 will put on the stocks:

 

Sources: Yahoo Finance, Gary Gordon Investor

MGIC’s current stock price implies that after earning $11.41 a share from 2018 to 2024, going forward from 2025 through infinity the stock will generate only a $10 per share value.  On the other hand, after losing $13.45 a share from ’18 to ’24, Wayfair will have an astonishing $327 per share value in 2025 based on expected earnings going forward.  When I first suggested the short, the market assumption was a still-dazzling $241 a share.

I’m sticking with my Wayfair short.  Looking forward to August 2.


Trump’s Federal Reserve problem.
How did this from the Presidential campaign…

“Republican presidential nominee Donald Trump…said on Monday that the U.S. central bank has created a ‘false economy’…’They’re keeping the rates down so that everything else doesn’t go down,’ Trump said in response to a reporter’s request to address a potential rate hike by the Federal Reserve in September.” (Fortune magazine, September 3, 2016)

…Turn into this recent comment?

‘Trump told CNBC the [Federal Reserve’s planned interest rate] hikes could damage America’s ongoing economic recovery from the Great Recession.  “I’m not thrilled. Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it”…”Debt coming due & we are raising rates — Really?”’  (New York Post, July 20,2018)

Here's how the switch occurred.  First, he inherited this fact:

 

Sources: Federal Reserve, Bureau of Economic Analysis

The US debt burden (total debt as a percent of GDP) expanded dramatically over the past 35 years.  As The Donald rightly noted, the historical job of the Federal Reserve is to moderate the economy by pushing against the trend – raising interest rates when times got good and lowering them as economic activity slowed.  But about 15 years ago, the Federal Reserve, in my not-at-all humble view, shifted from being an economic moderator to a debt enabler.  This chart makes my point:

 

Sources: Federal Reserve, Bureau of Economic Analysis, Department of Labor

The chart shows that since the early 2000’s, the “real” (after inflation) federal funds rate has averaged a historically very low 0%.  That has made the cost of the debt burden quite bearable.  Even the five expected increases in the fed funds rate through the end of 2019 will take the real rate only barely above 0%.

So why is Sir Donald in such a fit?  Partly because interest rate increases have strengthened the dollar, which threatens a higher trade deficit.  But also because he has big plans for more debt growth:

“The Trump administration expects annual budget deficits to increase nearly $100 billion more than previously forecast in each of the next three years, pushing the federal deficit above $1 trillion starting next year.”  (The Wall Street Journal, July 19,2018)

Growing government debt plus higher interest rates could take the government’s interest expense from around $300 million a year at present to nearly $1 trillion a year in a decade.  Whee!
Wrapping up. 
I caution against owning bonds because interest rates should rise for a while due to the coming fed funds increases and likely growing wage increases.  But I also believe the US will try desperately to keep a lid on the interest rate rise because our huge debt burden makes a rate increase very expensive.  So don’t buy bonds now, but a great buying opportunity may lie ahead.