MGIC Investment Corp (MTG) at $58.44

Step 1: Do you understand MTG’s business?
MGIC Investment Corporation is a holding company, which through its wholly owned subsidiary, Mortgage Guaranty Insurance Corporation (MGIC), provides private mortgage insurance (PrivateMI) in the United States to the home mortgage lending industry.

Mortgage insurance was invented by Max Karl, an attorney in Milwaukee, Wisconsin. He observed the struggles that people had with saving for a down payment, and understood the risks that mortgage originators faced in lending that money. He created MGIC and mortgage insurance in an effort to help people become homeowners faster by sharing some of the risk with the mortgage lenders.

What is PrivateMI? PrivateMI is a financial guaranty that reduces or eliminates loss to a lender in the event a borrower defaults on a home loan and the mortgage is foreclosed. In effect, MGIC shares the risk of lending money to a borrower. In essence, PrivateMI aims to make homeownership more affordable.

PrivateMI covers residential first mortgage loans and expands home ownership opportunities by enabling people to purchase homes with less than 20% down payments. PrivateMI also facilitates the sale of low down payment and other mortgage loans in the secondary mortgage market, including to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Fannie Mae and Freddie Mac are collectively referred to as the GSE. In addition, to mortgage insurance on first liens, the Company, through other subsidiaries, provides lenders with various underwriting and other services and products related to home mortgage lending.

Step 2: What are the potential risks of owning MTG?
There are alternative or cheaper ways to buy a home rather than using PrivateMI. One of the most popular alternatives is piggyback loans, such as a first mortgage with an 80% loan-to-value ratio and a second mortgage with a 10%, 15% or 20% loan-to-value ratio (referred as 80-10-10, 80-15-5 or 80-20 loans, respectively). Unlike mortgage interest, PrivateMI isn't tax-deductible. This makes competing products like 80-10-10 loans more attractive.

Deterioration in domestic economic conditions generally increases the likelihood that borrowers will not have sufficient income to pay their mortgages and can also adversely affect housing values.

Competitions not only from other PrivateMI companies, but also with mortgage lenders through captive reinsurance transactions. [Lenders have established captives--private insurers--to reinsure MGIC's portfolio. Here's the catch: To win mortgage insurance business from these lenders, MGIC must cede as much as 40% of its insurance premium to the captive in return for protection against large losses. But lenders flexed their muscles and established a loss rate well above historical levels, so they will most likely never be contractually obliged to help MGIC pay a claim. The net result is that the most profitable part of MGIC's margins has been recaptured by its lender clients. The percentage of premiums the firm cedes has more than doubled since 2000 and now exceeds 10%. What's worse, more than 45% of MGIC's insurance portfolio is now subject to some type of this premium transfer, and we fear the percentage could climb. In our opinion, MGIC's margins are at least 15% lower as a consequence--and may never recover.] (From Morningstar)

Changes in the business practices of Fannie Mae and Freddie Mac could reduce the company’s revenues or increase its losses i.e. level of PrivateMI required, whether preference given to mortgage insurer with “AAA” rating etc. Fannie Mae and Freddie Mac control more than 40% of the mortgage market, which lets them dictate terms to mortgage insurers.

Net premiums written could be adversely affected if the Department of Housing and Urban Development (HUD) reproposes and adopts a regulation under the Real Estate Settlement Procedures Act (RESPA) that is equivalent to a proposed regulation that was withdrawn in 2004. HUD regulations under RESPA prohibit paying lenders for the referral of settlement services, including mortgage insurance, and prohibit lenders from receiving such payments. In July 2002, HUD proposed a regulation that would exclude from these anti-referral fee provisions settlement services included in a package of settlement services offered to a borrower at a guaranteed price. HUD withdrew this proposed regulation in March 2004. Under the proposed regulation, if mortgage insurance were required on a loan, the package must include any mortgage insurance premium paid at settlement. Although certain state insurance regulations prohibit an insurer’s payment of referral fees, had this regulation been adopted in this form, the Company’s revenues could have been adversely affected to the extent that lenders offered such packages and received value from the Company in excess of what they could have received were the antireferral fee provisions of RESPA to apply and if such state regulations were not applied to prohibit such payments.

Increasing default rate year after year is a worrying sign. Percentage of default has climbed from 2.17% (1999) to 6.58% (2005).

Step 3: Insider Holdings
Collectively, directors and officers own about 1.14% of MTG, a $65 million investment. Plus, the CEO and directors must own shares exceeding 5 times the value of their annual cash compensation. Even better, return on equity is the primary metric in the managers' cash bonus plan. (From Morningstar)

The negative point is that there were significant insiders selling. CEO (Culver Curt) sold shares worth $2.4M on Feb3, 2006.

Step 4: Is MTG a good Company?
MGIC has one of the largest market shares in the very concentrated private mortgage insurance industry, consistently 20%-25%. It was 22.9% in 2005. (From Morningstar)

MTG has excellent return on equity (ROE) and return on assets (ROA) over a long period of time. Although ROE and ROA have been declined over the years, the current ROE and ROA are still impressive.

Year ROE ROA
12/05 15.1 9.9
12/04 13.4 8.7
12/03 13.0 8.3
12/02 18.5 11.9
12/01 21.0 13.9
12/00 22.0 14.0
12/99 26.5 15.1
12/98 23.5 12.6
12/97 21.8 12.4
12/96 18.9 11.6

Likewise, net profit margin is superior. MTG consistently earns one of the highest net margins in the S&P 500.

Year Net Profit Margin (%)
12/05 41.1
12/04 34.3
12/03 29.3
12/02 42.4
12/01 48.4
12/00 48.8
12/99 47.2
12/98 39.7
12/97 37.3
12/96 34.6

MTG’s current loss reserve (June 2006) stood at $1.09B, which is almost double the losses paid in 2005 ($612M). Its loss reserve has been increasing steadily over the year from $681M (1998) to $1.09B. In comparison to its competitors, PMI Group and Triad Guaranty Insurance have less than 1.5 times and 1.1 times loss reserve to its losses paid respectively. MTG is more conservative and better reserved than its competitors.

Step 5: Does MTG management shareholders-orientated?
I would let Culver Curt, the CEO, to speak for himself….

“Last year I wrote that we needed to maintain our discipline and not succumb to the “top of market” environment that existed at the time and chase short-term benefits. Rather we needed to stay focused on creating long-term, sustainable value for all of our constituencies. That was the objective then and it remains the same today.” (From 2005 Annual Report by Culver Curt)

Outstanding shares have been reduced by 23% over last 9 years from 118M (1996) to 90.7M (2005). Over the last 6 months, the management has repurchased additional 3M shares.

Also, as mentioned before, ROE is the primary metric in the managers’ cash bonus plan.

Step 6: Does MTG have a Moat?
No. However, MTG has the oldest and most detailed mortgage history database, which adds a considerable advantage in underwriting skill. Lenders prefer to be insured by successful underwriters. (From Morningstar)

Step 7: Does any superinvestor invest in MTG?
Bill Miller and Bill Nygren own MTG, but only as a small percentage of their portfolio; less than 2%.

Step 8: Is MTG undervalued?
Yes. I will clarify these using three simple valuation methods.

Valuation Method 1 (Liquidation Value) (December 2005):
Total investment portfolio = $5,486M
Cash = $4.6M
Accrued investment income = $66.3M
Reinsurance recoverable = $14.7M
Prepaid reinsurance income = $9.6M
Premiums receivable = $91.5M
Investment in Sherman Business = $158.6M (Explained in part 1)
Investment in C-BASS = $555M (Explained in part 2)
Total Liabilities = $2,193M
Total (Liquidation Value) = $4,193.3M

Market Cap = $4,980M

At current price of $58.44, MTG is selling at 1.19X liquidation value, which is very cheap indeed.

Part 1:
Sherman business value on MTG’s balance sheet was recorded on equity basis. However, Sherman true intrinsic value is higher than stated on its balance sheet. Asta Funding (ASFI), which has similar business model to Sherman, is valued over 3X book value. To be conservative, I would value Sherman business at 2X book value as it has significant leverage in comparison with Asta Funding. Total assets: Equity for Sherman and Asta Funding are 4.14 and 1.24 respectively.

Equity value in Sherman business = $79.3M

Estimated intrinsic value = $79.3M X 2
= $158.6M

Part 2:
C-BASS business value on MTG’s balance sheet was recorded on equity basis. However, C-BASS true intrinsic value is higher than stated on its balance sheet. In 2005, MTG’s share of pretax income was $111M on $362.6M investment in C-BASS. It would be impossible to find a business that has pretax return of over 30%. Therefore, to be conservative, I would value C-BASS business at 5X pretax income.

Estimated intrinsic value = $111M X 5
= $555M

Valuation Method 2:
Price/Book ratio: 1.2. This is the lowest price/ book value in the last 10 years.

Year Price/ Book
12/05 1.40
12/04 1.60
12/03 1.48
12/02 1.22
12/01 2.17
12/00 2.92
12/99 3.58
12/98 2.65
12/97 4.76
12/96 3.28

The average Price/Book ratios for the last 10 years and 5 years are 2.5 and 1.57 respectively.

Book value/ Share compounds at 15.4% over the last 5 years; and 11.8% over the last 3 years; and 9.9% over last year.

Year Book Value/ Share
12/05 $47.31
12/04 $43.05
12/03 $38.58
12/02 $33.87
12/01 $28.47
12/00 $23.07
12/99 $16.79
12/98 $15.05
12/97 $13.96
12/96 $11.59

Let say the MTG could grow its book value at 8.5% over the next 3 years and its price/book ratio is 1.5 at the end of third year, its share price would therefore be $90.60, which is about 55% increase from current price of $58.44. This is a conservative assumption and if it could grow its book value at higher rate or is priced at higher price/book ratio, its potential upside would be higher.

Valuation Method 3:
MTG price to earning ratio (PE) is 8X. This is half of the S&P500 PE.

Conclusion:
MTG is a simple to understand business, leader in PrivateMI, good management in place and undervalued. Although it does not have “Coke” competitive moat, it is a good investment with minimal risk of total investment loss.

P.S. To read my previous analysis on MTG in Feb 10, 2006.

Happy investing,
Dah Hui Lau (David)
dahhuilaudavid@gmail.com