The Benjamin Graham method of valuing

The Benjamin Graham method of valuing

Understanding The Benjamin Graham Formula Correctly - Nasdaq


Benjamin Graham formula




Which Of The Busted Fannie Mae Preferreds Are Better Buys?

Preferred issues of Fannie Mae and Freddy Mac have risen rapidly since Donald Trump's election.

The Benjamin Graham method of valuing special situations can be used to compare them to one another.

While they're all highly speculative, some appear to offer a much higher return than others.

This is obviously a risky proposition, depending on non-economic factors. But for investors with the capital and risk tolerance to bet on a positive outcome, it raises other questions. Are the preferreds still good buys? If so, which ones?

To figure this out, we can use Benjamin Graham's special situations formula, as described by Seeking Alpha contributor Wayne Olson in one of his excellent articles about the government-sponsored mortgage companies. The Graham formula is excellent for the preferred issues, since they are likely "all or nothing" bets, ultimately either resuming dividends or being wiped out. Here is the formula:

Indicated Annual Return = (GC - L (100-C)) / YP
Where G is the expected gain in the event of success
C is the expected percentage chance of success
L is the expected loss in the event of failure
Y is the expected holding period
P is the current price of the security

Olson used as his example one of the Freddie Mac preferreds, FMCKJ. I decided to run the formula on several of the Fannie Mae preferreds since I had been a Fannie shareholder years before the financial crisis.

For C, chance of success, I put 50%, not wanting to be more than half-wrong.

For Y, holding period, I put four years, figuring anything any deal would be finalized before the end of Trump's first (or only) term. Ackman predicts a deal within one year, but we're being conservative.

For G, expected gain in case of success, I assumed the highest-yielding issue (FNMAT) would go back to par - it's not cumulative, so no extra distributions are owed (unless a court rules the government acted illegally), and it's callable immediately, so it won't go too far above par. The rest of the issues I assumed would trade to produce the same yield as FNMAT, as calculated in the "full value" column. This may be too conservative - if Fannie comes out of conservatorship with a strong credit rating, and interest rates haven't risen too much, the three highest-yielding issues would probably trade a little above par, with the rest falling in line closer to par.

For L, expected loss in case of failure, I assumed they would all go to zero, which is conservative.

For P, I used Monday's closing price.

Here's how it came out in an Excel spreadsheet:

Security	Coupon	Par	Full value	Current price	Exp. Gain	Exp. Loss	Chance	Years	Expected annual return
FNMAT	8.25%	25	25	7	18	7	0.5	4	0.196
FNMAS	7.75%*	25	23.48	5.9	17.58	5.9	0.5	4	0.247
FNMAJ	7.63%	25	23.12	5.08	18.04	5.08	0.5	4	0.332
FNMAM	5.81%	50	35.21	9	26.21	9	0.5	4	0.239
FNMAG	5.38%	50	32.6	9	23.6	9	0.5	4	0.203
FMNAN	5.13%	50	31.09	9.14	21.95	9.14	0.5	4	0.175
FNMAH	4.50%	25	13.64	4.55	9.09	4.55	0.5	4	0.125
*Fixed to floating, minimum rate

As you can see, expected annualized returns are all over the map, ranging from 12.5% on the low-yielding FNMAH to 33% on FNMAJ, which would appear to be the best bargain if indeed these securities begin paying again.

While investors may be using somewhat different assumptions, arbitrageurs do not seem to be buying and selling the preferreds in a way that would rationalize the prices.

If you would like to start your own spreadsheet, here is the Excel formula for expected return that is plugged into cell J2, the expected return for FNMAT:

=(((F2*H2)-(G2*(1-H2)))/(E2*I2))

My assumptions for chance of success, holding period, and expected gain are only guesses, of course. Please let us know if you have different ones.

Which Of The Busted Fannie Mae Preferreds Are Better Buys?














FNM
FMCC       
FNMA