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
