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hello and welcome to business Mind Investing today we will go through a case study of one of the biggest winners for Peter Lynch we have covered Lynch in previous videos so if you haven't watched this I recommend you to check this out Lynch claims that investing is both an art and the science and well I completely agree I want to show you how those two combine in practice today we will study how and wipe their Lynch has chosen Fannie Mae as he speak and why it was a brilliant idea also please note that we are talking about 1977 when he bought this stock for the first time and it was far away from that strategy that happened in 2008 real estate crisis full name of the company is Federal National Mortgage Association and it was established by Franklin Delano Roosevelt in 1938.
if you know I think or two about history New Deal was introduced as an answer to the ongoing crisis in the 1930s it was a social economic package of reference with the aim of which was to increase the purchasing power of the population and to stimulate the economy one facet of the Housing Finance before the Great Depression was that Landing consisted mostly of short-term loans and down payments were huge usually about 50 percent of the home value Watkins were granted mostly by life insurers commercial Banks or Savings and Loan associations there's no Housing Finance markets so rates varied a lot in different parts of the country when the Great Depression happened it was estimated that about 20 to 25 percent home mortgages was in default if any May which was established in 1938 was a government agency with a purpose of buying mortgages from lenders so they could free up more funds and make more mortgages business model of the company was pretty simple borrow money at cheap variable interest rates buy mortgages with fixed trades at specific percent and pocket the difference let me give you an example that would borrow uh four percent use this money to buy fixed rate mortgage which would pay let's say five percent the difference would be profit before other expenses but the difference could be even bigger Lynch has bought first position in Fannie Mae in 1977 but he has sold as he was expecting increasing interest rates which would crush the profits and this is what and this is what happened basically in 1981 the variable rate was so high that the company wasn't making any money but the example I gave you earlier with the rates and imaginary numbers was just to make a point but if we use three numbers from 1981 when Fannie Mae bought some mortgages in mid 70s they would be paying around eight to ten percent fixed interest but unfortunately for the company 1980s was the time when interest rates in USA was at the highest level um it was an aftermath of energy crisis and Rising prices this was the time when Paul Walker was motivated to slush down the inflation it's interesting period from economic and stock market point of view but that's too much to talk to to talk basically today when interest rates rise so did the cost of borrowing for Fannie Mae it is a good importance of it's a good illustration of importance of return on Capital employed which should be higher than the cost of capital it illustrates what Terry Smith has said and we covered the example in one of previous videos you simply cannot make money borrowing at 18 and being paid only eight to ten percent this had negative effects on the company and stock plummeted from nine dollars in 1974 to two dollars in 1981.
in 1992 big change occurs for the company with the guy named David Maxwell he had an idea to reorganize the company in a manner that would enable possibility to offset the biggest risks which was changed in interest rates he wanted the company to sell mbs's name that now might have very negative connotations but back then this sort of financial product was in early steps of its development industry was just getting started but what's really MBs is in this new business model Fannie Mae would be buying mortgages however now they would bundle them together and resell to Banks insurance companies or other entities wanting to invest in mortgages and in that process they were gifted they were gaining the FTP for that Maxwell did not invent this idea this is what Freddie Mac was doing which was another company created by the government that went public in the 1970s it's worth noting if you want to understand better Lynn's investing Peaks he'd not gamble into this new idea that the company started he saw an analogy between another company doing it and what management at Fannie Mae was trying to do let's put things that happened with Fannie Mae during clinch career into the timeline he has started the position in 1977 but he was expecting higher interest rates so he closed the position and he was right because in 1981 the company crashed one year later big change started to happen and that was what got Lynch interested he called the company in 1983 to inquire more about it the company still had a portfolio of 60 billion dollars consisted of mortgages with fixed interest rates the average they were yielding was 9.29.25 however the cost of debt was 11 11.87 percent one does not have to be a math wizard to realize that this portfolio wasn't making any profit however there were signs of light at the end of the tunnel because Lynch noticed how small the companies overhead expenses was he compared it to the banks that had two to three percent overhead while Fannie Mae was facing only 0.2 percent so 10 times lower Lynch even makes a remark that FM had 1400 employees which was probably about number of Bank of America's branches another strength of the company was in its quasi-governmental status which enabled it to borrow at cheaper rate than any Bank nevertheless the restructuring seemed to work as after eight quarters of losses company had its first profitable quarter however stick however the stock didn't move anywhere so Lynch bought again in 1984 and in this year he increased his position to point uh 37 of his assets therefore not a huge commission to a stock however please note that sometimes he bought small number of shares as kind of a waiting list just to tune in later I thought this was a year in which Fannie Mae decided to switch their boring from variable interest rates to fixed rates they would simply issue bonds with fixed rates doing so they penalized their short-term earnings however making company less vulnerable to swinging interest rates so you can see that the Gap would be smaller in this new new model however the Gap with the the Gap would be pretty much independent from interest rates in 1985 we could safely say that Fannie Mae had two engines of growth fixed income mortgages and mbs's fixed income has become less vulnerable to interest rates although less lucrative in a period of low interest rates it was less vulnerable to catastruct that happened back in 1981.
this is also year that a lot of defaults happened in Texas and people were leaving their homes FM owned a lot of those mortgages and fear about that part of portfolio crafting but this was actually benefiting the company as a lot of competition could not survive and competitors cleaned out Peter Lynch realized how fast the MBS industry was developing he made the prediction that Fannie Mae could grow their MBS portfolio to stunning 100 billion dollars and with only one percent yield they would make 1 billion dollars profit on this portfolio remember that their overhead was minuscule in comparison to bugs so he assumed that company could make seven dollars per share in closed couple years with seven dollars per share price that gave him PE of one this is just crazy in 1986 that was a year when Fannie Mae got rid of another part of its old portfolio mbs's were becoming more and more substantial for the companion Market was booming in 1987 Texas crisis got worse and a lot more defaults happened Fannie Mae has become biggest Real Estate Mogul just because of defaults company had to allocate a lot of resources in order to manage foreclosures and get rid of its new portfolio of Real Estate this didn't worry much as he was in for the MBS business not all fixed rate mortgages his position at the time was between 2 and 2.3 percent of total assets when describing events that took place in 1988 he called this sell the house the boat the cars and the barbecue and put the money into this sort of Buy he increased the position to three percent also in this year new changes happened in accounting rules and fees were booked in the period as they were received so one quarter they could book 100 million dollars of earnings next quarter that would drop to 10 million earnings that would scare out investors and cost stock to fall he also notes that in 1989 Warren Buffett owned 2.2 million shares and as he respected him I guess it reinforced his conviction if anime this was the year where Fannie Mae and 400 million dollars in fees from mbs's worth over 225 billion dollars Lynch was right in assessing that mbs's would be huge thing Fannie Mae has become a fast grower with earnings growing at 15 to 20 percent a year it's an example of how companies move from one category to another you can get a fast grower from a turnaround and actually markets might not notice that for a long time in 1990 Fannie Mae has been hit deeply by USA getting involved in Gulf War because there was a panic about real estate depression that's actually the real estate Depression was only for so-called fat cut houses and Lich also noticed that Fannie Mae didn't write any mortgage for houses above 200 000 dollars they averaged around 90 000 dollars but that's not how investor felt and stock fell from 42 to 24 dollars but then quickly rose again to 38.
it was quite a roller coaster for Peter Lynch one year later he left Magellan but Fannie Mae had become a number one holding and its price went up to 60 dollars this stock was turned around at two dollars a share in 1981 and sold for 60 dollars in 1991. which gives us roughly 40.5 percent annual rate of return Hefty profit I would say but imagine you got scared in 1990 and sold at 24 dollars just one year before 1991 you still would get 30 percent let's recap what we have learned today from this wonderful investor first of all you might have the profit on Fannie Mae but he started learning about the company in 1977 and he retired in 1991.
throw all those years he tracked companies progress he looked to competition in assessing competitive advantage of Fannie Mae and that's how we realized that FM overhead was Tiny another important thing is to get into understanding of the problem that everyone seems to be scared of a lot of investors predicted correctly that there was depression incoming for a real estate but only for expensive trophy houses enough to notice that this won't be a problem for the compound look how many things have happened in the period we analyze energy crisis of 70s High inflation skyrocketing interest rates Texas real estate crisis Gulf War it hasn't been that optimistic and with flowers and joy I hope you learned something new from today thanks for watching and stay tuned for the next videos
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