Description

Thesis: As the economy recovers MGIC’s PE will expand back to historical norms, working with continued earnings growth for a five year compound annual return of over twenty percent.

A short description, from www.hoovers.com:

“MGIC Investment owns Mortgage Guaranty Insurance Corp., which insures low or no down payment mortgages, letting otherwise qualified buyers who can't scrape up the standard 20% down payment get mortgages. The leader in the field, MGIC also offers customer support services under its "Customers for Life" program. Although most of MGIC's sales come from insurance premiums, the company has been converting its in-house payment and default predictive tools into profit centers by offering them to other lenders. Its eMagic.com unit offers a variety of loan origination tools. MGIC also invests in troubled mortgages through its 46% interest in C-BASS and provides property valuation services.”

MGIC is the top dog in the private mortgage insurance field, with a market share of 25%. The second and third players are PMI and Radian Guaranty, with 18% and 15%, respectively.

MGIC has compiled some impressive operating statistics in the last five years:

EPS ROE PE
2000 5.05 21.89 13.35
1999 4.30 25.61 14.00
1998 3.39 22.52 11.74
1997 2.75 21.04 24.18
1996 2.17 18.72 17.51

From 1996 to 2000 MGIC recorded a compound annual earnings growth rate of 23.51%, and the market valued those earnings at an average multiple of 16.16. MGIC’s return on equity averaged 21.96%, compared with PMI’s 16.42% and RDN’s 14.58%.

Recently MGIC’s PE has dropped to 10.62. As the economy slows down, and unemployment rises, pressure on the housing market and mortgage defaults means problems for mortgage insurers. If one feels the current recession will be extended, MGIC’s operating results will suffer. Also, a large holder of MTG common stock, Northwestern Mutual Life Insurance, has been selling.

If the market is obliging, I look for companies which if they follow their operating histories show a good chance of returning a 20% CAGR for five years. The table below shows some possible criteria resulting in that growth rate. The statistics are all as of the third quarter, so the whole numbers in the first column should actually be read, for example, “As of the end of the third quarter, 2002.”

Ticker: MTG
Date: 12/27/01
Current Share Price: $61.00
Current EPS: $5.65
EPS Growth Rate: 13.81%
Payout Ratio: 1.77%
Projected PE: 14
Start Year: 2002
My Return on divs: 0.00%

Year EPS Dividend Basket Price Compound Return
2002 $6.43 $0.11 $0.11 $90.02 47.77%
2003 $7.32 $0.13 $0.24 $102.46 29.75%
2004 $8.33 $0.15 $0.39 $116.61 24.25%
2005 $9.48 $0.17 $0.56 $132.71 21.58%
2006 $10.79 $0.19 $0.75 $151.04 20.00%
2007 $12.28 $0.22 $0.97 $171.89 18.96%
2008 $13.97 $0.25 $1.21 $195.63 18.22%
2009 $15.90 $0.28 $1.50 $222.65 17.67%
2010 $18.10 $0.32 $1.82 $253.40 17.24%
2011 $20.60 $0.36 $2.18 $288.39 16.89%

If one believes the economy will recover and MTG’s PE will expand to 14, below the average of above 16, MTG need only achieve an EPS growth rate of 13.81% to provide a 20% return. This is substantially below the historical growth rate of 23.51%.

The following table uses the same assumptions in an ROE model.

Ticker: MTG
Date: 12/27/01
Current Share Price: $61.00
Book Per Share: $27.52
ROE: 19.47%
Payout Ratio: 1.77%
Projected PE: 14
Start Year: 2002

Year BV/Share (Starting) EPS Dividend Basket Price Compound Return
2002 $27.52 $5.36 $0.09 $0.09 $75.01 23.13%
2003 $32.78 $6.38 $0.11 $0.21 $89.36 21.17%
2004 $39.05 $7.60 $0.13 $0.34 $106.45 20.52%
2005 $46.52 $9.06 $0.16 $0.50 $126.81 20.19%
2006 $55.42 $10.79 $0.19 $0.69 $151.06 20.00%
2007 $66.02 $12.85 $0.23 $0.92 $179.96 19.86%
2008 $78.65 $15.31 $0.27 $1.19 $214.37 19.76%
2009 $93.69 $18.24 $0.32 $1.52 $255.37 19.69%
2010 $111.60 $21.73 $0.38 $1.90 $304.21 19.63%
2011 $132.95 $25.89 $0.46 $2.36 $362.39 19.58%

(I fear that last table is going to be a little bit difficult because of the word wrapping.)

In order to provide a 20% return, MGIC must continue forward with an ROE of at least 19.47%. This is below the historical ROE of 21.96%, and MGIC has not failed to cross that threshold since 1996.

Investors will form their own opinions on the strength of the economy and the housing market, and I will not pretend to have any special expertise. Those who feel the American economy may gain its feet sooner rather than later may want to take a second look at this company, whose long term growth rates are just as impressive: an EPS compound growth rate of 24.59% from 1992 to 2000.

Catalyst

As the economy recovers MGIC’s PE will expand back to historical norms, working with continued earnings growth for a five year compound annual return of over twenty percent.