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Here's My Top Value Stock to Buy Right Now

Finding value when the stock market is setting new records tends to be difficult. Investors have to be careful that they are not buying stocks as earnings are peaking. This is often the difference between a value stock and a value trap. Sometimes a stock is cheap because the market is giving the company no credit for a line of business or some sort of asset. The market has beaten up on mortgage real estate investment trust New Residential (NYSE: NRZ) -- but it's not giving the company's cash-generating operating business enough credit.

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New Residential vaults into top echelon of mortgage lenders

New Residential has three main areas of operation: mortgage investing, servicing, and origination. I recently wrote about New Residential's servicing portfolio and how it could help mitigate the effects of the Federal Reserve's impending reduction in asset purchases. But investors also need to know about New Rez's mortgage origination business.

New Residential has been beefing up its mortgage origination business, and recently completed its purchase of Caliber Home Loans. This transaction puts New Rez in the top five nonbank lenders in the U.S., and on a pro forma basis it funded $45 billion in origination in the second quarter.

Unlike mortgage REITs, mortgage originators generally trade well above book value, especially those that interact primarily with the borrower, as opposed to those who purchase completed loans from smaller lenders. Mortgage REITs rely mainly on interest income, but originators have the ability to make a loan, sell it, and make another.

At the end of 2020, New Residential estimated there was between $2.90 and $6.52 per share in hidden value with the mortgage origination business -- and that figure didn't factor in the Caliber deal. With the acquisition of Caliber, that number should increase, given that Caliber has a strong retail footprint and presence in the purchase market, which is worth more than the typical correspondent-type lender that New Residential had prior to the acquisition. This is important because the purchase market is much more stable than the refinance market. If rates rise, refinance opportunities decrease greatly, but people still buy houses. A retail outlet which has an office and loan officers out in the field, talking to realtors will get a much more stable flow of business than a lender that relies on purchasing loans from other, smaller lenders. That is why Caliber adds so much value to New Residential.

Mortgage originators trade at a premium to mortgage REITs

New Residential should be thought of as a sum-of-the-parts story, with overlooked assets that investors don't factor into the share price, leading to a lower-than-deserved valuation. In these circumstances, the company may find it attractive to spin off those assets in order put a value on them. New Residential discussed such a possibility last year.

New Residential has historically been mainly a mortgage REIT, and like most mortgage REITs, it trades on dividend yield and book value. At the end of June, the company had a book value per share of $11.27 and is trading at a 3% discount to book. This is a typical multiple for a mortgage REIT these days, and you can think of book value as "fair value."

But mortgage originators' ability to "recycle" their assets makes them worth more. If you look at the other top non-bank originators (Rocket, UWM Holdings, Loan Depot, and PennyMac Financial), you will see these stocks generally trade around three times book value per share.

New Residential will probably update shareholders on the combined mortgage bank's projected earnings and book value when it announces third-quarter earnings in October. At that point we will have a better indication of the embedded value in the mortgage origination operations.

The company just increased its dividend to $0.25 per quarter, which gives the stock a dividend yield of over 9%. This is well above the typical mortgage originator, and more in line with mortgage REITs. With New Residential, you get the steady income of a mortgage REIT along with the operating company, which provides growth potential down the road. New Residential is the sort of stock that would appeal to both a value investor and an income investor.

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Brent Nyitray, CFA has no positions in the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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