Morningstar Advisor - Spring 2008 - 56

Morningstar Conversation Morningstar Analyst’s Take Now would be exactly the wrong time to sell John Hancock Classic Value r Although the fund is facing an uphill climb, we’d stay put. r appreciate management’s reasoning in We sticking with its top picks. r Management’s track record also bolsters our optimism. r it did in early 2000 and does now, As management’s approach requires a strong stomach and ample patience. By Michael Herbst, 01-11-2008 vacant homes are the homes that were built and are unoccupied or sold and unoccupied. That number grows when you build more homes than the population growth, which is what we did for about three or four years. We’ve been undershooting population growth, or normal demand for housing, for the past 18 months. Right now, at about a million units a year, we’re shorting what you need by 600,000 or 700,000 units a year. It doesn’t actually show up in the data because people are, I believe, deferring home purchases. The household formation is growing at a slower rate than population—meaning people are living with their parents, or whatever they’re choosing to do, to avoid buying a home and waiting until they get the best price. I believe there’s some pent-up demand, so I’m now not looking at the inventory data. I’m looking at the normal level of demand. How much cumulatively did we build in excess of that normal? How much cumulatively are we shorting the normal? When you do that, you’re less than 18 months away from equilibrium. If you go beyond 18 months, theoretically you’re in a housing shortage. The other things that go on is income levels continue to grow, housing prices continue to fall, and if interest rates—which are key to this discussion—fall, affordability moves back into line, such that the median income earner can afford the median home, which we got out of whack on. Those are the three ways to correct the problem, and all three are working in favor of correcting it. KK: Let’s talk about financials. What’s the overall weighting in the portfolio for financials? RP: It’s around 42%. KK: Please talk about Freddie Mac. It was your and Fannie closed at $20.14 and $21.70 per share, respectively.) These are businesses that have enjoyed a fantastic franchise. They almost describe the definition of what a good business is. They do something that no one else can do. They can hedge a mortgage portfolio with long-term instruments that are typically callable debt, so they can basically hedge the interest-rate risk of holding a mortgage. They tend to attract competition only during periods of time when there’s a steep yield curve or when somebody wants to play an interest-rate betting game, because most others can’t effectively hedge the holding of an interest-rate instrument. So over very long periods of time, they’ve earned very high returns. If you look at them as almost a hedge fund, their portfolio of holdings has done quite well long term. At the same time, they’re an insurance business. They do both: They insure mortgages held by others, and they hold mortgages for their own portfolio. Because they have this sort of quasi-monopoly position with implicit government backing, they’ve earned over 20% aftertax return on equity over their history. It’s a good business, and today, the good business has gotten so much better, because there is no competition right now. If you think of the insurance part of the business, it’s very similar to how other insurance companies work. When there’s some kind of catastrophe, in this case the subprime mortgage crisis, what happens? Rates go up. This is exactly what’s gone on here. Fannie and Freddie have dramatically raised their guarantee fees and tightened their lending standards such that the business they’re writing today is about as good as it gets. Probably the best it’s ever been in their entire history. Meanwhile, the spread between their borrowing costs and their yield on a mortgage has widened to about as good as it ever gets. This is the best situation you can imagine if you didn’t have a historical portfolio or balance sheets to worry about. The unanswerable are the two things that every single player is looking for, so you’re not going to be able to beat it. Either the rate of deterioration of home prices slows down or the rate of delinquency on mortgages slows. KK: Which do you think is most likely? RP: I think they’re both likely. All the natural corrective mechanisms—for home prices as well as excess home inventories—are working as you would expect. The number of new homes being built right now is so far below the population growth that we’re going to work off all the excess, and we’re going to be in a housing shortage situation. When you do the simple arithmetic on the numbers, it’s not that far away. KK: Some people have the opposite opinion— that it’s going to take a number of years to work off some of the inventory. RP: It depends on what you mean by inventory. If you mean inventory of people who decided to put their house on the market, that’s one thing. But those people have to move somewhere else once they sell their house. You have to be looking at vacant homes, and largest position as of Dec. 31. RP: I’ll discuss Freddie and Fannie Mae, because they’re pretty much the same story. (On the day of this interview, March 6, Freddie 56 Morningstar Advisor Spring 2008

Morningstar Advisor - Spring 2008

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