As a value investor, I generally try to find situations with easily understood business models, predictable results, and limited risk of capital impairment. Mr. Cooper Group (COOP) checks none of these boxes, so this will naturally be my first post! An 86 page investment presentation is included below.
In my opinion, COOP represents a separate and potentially compelling opportunity set for value investors: options. This includes both (1) listed option instruments (call options, warrants) and (2) securities with call option-like characteristics (levered equities with small market caps relative to asset values). In either instance, there exists large upside if sentiment improves.
Options rarely offer protection against capital impairment – most have 100% downside. This doesn’t mean that options can’t be attractive, however, and properly sized opportunistic positions can be solid profit generators over time.
For an excellent discussion on special situation option investing, I recommend reading Jack Schwager’s interview with Jamie Mai in Hedge Fund Market Wizards.
“To varying degrees, all of the trades we’ve discussed so far have reflected situations where we did not have a high level of conviction ourselves about the outcomes we were seeking to make money on. Instead, we had conviction that the odds were substantially mispriced, providing us positive expected value, even though we might not have had a strong view about the direction of the underlying market.
Whereas the classic value investor achieves capital preservation by taking risks only when he is confident that he won’t lose a meaningful amount of money, we think about risk more probabilistically. We are just as fanatical about capital preservation, but instead of achieving a margin of safety by knowing that a company has assets or cash flow that are not valued properly by the market, we achieve our margin of safety by having a high expected value.”Jamie Mai
COOP is the 3rd largest mortgage servicer in the U.S. and a leading mortgage originator. The current corporate entity is a result of the 2018 merger between Nationstar (NSM) and WMIH Corp, which effectively combined NSM’s operating business with WMIH’s $6bn of unutilized tax assets. I believe that this somewhat odd merger is resulting in relatively uninformed and technical selling pressures, contributing to the current mispricing. With 7x LTM leverage, COOP is certainly a levered equity with option-like payoff profiles.
Mortgage lending and servicing is a deceptively complex industry and business model. Earnings are volatile and key regulations change. With that said, my research leads me to believe that earnings are more likely to improve than decline in future years. There is significant latent earnings power in the business, yet the current valuation is giving no material credit for future improvements – this provides investors a “free look” on COOP achieving various levers.
My presentation lays out several realistic assumptions that could drive FCF/share to $3.70. At a reasonable 12% FCF yield, COOP would be worth ~$31/share, or +240% vs. yesterday’s closing price of $9.10. This is the magnitude of potential upside that one should look for in a levered equity.
I have decent conviction in my base case, but the inherent volatility of the business model precludes any conviction from being high. The outcomes are nonetheless positively skewed.
I’ve included a relatively long presentation to explain my investment thesis and analysis, but don’t expect future investment ideas to be this long or detailed. Most posts will be shorter one-off ideas and thoughts that develop and build over time with new posts. In addition, I expect future posts to be in text format (as opposed to a formal presentation). My first post should be somewhat of an outlier.
As a reminder, I don’t want to de-emphasize the fact that there is some probability of substantial downside in COOP. At other non-bank mortgage servicing peers, unexpected regulatory actions resulted in stocks declining >90%. That risk is present here. This situation should be respected for what it is – an option with 100% downside. The stock will be volatile, and investors will need to build their own conviction in the fundamental thesis to stomach this volatility.
I currently own shares in COOP.