If You Absolutely Must Speculate in Subprime Lenders...
By Dan Ferris, editor, Extreme Value
March 15, 2007

Warren Buffett is looking for a new chief investment officer to replace him at Berkshire Hathaway.

Among the traits Buffett is looking for – including independent thinking and emotional stability – one made me sit up and take notice. In his annual letter to shareholders, Buffett wrote that he needs to find a replacement who is "genetically programmed to recognize and avoid serious risks, including those never before encountered."

I, too, have learned that avoiding risk is at least as important as making money. That's why I only buy stocks that are safe and cheap, not just cheap. Buffett is right, and in light of his comment, we should address some matters without delay.

First, the financial headlines are dominated by the implosion of the subprime-mortgage market. The latest news: The largest independent, publicly traded subprime mortgage originator, New Century Financial, fell 69% last week, sent crashing by murmurs of bankruptcy and a criminal investigation.

Subprime mortgages are mortgage loans made to borrowers with bad or no credit. The main problem is that, like most underwriting businesses, it's a black box to outside passive minority investors. You can't see inside, and management isn't going to tell you what's in there.

You can even be an insider, a bona-fide investment genius, and still get blindsided. David Einhorn of Greenlight Capital is one of the best value investors operating today. Greenlight owns 6% of New Century, and Einhorn got himself elected to the board of directors. Now, New Century has been kicked off the New York Stock Exchange, and its survival is in question. Being smarter, more successful, and more experienced than most investors didn't help Einhorn one bit. He threw in the towel and resigned from the board last Wednesday.

It reminds me a little of when Warren Buffett bought preferred stock in USAir, before it went bankrupt... or the time Longleaf Partners bought Fleming, the grocery distributor, before it filed Chapter 11. And it reminds me of some of my own mistakes. I figure if it's a challenge for David Einhorn, Mason Hawkins, and Warren Buffett to avoid catastrophic risk, then it must be a challenge for everybody.

In the spirit of avoiding big risks, the best advice – the only advice – I can give you about subprime companies is that ignoring these stocks will help you get rich much faster than speculating in them. There's too many well-financed and well-run financial companies out there more deserving of your capital.

I hate to turn right around and contradict myself... but here goes. It's true that you don't need to know anything about subprime mortgages to get rich in stocks. However, I can't ignore the fact that the current rout of subprime mortgage stocks will prove to be a lucrative opportunity for the extraordinarily diligent speculator. Nor can I ignore the fact that you might be tempted to jump into the subprime space, value-seeking contrarian that you are. So, I feel compelled to offer my two cents.

Nobody knows what's going on underneath the hoods of these companies. If you can devise a way to get under there, and if you like what you see, and if you can get it at the right price, you're likely to make a killing over the next year or so. I've looked around a little, and the best I can do is to make assumptions about who's going to survive based on some clues in the financials. If you want to play around with subprime stocks, I recommend you start by taking a good, long look at Accredited Home Lenders (LEND).

Warren Buffett Is Gobbling Up This Stock Why Do Rich Investors All Say the Same Thing?

Accredited appears to be the best underwriter in the space. Its loan losses and delinquencies have remained below industry averages since its inception in 1990. It's a low-cost loan originator, paying only 1.7% to originate, versus 2% or more at competitors. Its reserves have so far proved somewhat more conservative than the industry as a whole.

Accredited is having its share of trouble, though – enough that it's stock fell 60% in one day earlier this week.

Who knows if this company will survive through the mess? Not me. Speculate at your own risk, and good luck.