A Winner in a Mortgage Rebound

12/17/2007 12:00 am EST

Focus: STOCKS

John Dessauer

President, John Dessauer Investments, Inc.

John Dessauer, editor of John Dessauer’s Investor’s World, says investors are far too gloomy, and he finds a stock he thinks will bounce back nicely along with the markets.

The US stock market is volatile and will remain so until we have enough hard facts about subprime adjustable rate mortgages (ARMs). Only 0.51% of Freddie Mac’s $713 billion loan portfolio is 90 days delinquent, [and even] within the subprime category, over 85% of all borrowers are paying as agreed.

The big bulge of subprime ARM resets is just beginning. March 2008 is the peak month for subprime-mortgage resets. By the time we get to April, I believe it will be clear that the doomsday scenarios are wrong. That should trigger a huge relief rally in our financial stocks.

Investors are correct to be concerned, but the exaggerated pessimistic spin on every bit of news about home prices and mortgages is grossly misleading. I believe the popular fear has created a huge opportunity, one not seen since late 2002. The right investment strategy in 2002 was to take advantage of the panic and buy what the crowd was selling. I believe that strategy will produce handsome profits again in the years ahead.

McGraw-Hill (NYSE: MHP), down 37% from a 52-week high of $72.50, is a diversified information company with businesses that include Standard & Poor’s research and rating company, textbook publishing, and BusinessWeek magazine.

The third quarter was excellent: earnings per share, excluding a small restructuring charge, were $1.34, far above the expectation of $1.19 and 26% better than 2006. But management said during the third-quarter conference call that fourth-quarter sales and earnings would come in below last year’s.

After that news, the stock collapsed. But the company’s subdued outlook is due entirely to the S&P ratings business, which is suffering from the credit crunch and lower volumes of new securities to be rated.

As a result, analysts, such as those at Argus Research, have marked down their earnings expectations. But they still see $3.02 a share this year and $3.42 in 2008. The steep fall in the stock is our opportunity to buy McGraw-Hill at an attractive price. The long-term average P/E is 21x, indicating a 12-month target of $72, even if lowball earnings expectations remain unchanged.

There are some good reasons to believe that earnings expectations are too low. Some parts of the ratings business are still on an up trend. Ratings for international securities (42% of the total) grew at a double-digit rate in the third quarter. That trend should continue. The education division has a 32% share of the national textbook publishing business and is also growing nicely. McGraw-Hill obviously is a play on the recovery of the secondary mortgage market. I believe that will happen sooner than many on Wall Street expect. (The stock closed above $45 Friday—Editor.)

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