TCS Daily


The Sage of Santa Fe

By James K. Glassman - May 14, 2004 12:00 AM

Five or six years ago, a friend I have known since high school -- let's call him R. -- rhapsodized about a money manager who lived in, of all places, Santa Fe, N.M. "Find Garrett Thornburg," said R. "This guy has the best financial mind in America, and who knows about him? Hardly anybody. You should write the story."

Better late than never, Garrett Thornburg himself walked into my office last week -- a big, hearty, outdoorsy-looking fellow who laughs a lot, talks fast and rarely pays visits to Washington. Why should he? He lives in the best place in the country (next to Santa Barbara, Calif., and Litchfield County, Conn.) after escaping New York in 1982, when his employer at the time, Bear Stearns, turned down one of his more interesting financial-engineering ideas, a bit of alchemy involving tax-exempt industrial revenue bonds.

The reason that R. was so enthusiastic is that Thornburg has brought a fresh eye to the money game. He is probably best known for starting a series of bond funds whose holdings are "laddered," that is, the bonds in each portfolio come due in sequence, thus protecting the investor against rising interest rates.

As a bond matures, the cash from its sale is used to buy a new bond that matures at the end of the ladder, meaning further in the future. As a result, if interest rates rise (as they are doing now), the overall rate of interest paid by the bond fund will rise as well because the fund keeps buying bonds at higher interest rates.

These laddered-bond funds -- Thornburg Limited-Term U.S. Government (LTUCX), for intermediate-term Treasury notes; Limited-Term Municipal National (LTMCX), for intermediate-term munis; and so on -- have proved enormously successful, and if you're looking for a way to protect yourself against the higher interest rates that seem practically guaranteed, they're just what you need.

You can, of course, construct your own ladder and avoid Thornburg's fees. For example, if you have $25,000 to invest, put $5,000 in each of five T-notes: one maturing in 2005, the next in 2006, on out to 2009. As the 2005 note matures, buy a new note maturing in 2010. If you want tax-exempt income from municipal bonds, however, it's probably better to choose a Thornburg fund because it's hard for a small investor to get good prices in the illiquid muni markets.

After establishing the bond funds, Thornburg, between 1995 and 2000, launched a series of stock funds. Recently, all three have won important honors: Bill Fries, manager of Thornburg International Value (TGVAX), was named Manager of the Year by Morningstar in his category for his 2003 performance; Fries was also selected by Business Week as one of the "best mutual fund managers" for 2004 for his stewardship of Thornburg Value (TVAFX); and Thornburg Core Growth (TCGCX), managed by Alexander Motola, won the 2004 Lipper Fund Award in the multi-cap growth category.

Last year, International Value returned 40 percent, beating its benchmark by 6 percentage points; Value returned 35 percent, beating the Standard & Poor's 500-stock index by 8 points; and Core Growth returned 55 percent, whipping the S&P by 27 points. All three funds have also beaten their benchmarks over the past three years.

In my view, the best of the funds is International Value, which receives five stars (tops) from Morningstar and ranks in the top 1 percent of its category over the past five years. It was started because Thornburg said he found so many great companies abroad that foreign stocks were accounting for more than one-fourth of the original Value fund's holdings.

One of the endearing, innovative features of the Thornburg Web site (www.thornburg.com) is that it includes write-ups on the top 10 holdings of each of the funds, with an explanation of why the manager bought the stock. International Value's No. 1 holding is Euronext, the largest European securities trading company, which owns exchanges in Amsterdam, Brussels and Paris. Last year Euronext sold its electronic trading platform to the Chicago Board of Trade. One reason Fries likes Euronext is that it has become a major market for derivatives, demand for which has been booming.

Ranked after Euronext are Kingfisher PLC, a London-based home-improvement retailer that "has traditionally paid a meaningful dividend and . . . is well capitalized," according to the Thornburg site; Samsung Electronics Co. of Korea, "enjoying strong brand identity at home and growing credibility abroad"; Cadbury Schweppes PLC (CSG), the Britain-based manufacturer of beverages and candies.

The fund also owns Toyota Motor Corp. (TM), Hyundai Motor Co., BP PLC (BP) and Burberry Group PLC, the retail clothing chain, whose "risks are outweighed by a substantial discount to its peer group, impressive cash generation and superior growth profile."

For the domestic value fund, Fries looks for three kinds of companies: cyclicals such as Deere & Co. (DE) that carry low valuations (Deere's price-to-earnings ratio based on expected 2004 earnings is just 14) because the market dislikes them; consistent earners such as Fannie Mae (FNM) that are under-appreciated; and "emerging franchises," which are growth companies with a good chance to be solid long-term brands.

Examples of this last group -- the most interesting to me -- include E-Trade Financial Corp. (ET), the online brokerage firm, whose stock is down by four-fifths from its all-time high and trades at a forward P/E of 12; Interactive Corp. (IACI), Barry Diller's umbrella for such online firms as Expedia, Hotels.com, Lending Tree and Ticketmaster; and Electronic Arts Inc. (ERTS), which makes software for interactive video games.

But I have saved the best of the Thornburg companies for last. It's a real estate investment trust, or REIT, called Thornburg Mortgage Inc. (TMA). What makes it attractive is its whopping dividend yield, now 10.1 percent. What makes it Thornburgesque is its way of doing business, which is both unusual and elegant.

The firm started out as a conventional mortgage REIT, buying up groups or "pools" of home-mortgage loans that had been turned into securities -- that is, bonds, typically with adjustable interest rates. These collateralized mortgage obligations (CMOs) are the basic assets of REITs such as Annaly Mortgage Management Inc. (NLY), but Thornburg decided to move into a more profitable realm. While retaining a chunk of CMOs, he branched out into originating mortgages himself.

"We decided to create a new kind of mortgage company," he told me. He lends mainly to wealthy individuals who have the best credit. "We make only adjustable-rate mortgages, and we keep every mortgage we make." In other words, Thornburg Mortgage owns the loans and collects interest on them, rather than selling them to a large financial institution or slicing and dicing them into CMOs for investors.

Thornburg offers its mortgages over the Internet and in print advertising and direct mail, and it farms out the underwriting and the servicing. The firm has no branches, no expensive overhead. So far it has made about $8 billion in loans, averaging about $500,000 each, with a low loan-to-value ratio of about 67 percent -- which means that the borrowers retain a lot of equity in their homes, reducing Thornburg's risk.

How good are the loans? "Our cumulative credit losses since we began acquiring loans in 1997 total just $174,000, and we have not realized a loan loss in the past eight quarters," says the firm's annual report. Thornburg himself adds, "Our delinquent loans are two basis points," or 0.02 percent of the portfolio. That's a flabbergastingly low number in the lending business.

So why don't other lenders use the Thornburg model? "Banks have a legacy system," he says. They have networks of branches; they're trying to sell customers stocks and certificates of deposit and car loans. "We can do this one thing better than anyone else." In fact, the service is so good that nearly one-fourth of the mortgages come from referrals from current customers, shareholders and employees. One of the features: You can change the terms of your loan (say, from a mortgage that adjusts every month to one that locks in a higher rate for three years and adjusts annually thereafter) by paying a $1,000 fee.

Thornburg Mortgage builds its portfolio so that its borrowing matches its lending. In other words, when it sells an adjustable-rate mortgage that guarantees a rate for three years, it funds that mortgage by borrowing money at a fixed rate for three years.

The good news is that many investors don't seem to have a clue about Thornburg's mortgage business. As Robert Mitkowski Jr. of Value Line wrote recently, "Investors sold off the . . . shares this month when better-than-expected job market figures suggested the Federal Reserve might soon begin raising interest rates." In fact, higher short-term rates won't hurt the company at all, says Thornburg. "We're better off with interest rates higher rather than lower," he says, since his interest income will rise, too, increasing the firm's return on its fixed equity.

Over the past five years, since Thornburg began revising his REIT's business, the dividend has risen annually, from 91 cents a share to $2.49. An estimate of $2.60 appears about right for 2004, and the stock on Thursday was trading at $25.30. That's more than 10 cents on the dollar -- and, if history is a guide, the return will rise in the future.

There are drawbacks. Thornburg funds are sold through financial advisers and brokers, and the expenses can be relatively high. Also, the dividend from Thornburg Mortgage, as a REIT, is fully taxable at the ordinary income rate. It does not qualify for the current 15 percent rate cap of conventional corporate dividends. As a result, Thornburg Mortgage is best held in a tax-deferred account such as an IRA.

Also, 10 percent dividend yields don't come risk-free. If the economy heads south or if interest rates soar, borrowers could become strapped for cash, and loan losses could rise. Hedging interest-rate exposure -- that is, balancing assets and liabilities -- can be tricky. And Thornburg is expanding like crazy, which isn't easy for a REIT, since it has to pass at least 90 percent of its profits through to shareholders each year.

The company's assets have more than quadrupled in four years, and its net income has gone from $26 million to $177 million. This looks like a wonderful business. But then, what do you expect from the guy with what R. calls "the best financial mind in America"?

To correct and clarify: Last week, I said that Rouse Co. was not a REIT but rather taxed as a conventional corporation. That was incorrect. Rouse switched to REIT status in 1998. Also, in a discussion of the effects of rising interest rates on REITs, I wrote that Rouse had $4.5 billion in debt and pays $223 million in interest and, "if the rate on Rouse's overall debt rises half a percentage point, that's $22 million in additional expenses." That is technically correct, but perhaps unnecessarily confusing.

A Rouse official wrote to say that most of his company's debt carries a fixed interest rate, so if general rates rise by a half-point in 2004, "our interest expense would increase by approximately $4 million." I am glad to have this information, but my intention was not to project Rouse's exact interest expense this year; rather, I was simply saying, in a generic sense, that if rates rise, REITs with heavy debt will see expenses rise. Sorry if I misled anyone.


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