“Farmer Mac” A.K.A. Federal Agricultural Mortgage Corporation (AGM): The Freddie Mac of Farms and Ranches Has a P/E Below 9 and an ROE Above Most Banks
This is one of my “initial interest posts”. But, in this case it’s going to be more of an initial-initial interest post. I am in the early stages of learning about this company. And it’s likely to take me some time to get to the point where I can give as definitive a verdict on whether or not I’d follow up on the stock as I normally give in these posts.
First, let’s start with the obvious. As you probably guessed from the name, “Farmer Mac” is a government sponsored enterprise like Freddie Mac and Fannie Mae – except it operates in the agricultural instead of the residential market. The company has two main lines of business – again, this is just like the Freddie Mac business model except transplanted into the agricultural mortgage market – of 1) Buying agricultural (that is, farm and ranch) mortgages and 2) Guaranteeing agricultural (that is, farm and ranch) mortgages.
As a government sponsored enterprise operating in the secondary market for mortgages – the company has the two competitive advantages you’d expect. One, it has a lower cost of funds (on non-deposit money) because it issues debt that bond buyers treat as being ultimately akin to government debt. The same bond buyer might be willing to accept a 2.45% yield on a 10-Year U.S. Treasury bond and just a 3% yield on a Farmer Mac bond. This cost above the rate the U.S. government borrows at is much narrower for Farmer Mac than it is for most banks that make agricultural loans.
The other cost advantage is scale. Yes, there are banks – like Frost (CFR) – that have very low financial funding costs. But, these banks usually have to invest in hiring a lot of employees to build a lot of relationships, to provide customer service to retain customers, etc. that leads to a “total cost of funding” that is higher than what Farmer Mac has to pay. To put this in perspective, Frost’s deposits are basically the same as its earning assets (loans it makes plus bonds it buys). Frost has about $200 million in deposits per branch. This isn’t a bad number – it’s 1.5 times the deposits per branch of Wells Fargo and 2 times the deposits per branch of U.S. Bancorp (and more like 3-4 times the entire U.S. banking industry’s deposits per branch). Frost’s deposits per branch are pretty close to industry leading for a big bank. So, we can use that $200 million in deposits they have and assume a bank will almost never have more than $200 million in assets – because it doesn’t have more than $200 million in deposits – per branch. Farmer Mac has $200 million in assets per employee.
As a rule, one employee is going to cost you a lot less than one branch.
To put this in perspective, most banks spend more on rent relative to their assets than Farmer Mac spends on everything relative to its assets.
Last year, Farmer Mac spent between one-quarter (0.25%) and one third (0.33%) of one percent of its total assets on all of its non-interest expense. This is extraordinarily low relative to even the most efficient banks in the United States.
As an aside: there are a few U.S. banks – a very, very few – that charge so much in fees for non-sufficient funds, monthly charges on checking accounts, ATM fees, debit card fees, wealth management fees, etc. that they can offset so much of their non-interest expense with non-interest income that their NET non-interest expense is similar to Farmer Mac’s roughly 0.3% of assets.
You’re probably familiar with the DuPont analysis approach to breaking down the return on equity of an industrial company. You can take apart an industrial company’s ROE by breaking it down into margin (profit/sales), turns (sales/assets) and leverage (assets/equity).
A financial institution works pretty much the same way. You can break a bank’s efficiency down into 3 parts:
- How much does the bank pay in interest on the funds it has?
- How much does the bank pay in non-interest expense on the funds it has?
- How much equity does the bank use relative to its total funds?
There are some other factors – like charge-offs – which matter too. We can discuss those in a second. But, I’m going to spoil that discussion a bit here. I’m not so confident that we can know what Farmer Mac’s long-term charge-off rate will be. Because of the kind of loans it holds – largely first-lien mortgages on farms and ranches – Farmer Mac may have no losses in some years and then more losses in a single year than it has had in a whole decade. Although Farmer Mac was chartered several decades ago – it has a somewhat limited history relative to the length of agricultural cycles. The big determinant of losses in something like agricultural mortgages is really whether there has been a large build up in debt (especially borrowing against land values) in previous years. The last time there was a clear debt bubble in U.S. agriculture – the early 1980s – predates Farmer Mac’s existence. So, looking at Farmer Mac’s likely future charge-offs is a lot like looking at a bank that makes residential mortgages. Other than in the 2008 financial crisis – residential mortgages had very low charge-offs. But, there were then enough charge-offs in the years around 2008 to wipe out some banks (these charge-offs were sometimes more in one year than the bank had charged-off in the entire decade prior to that year). So, again, we find Farmer Mac is a lot like Freddie Mac.
So, let’s put aside likely charge-offs at Farmer Mac for a second. Instead, we’ll do that sort of DuPont analysis for banks I suggested above. Will Farmer Mac have a higher or lower return on equity than U.S. banks?
Higher.
Here’s how we know that.
- How much does the bank pay in interest on the funds it has?
Last year, Farmer Mac’s total interest expense was less than 2.1% of its average assets. Looking at the same question from a different angle – we can see that depending on how short-term or long-term a Farmer Mac bond is, it pays anywhere from 1.2% to 3.3%. For example, a Farmer Mac bond due in about 4 years yielded about 2.9% when issued. Right now, a U.S. Treasury bond maturing at the same time, yields about 2.1%. That example is somewhat misleading – it overstates Farmer Mac’s cost of borrowing – because U.S. Treasury yields are lower now than when those Farmer Mac bonds were issued. Regardless, you can see that Farmer Mac’s cost of borrowing is less than 1% above the U.S. government’s own cost of borrowing. The company’s cost of funding from an interest expense perspective alone is not lower than many larger, successful banks. It is lower than some small, less successful banks.
- How much does the bank pay in non-interest expense on the funds it has?
This – rather than some interest advantage – is what makes Farmer Mac better positioned in terms of ROE than U.S. banks. Banks can pay so very little interest on certain deposits – basically none on checking accounts of households, for example – such that they could certainly match or beat Farmer Mac on that score. Where they can’t beat Farmer Mac is on the non-interest expense. Banks normally have low interest expense precisely because they offer a lot of services to their depositors. Farmer Mac doesn’t have depositors. It just issues bonds and buys mortgages (and does a few other things like guaranteeing mortgages). So, it has very low non-interest expense. This means Farmer Mac’s combined cost of funding compares well to many (though not all) banks. Let’s say Farmer Mac has a 2.1% financial expense on its total assets. And let’s also say Farmer Mac has a 0.3% non-interest expense on its total assets. The company’s “all-in” cost of funding is 2.4%. Let’s round that up to 2.5%. Okay, so Farmer Mac can fund itself at 2.5% and then buy assets that yield more than that.
- How much equity does the bank use relative to its total assets?
This is leverage. And it’s the biggest advantage Farmer Mac has over a bank in terms of ROE achievement. There are a few ways to measure how leveraged Farmer Mac common stock is. The method I’m going to use is definitely not the one the company’s management would use. But, I’d say the company ended last quarter leveraged about 35 to 1.
What I mean by this is that total assets at Farmer Mac are about 35 times the tangible equity attributable to the common stock. Banks – and Farmer Mac – count other equity (such as preferred stock) in their capital structure when measuring leverage. As a potential holder of the common stock – this isn’t relevant to you. What matters is the risk from leverage and the return from leverage in terms of assets/common stock equity. At Farmer Mac, that ratio is about 35 to 1.
What does this mean?
Let’s assume Farmer Mac can borrow at 2.5% a year “all-in” (this includes both the interest cost and the non-interest cost of their operation) and buy loans that yield 3.2%. This would give the company a 0.7% pre-tax return on its assets (3.2% – 2.5% = 0.7%). The company would then pay a 21% tax rate leaving it with a 0.55% return on its assets. Let’s call that 0.5%. So, if Farmer Mac could make a 0.5% after-tax return on its assets – what would you, the common stock holder, earn on your equity?
About 18%. We take 0.5% and multiply it by the 35 times leverage and get 17.5%. Again, let’s round that down. We’re left with a 17% return on equity.
How close is the situation I just described to Farmer Mac’s actual returns?
Pretty close. The official results for last year were an ROA of 0.5% and an ROE of 14.8%. Farmer Mac likes to report “core” earnings and “core” ROE. I’ll give you those numbers here – though, I have some problems with the fact they use these figures. From 2015-2018, Farmer Mac’s “core” ROE was 13-17% a year. Let’s call that an average ROE of 15%.
We also know Farmer Mac’s dividend payout ratio. Farmer Mac pays about one-third of its earnings out in dividends. It uses the other two-thirds to compound book value. This suggests that Farmer Mac’s returns – relative to book value per share, NOT stock price per share – will be a 10% growth rate and a 5% dividend yield.
To calculate your own likely return – and the form it will come in – when buying AGM, you would just divide that 10% + 5% = 15% expected return on BOOK value by the ratio of price-to-book you will be paying.
Farmer Mac ended last year with a book value of $49 per share. As I write this, the stock is trading at $71 a share. So, the price-to-book value is $71/$49 = 1.45 times book value. Again, let’s just round that up to 1.5 times. So, let’s say Farmer Mac will cost you about 1.5 times its book value.
This implies your return in the stock should be 15%/1.5 = 10% a year.
The current dividend yield is 3.66%. The rest of your 10% a year return will have to come from growth. Historically, Farmer Mac has grown its balance sheet by about 10% a year. And Farmer Mac is currently retaining enough earnings to keep growing at 10% a year while maintaining the same 35 to 1 leverage ratio I mentioned earlier.
Let’s talk about loan losses.
This is part of the complication with a bank’s reported earnings versus what it is actually earning – in cash – each year. A bank makes adjustments to its allowance for loan losses. This change in allowances may not match actual charge-off ratios, delinquencies, etc. In theory, allowances are supposed to be higher than charge-offs in good times and this will smooth out reported results. In practice, allowances tend to get raised higher after charge-offs start becoming a problem. So, allowances are less helpful in highly cyclical forms of lending than you’d think.
How high are Farmer Mac’s charge-offs in agricultural lending?
Nearly nil. The company often shows a graph going back 20 years. This isn’t very helpful. Agricultural loan losses in the U.S. have been very low for the last 20 years. Farmer Mac’s loan losses have been about 0.02% a year over the last 20 years. That’s not a typo. It’s lower than the agricultural lending other banks do. The publicly traded banks you’d be looking at tend to do less mortgage based agricultural lending and more for financing working capital and things like that. But, even U.S. banks generally have only charged-off about 10 times what Farmer Mac has (0.2% a year) over the last 20 years. We can, of course, assume that Farmer Mac will charge-off 0.2% a year (10 times what it actually has) in the next 20 years versus the last 20 years.
But, I don’t think that’s all that helpful as a guide.
Ninety-day delinquencies on Farmer Mac’s loans are actually quite high. This isn’t unique to Farmer Mac. One thing I noticed when reading Bill Ackman’s old short report on Farmer Mac is that he assumed high delinquencies in agricultural loans relative to allowances (and charge-offs) must be unsustainable. It’s actually proven to be totally sustainable. The industry’s delinquencies relative to charge-offs have often been about 5-10 times higher. In other words, a bank that has $50 million in 90-day delinquent agricultural loans is likely to charge-off only $10 million or less of those loans this year.
There are a lot of reasons why agricultural loans may often be delinquent but rarely be charged-off. The most likely explanations are: 1) that cash income for a farmer or rancher is much more variable than wages paid to a homeowner, 2) payments on agricultural loans are due far less frequently (often only once or twice per year – instead of 12 times per year for a homeowner), so a 90-day+ delinquency may indicate missing only one or two payments (as opposed to more than 3 for a homeowner), 3) agricultural borrowers often have better balance sheets – because they are businesses not consumers – than households (farmers and ranchers tend to have more short-term assets than short-term debt; while households can be quite illiquid) 4) for the last 50 years: farmer and ranchers have seen their income rise faster than other types of workers (they’ve become progressively higher-income relative to U.S. workers generally), and 5) farmland is a better investment than a single-family home, so the collateral is safer long-term (though this does not necessarily mean the collateral is safer in the short-term).
I think all 5 of those points are true. But, I don’t think that makes Farmer Mac any safer than Freddie Mac. The stock may move a lot with rising and falling projections for farmer income – so, crop prices and yields and so on – expected in the next year or two. But, I don’t think that’s what could kill this company. What could kill Farmer Mac is the same thing as what killed Freddie Mac – rapidly rising borrowing against rapidly rising asset values. Without big increases in debt – which almost certainly have to both cause and be supported by – rapidly rising land values, the stock should be safe. But, in a big enough farmland bubble, I don’t see any way the stock could be safe even if management intends to be quite conservative. In this case, I’m not sure management intends to be conservative. They have certain targets, guidance ranges, etc. that aren’t especially conservative.
So, is Farmer Mac an especially safe stock?
No.
But, is it so un-safe you can’t buy it today?
I wouldn’t say that. Yes, it’s leveraged 35 to 1. But, as long as you don’t see meaningful upticks in the debt/asset ratio of the entire agricultural sector – charge-offs in farm and ranch loans will be very, very low compared to almost any other kind of lending. Outside of a bubble, these are very safe loans.
Inside a bubble, I think you’d have to sell the stock. It seems entirely possible the company’s equity would be completely annihilated in the bursting of any farmland bubble. We had one close to 40 years ago now. At some point, we’ll have another. When we do, Farmer Mac stock could go to zero.
A lot of people reading this will say that it’s the leverage ratio of 35 to 1 (by my calculation – not the company’s) that makes this stock uninvestable. I think that’s misleading. It’s very possible to go broke when leveraged 2 to 1. There are banks leveraged just 10 to 1 that are riskier than Farmer Mac. No, I won’t give you their names. But, I’ve looked at them. And I know that being 70% less leveraged than another financial institution does not mean you’re safer.
What does determine whether a financial institution is safe or not?
If your focus shouldn’t be on leverage alone – what should you focus on?
How should you evaluate the riskiness at Farmer Mac?
Ask yourself these 4 questions:
- How certain is the company’s access to credit in even the worst market environments?
- How certain is it that the company’s borrowing cost will stay exceptionally low?
- How certain is it that the company’s expense ratio will stay exceptionally low?
- How certain is it that the company’s charge-offs will stay exceptionally low?
Uncertainty about any of those 4 things is the risk in Farmer Mac – not the leverage ratio in itself.
To put this another way, yes Farmer Mac has so much leverage it could quickly demolish a lot of book value if something went wrong. But, if the company’s business model remained intact – it also has so much leverage it would quickly earn its way out of the hole created by that loss.
The thing to focus on is the earnings engine and whether it remains intact. Is that spread – we’re talking yield on the assets less borrowing costs, expenses, and charge-offs combined – almost certain to stay positive?
If so, you’re almost certain to do well in Farmer Mac stock. If not – there’s a real chance of the stock going to zero at some point.
An investor interested in Farmer Mac should spend 95%+ of his time worrying about the risks.
Ninety-five percent of your time thinking about risks. That leaves only 5% to think about everything else.
Don’t you need to worry about valuation, future growth, etc.?
No. You don’t. And we can see why with some numbers here…
Dividend Yield: 3.7%
P/E ratio: 8.2
Payout ratio: 30%
Long-term asset growth (historical): About 10% a year
Long-term asset growth (management’s plan): About 10% a year
There are two ways of thinking about this. One, let’s assume you are intending to buy and hold Farmer Mac forever. Okay. We can cross out the P/E ratio then. What you are getting is a 3.7% dividend yield that will grow at 10% a year. That’s too cheap. It’s far too cheap. You’ll beat the stock market, bonds, etc. if that turns out to be true.
Let’s look at it another way. You’re not a true buy and hold investor. You are just going to buy today at an 8.2 times P/E and sell in 10 years. In 10 years, the stock will be priced at a “normal” (for stocks generally) P/E of 15. Take today’s EPS of $8.76 a share, compound it at 10% a year for 10 years, capitalize it at a 15 times multiple – you get a 2029 stock price of $341 versus today’s $75 stock price. That would give you a compound annual return from capital gains of 16.4% a year. The dividend yield adds 3.7% a year (and that would actually grow – but, let’s pretend it won’t here). That’s a 20% total return over 10 years. If we’re wrong and the company grows 5% instead of 10% – honestly, that can’t change the buy decision. Lower growth would mean a higher payout ratio. And even without a higher payout ratio – if the stock did reach a P/E of 15 after 10 years, you’d still have a 15% a year annual return. When you find a stock where you can be wrong for 10 years and still make 15% a year – you should buy it.
So, how can we come up with a scenario where Farmer Mac stock returns less than 10% a year over the next 10 years?
It’s actually pretty hard to think of a reasonable scenario. Here’s why. The P/E is 8.2. If the P/E – without any earnings growth – ever just goes from 8.2 to 15 over 10 years, that’s a 6% annual return from the multiple expansion. The dividend is nearly 4%. The nominal value of the agricultural mortgage market grows over most 10-year periods. It’s possible this stock could return about 10% a year over 10 years without growth. And yet it’s almost certain Farmer Mac will grow.
My point is that it’s not worth thinking about whether this thing will return 10%, 15%, or 20% a year over 5 years, 10 years, or 15 years. If the stock survives the risks inherent in this business model – it’ll keep doing something like that. And something like that will beat the market.
The risk here is not that Farmer Mac stock returns 7% a year while you own it. The risk here is that Farmer Mac stock one day goes to zero.
It won’t be tomorrow. But, Freddie and Fannie were good businesses that made investors – Warren Buffett included – very, very rich up through the 1990s. If – however – you held the stocks through the financial crisis – you lost everything.
There’s certainly nothing inherent in being a government sponsored enterprise with a mortgage portfolio that means you will fail. There shouldn’t even be anything in that business model that means you will be a high risk stock. The actual idea behind the business is not high risk.
But…
Having the ability to borrow at nearly the same rate as the U.S. government means you will have access to low cost funds you can use to achieve high returns on equity by buying low yielding assets. This is the risk. And it’s not unique to companies with some sort of implied government support. Any public company with a triple-A credit rating or near triple-A credit rating could fall into the same trap. A couple did. AIG’s credit rating contributed to its mistakes. And GE’s credit rating allowed it to – from almost the moment Jack Welch became CEO till today – keep increasing the financial risk it was taking.
Ironically, anything that is perceived as so safe it won’t default on its bonds can become risky from shareholders precisely because it can borrow so cheaply. It’s not that these kinds of companies have anything special about them that makes them risky. It’s that anyone who is given nearly unlimited access to low cost funding for a very, very long time will eventually stretch to do slightly less and less safe things.
Now we can talk about the real risks I see with Farmer Mac.
The company has a long-term plan to grow EPS at an above average clip. Whenever a financial institution does that – you need to be worried. Trying to reach that goal – especially trying to reach it consistently – can lead to making numbers up, doing this outside your circle of competence, and basically just incrementally taking on a little more risk each year. I don’t like the long-term financial goals here. I’d rather they not share any growth goals with investors.
None of the people at the top of the company have been with Farmer Mac very long. Some have been in the industry. And I didn’t talk about what the “industry” is here. But, basically there are other entities quite similar to Farmer Mac in terms of what they do. Farmer Mac does not have a big share of the agricultural mortgage market. It’s maybe like 10% right now. Top executives have been with Farmer Mac for only like 1-6 years. The CEO is very, very new.
I really don’t like seeing a lot of outsiders at a financial company.
Finally, nothing about the company’s management makes me think they are all that conservative. They definitely want to do well for shareholders and get the stock price moving. They are aware they trade at a big P/E discount (like 30-50% probably) to other mortgage type companies. They even talked about how part of the reason they raised their dividend payout ratio to about one-third is to better match other bank stocks.
I don’t like any of this.
It’s not the business model that bothers me. It’s having no real long-term insight into the culture, the people, the degree of conservatism etc.
I’m going to wrap up this initial-initial interest post here. It’s very, very early in my look at Farmer Mac.
I haven’t gotten into actually describing this business very much. I did that on purpose. I think breaking down exactly what Farmer Mac does – rural utility loans versus USDA loan guarantees versus outright purchases of first lien farm and ranch mortgages, etc. – is far too complicated and far too distracting to get into in a first post on this company.
The general idea of unbelievably high leverage used to borrow cheaply and lend a little less cheaply with virtually no charge-offs and virtually no day-to-day expenses while matching the length of the borrowings and the length of the lending against each other is what we need to focus on here. And the fact that Farmer Mac is like Freddie Mac. And that Freddie Mac is both a company that made people like Warren Buffett and Peter Lynch a lot of money and cost many more investors all that and more a couple decades later. The situation here is similar to that. Farmer Mac is priced way, way too cheap if it doesn’t do risky things. The company’s return on retained earnings is going to be much, much higher than at other banks. It should trade at a higher P/E than banks do – not a lower P/E.
But…
It could also go to zero eventually. The “eventually” part is key. You have to watch something like this for drift in strategy, risk-taking, etc.
To sum up: Farmer Mac is clearly an above average business at a below average price.
But, it might turn out – in the long-run – to be a lot more risky than most businesses.
For now I’d rate my initial interest level at 50%.
Personally, I will not be researching this stock any further.
Why not?
Is it the riskiness?
No. It’s the visibility of the stock. I manage accounts that follow an “overlooked stock” approach. I only buy stocks I think are overlooked. I buy the best businesses I can find. But, I only buy the best businesses I can find that I truly believe are “overlooked stocks”. I don’t look at Apple, Amazon, Facebook, Netflix, etc. no matter how good I think those businesses might be.
Stocks in the accounts I manage currently have annual share turnover ratios – basically, the number of shares they trade in a year relative to their total shares outstanding – of between 2% and 65%. Put another way, their shares “churn” somewhere in the 18 month to 50 year range. Obviously, a stock with a 50-year “churn” is something almost entirely owned by founders who never sell the stock. Individual investors never hold something that long. But, some patient outside investors in overlooked stock do hang on to shares for an average of 18 months or so. This is not true of most U.S. companies. And it’s not true of Farmer Mac. The stock has churned about 100% this last year. On average, shares are being flipped once per year. That’s not the highest churn rate out there. The stocks I mentioned before – the Apples and Facebooks and such of the world – get traded even more rapidly than that.
So, for me, something like Farmer Mac is a pass.
I focus on overlooked stocks. And I’m not interested in putting managed account money into stocks where there’s an active market of traders flipping the stock frequently. As a rule – that’s not a good way to find inefficiently priced stocks. The market cap here – at about $750 million – is also far from a micro-cap.
So, this one is a pass for me. The stock is too big and too actively traded.
This is not an especially overlooked stock. Considering what it does, its size, etc. – yes, it’s overlooked. I think only one analyst covers it.
For an $800 million market cap stock on the NYSE – yes, Farmer Mac is “overlooked”.
But, compared to the stocks I own in the managed accounts – no, Farmer Mac isn’t an overlooked stock.
Geoff’s initial interest: 50%