In the wake of the subprime fallout in the United States, shares of Countywide Financial have fallen considerably.

Countrywide is America’s #1 home loan lender and the country’s third largest federal savings bank. The Steadyhand Global Equity Fund holds shares in Countywide, and given the recent volatility in the company’s stock price, we wanted to provide investors with some visibility on the company. The following is an update from the manager of the fund, Edinburgh Partners.

We took a position in Countrywide Financial last year because it was one of the cheapest stocks in our database. The shares had a price-to-earnings (P/E) ratio in year five of under eight times under a central case scenario where the U.S. housing market suffered a two year downturn before returning to a subdued level of growth [as a central part of their research process, Edinburgh Partners focuses on forecasting the five year earnings of a company]. Our earnings forecasts in years one and two were substantially lower than the market’s expectations. Conscious of buying the shares in the face of a downturn in the U.S. housing cycle, we took only a 2% position in the portfolio, our smallest entry level.

The surprise to our forecasts has been the extent of the contraction in the spread at which Countrywide can sell on mortgage risk to investors other than the government sponsored entities (Freddie Mac and Fannie Mae). At present, Countrywide sells on 68% of its mortgage production to these GSEs, so the risk is to only 32% of its book. The GSEs have a political mandate to stabilise the mortgage market.

As margins contract, Countrywide (and all the other mortgage lenders) will step back from writing new loans, and growth will slow in the short term. However, as many rivals we believe will exit the market, Countrywide will emerge stronger as the market returns to normality.

The bankruptcy speculation in the market stemmed from one particular research note, which we have read. The argument it suggested was that if confidence fell and Countrywide was unable to access credit, it would no longer be able to function. This argument can be applied to every bank, and there are many with weaker positions than Countrywide. Unlike many of its smaller peers, the company has confirmed access to short term and back up lines of liquidity.

On our revised forecasts, the shares are cheap, even if we were to find that we need to revise our expectations further. The shares are currently trading at 80-85% of book value. Over the last 20 years, the shares have traded in a range of 100%-250% of book value. Whilst losses are certainly possible, continual losses are now the central market assumptions.

We know that buying shares on the basis of their long term valuation is the way to achieve good returns, even though this often feels uncomfortable. Therefore, as long as the shares conform to our valuation criteria, we will be holding on to our position. At this stage, the shares comprise less than 2% of the portfolio and we expect to buy further shares when the end of the housing market downturn becomes apparent.