Valuentum Members Are Reminded of the mREITs
publication date: Dec 5, 2013
author/source: Brian Nelson, CFA
“I am the advisor you referenced in the July newsletter who sold AGNC. Your timely article made me re-look at all of the mReits we owned, and we sold off nearly all of them over the following month after your article. I just calculated where we sold (because of your article) compared to where the mReits are today. Your article, which influenced the selling saved our clients over $1.1 million in equity price drops. That translates into $11,000 per year of fee income to the firm. You can bet that we will be re-subscribing when the time comes. Thank you for your hard work, and bringing additional value that was not owed or expected."
-- Tim A. (source: Valuentum testimonials), email on August 23, 2013
Sometimes it’s easy to forget that the value of an investment research service not only rests on the ideas that it generates, but also on the pitfalls it helps members avoid. That’s why we are so selective with the companies we add to our actively-managed portfolios. We want our portfolios to achieve their respective goals, and sometimes, this means we don’t trade very often. However, low portfolio turnover doesn’t mean the portfolios aren’t working hard to achieve their goals and the ideas held within them aren’t the best ideas on the market today. Here’s the story behind perhaps the best call of 2013. It wasn’t one that we acted on, but rather, it was one that we encouraged members to avoid.
We first initiated coverage on the mortgage REIT industry with a ‘VERY POOR’ rating September 2012. Here was our independent, objective take on the group at the time:
…almost all of (the mortgage REITs) generate a return on tangible equity that is less than our estimate of their respective cost of capital (generally 10%). Further, almost all constituents in the group have distribution payout ratios higher than 1, revealing a significant dependence on the healthy functioning of the capital markets for new funding, which cannot be guaranteed and at times can become prohibitively expensive.
Further, the reliance on debt to finance properties exposes residential REITs to the risk that their future cash from operations may at some point in the future be insufficient to make required payments of principal and interest. Leverage, the amount of debt exposed to variable interest rates and future free cash flow generation need to be monitored very closely (as REIT distribution requirements limit available cash on the balance sheet). The success of a mortgage REIT depends heavily on its ability to acquire assets (agency securities) at favorable spreads over borrowing costs, which can rise materially in the event that short-term interest rates increase or the market value of its investments decline (margin calls are also possible).
Our research indicates that the highest-yielding firms in the group have a tendency of having the greatest amount of leverage (as measured by total assets divided by total shareholders' equity), the most aggressive business models, and offer the greatest level of risk to investors. Generally speaking, we're uncomfortable with 'asset/equity' leverage levels above 6 for any constituent in the group, given the long-term threats of a rising interest rate environment, which could significantly impair operations should income be exceeded by the expense incurred to finance investments. All things considered, the large distribution yields presented by some constituents in the group may not compensate investors for the tremendous risks inherent to their respective business models.
It was a wild ride since we initiated on the group September 2012, but the decline of the constituents didn’t really accelerate until our May 2013 note titled ‘The Mortgage REIT Business Doesn’t Work…,’ where we warned that:
The book value of some mortgage REITs will be punished regardless of what happens to interest rates…a rising interest rate environment can be devastating by causing other comprehensive losses (unrealized losses on investments marked to market) that will completely wipe out period spread income, causing rapid and uncomfortable declines in book value. Dividend payments may not be sustainable under these conditions.
It wasn’t too long after we published the May 2013 piece that firms in the mortgage REIT industry such as Annaly Capital (NLY) and American Capital (AGNC) starting slashing dividends. We highlighted the large number of research houses that were wrong and/or late in their analysis on the mortgage REIT group in this July 17 piece, and while Goldman Sachs wasn’t included, its ‘Sell’ ratings today on Annaly Capital and American Capital can probably be considered in the late camp. The news has reminded Valuentum members that there is tremendous value in a service that not only helps uncover investment gems but also helps steer members away from bad ideas in a timely fashion.
Here’s what Goldman had to say about Annaly Capital today:
We are Sell rated on NLY, as we expect book value to fall as rates rise and MBS spreads widen post Fed tapering. As NLY continues to take actions to protect book value by taking down leverage, rotating into shorter-duration assets and increasing its hedge ratio, we estimate earnings headwinds and dividend cuts of ~40%. We expect total returns of 2% over the next 12 months, which is relative underperformance compared to 10% average upside for the sector. This assumes book value declines 14% from 3Q13 levels to 4Q14 and that the stock to trades at 0.87x this level to $9.50 for 5% price downside (vs. current P/B of 0.79x). We also assume dividends of $0.80, implying a dividend yield of 8.0% off current price levels.
Here’s what Goldman had to say about American Capital today:
We are Sell rated on AGNC, as we expect book value to fall as rates rise and spreads widen post Fed tapering. As AGNC continues to take actions to protect book value by taking down leverage, rotating into shorter-duration assets, and increasing its hedge ratio, we estimate continued earnings headwinds and an increased risk to dividends. We expect book value to fall 15% from $25.27 in 3Q13 to $21.39 by 4Q14, and that the stock trades to 0.86x this level (vs. current levels of 0.78x) for our $18.50 price target for 6% price downside. We expect 2014 dividends of $2.00, implying a dividend yield of 10% on current price levels, bringing the total return for 2014 of 4%, which is relative underperformance vs. the 10% average total return for our Neutral-rated coverage universe.
Goldman’s initiation today on the mREITs has been an important reminder to Valuentum members of the advantage of having an investment research firm that can not only highlight winners for your portfolio, but also steer your portfolio away from losers in a timely fashion. We don’t plan to be active in any mREIT anytime soon.