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When it comes to income-based investing, the mortgage REIT sector offers some of the highest-yielding stocks in the market. More often than not, investors tend to establish positions in these companies without reading between the lines, and, as a result, fail to take advantage of the long-term value some of these companies have to offer. In this article, I wanted to examine two of the leading mortgage REITs and the upside they possess based on the following criteria:

Each must have a potential upside of at least 20% when using Graham's Number

Each must be trading at least 1% below its 50 DMA and 1% below is 200 DMA

Each must yield at least 12.0% as of the close of 11/29/12

Each must be down at least 10% since 09/13/12 - Day 1 of QE3

Before I begin examining both companies, I wanted to first explain how value is determined when using Graham's Number. According to Eben Esterhuizen the Graham Number is:

"a figure that measures a stock's fundamental value by taking into account a company's earnings per share and book value per share. The Graham number is the upper bound of the price range that a defensive investor should pay for the stock. According to the theory, any stock price below the Graham number is considered undervalued, and thus worth investing in. It is used as a general test when trying to identify stocks that are currently selling for a good price."

The 22.5 is included in the number to account for Graham's belief that the price to earnings ratio should not be over 15 and the price to book ratio should not be over 1.5 (15 x 1.5 = 22.5).

The first of these companies is Annaly Capital (NYSE:NLY) which currently possesses a P/E ratio of 10.17 and trades at a 4.12% discount to its 50 DMA and an 11.47% discount to its 200 DMA. In my opinion, there are three secondary factors to consider in terms of Annaly. The first thing to consider is the fact that shares of NLY have been trading down 16.27% since September 13th, which was the start of QE3 (aka, the first day the Federal Reserve had initiated its plans of spending $40 billion per month on mortgage purchases).

The second thing to consider is the fact that Annaly Capital announced that it would be acquiring the remaining outstanding shares of CreXus (NYSE:CXS) that it does not already own. Not only does this acquisition diversify Annaly's portfolio, but could yield further acquisitions in the near future. According to Wellington Denahan, the Chairman and CEO of Annaly:

"A powerful step in this direction is the proposed acquisition of CreXus. We believe that wholly owning the commercial real estate platform we currently manage through FIDAC is complementary to our existing business and return profile and should provide stable and diversified risk-adjusted returns to our shareholders. CreXus' capabilities and growth may be significantly enhanced when coupled with Annaly's broad capital base."

The acquisition of CreXus breaks Annaly's traditional Agency-MBS mold and therefore could lead to future acquisitions of mREITs dealing in both the commercial and non-Agency MBS spaces.

Lastly, and most importantly, the company presents a very nice value proposition when using Graham's Number. NLY's diluted TTM earnings per share at 1.45, and a MRQ book value per share value at 16.60, implies a Graham Number fair value = SQRT (22.5*1.45*16.60) = $23.27. Based on Thursday's closing price of $14.68, a potential upside of 36.92% is implied when calculating the company's Graham Number.

The second of the two mortgage REITs in focus is American Capital Agency (NASDAQ:AGNC), which currently possesses a P/E ratio of 4.71 and trades at a 1.06% discount to its 50 DMA and a 5.90% discount to its 200 DMA. In my opinion, there are three factors to consider in terms of American Capital Agency. One of the first things to consider is the fact that shares of AGNC have been trading down 12.97% since September 13th, even though share price has held steady over the last few trading sessions.

The second thing to consider is the philosophies behind the company's recent $500 million share repurchase announcement, "Those plans are largely designed to give management the ability to repurchase shares when trading at a discount to book value. Such purchases are likely to be preferable to buying more agency RMBSs at prices that will be comparably higher than their own equity." According to fellow SA Contributor James Shell, "At the current dividend rate of $1.25 per share, the share buyback will result in a reduced dividend payout of $76M per year, and with the most recently announced interest rate spread of 1.42%, the reduction in portfolio will reduce AGNC's interest income by about $50M, so the net benefit of the share buyback will be around $27M." All this for $27M doesn't sound like there's much benefit to it; however, I think that $27M could be used to add additional stakes to pre-existing portfolio position or be used to enhance the company's diversification efforts.

Lastly, and most importantly, the company presents a very nice value proposition when using Graham's Number. NLY's diluted TTM earnings per share at 2.46, and a MRQ book value per share value at 32.51, implies a Graham Number fair value = SQRT (22.5*2.46*32.51) = $42.41. Based on Thursday's closing price of $31.46, this implies a potential upside of 25.00% from current levels.

Now that I've demonstrated the potential upside both Annaly and American Capital bring to the table, it's time for me to elaborate on one of the negative catalysts the mortgage REITs may face going forward. The primary negative catalyst for the sector as a whole will be the continued spending habits of the Federal Reserve during the latest round of QE3. One of the things I had previously noted was the fact that, "this program itself was designed to serve two purposes, an easing of various mortgage lending requirements for homeowners and to support a rebound in the housing market. As a result of the $40 billion per month spending spree many of the mortgage REITs are taking a defensive stance by making some very desperate moves."

Since the Fed is acting like a pseudo-mortgage REIT and buying up residential mortgage paper at a very torrid pace ($40 billion per month to be exact), I strongly believe we could see an even further decline in the price of these securities, if something isn't done to counteract the Fed's process.

How can one counteract the Fed's process? The good thing about the Fed's purchasing activity is the fact it won't last forever, but in the meantime, these firms will need to soften the blow by diversifying through acquisition. As I've previously noted, it's going to be very hard and virtually impossible to outspend the Federal Reserve, and as alternative many of the mREITs will need to start looking at possible acquisitions. One possible target that I think would be a good acquisition for either Annaly or American Capital would be Chimera Investment Corp. (NYSE:CIM).

If either Annaly or American Capital were to make a bid for Chimera, they would be getting a pre-established portfolio that includes a vast array of securities which fall into various asset classes. How so, you ask? Chimera currently deals in various "asset classes which include agency or non-agency RMBS; prime, jumbo prime, and Alt-A mortgage loans; first or second lien loans secured by multifamily properties, mixed residential or other commercial properties, retail properties, office properties, or industrial properties; and asset-based securities (ABS), including commercial mortgage-backed securities, debt and equity tranches of collateralized debt obligations, and consumer and non-consumer ABS."

Final Analysis

Although there is clear upside potential in both Annaly and American Capital, I still think investors should proceed with caution for two reasons. First is the fact that many of the mortgage REITs have reduced their dividends over the last few years due largely in part to both prepayment risk and a reduction in the yield curve. The second thing to be concerned about is the Fed and its spending behavior. Given the fact there is no timetable for the end of QE3, no one can be too certain as to when the Fed plans on ending its purchasing program which could certainly hinder the spending of such firms as NLY and AGNC.

Source: 2 Heavily Undervalued mREITs Offering Investors Double-Digit Yields