American Capital Agency (AGNC) has plummeted today (7/5/13) in response to more tapering talk by the Federal Reserve. This talk was a result of another better than expected (yet still anemic for a recovery) jobs number showing that the market added 195,000 jobs in June. At the time of this writing, AGNC is now trading down 7.5% on the day to $20.21. The stock is deep into bear territory now. Interestingly, although AGNC did recently announce its latest quarterly distribution, which was cut by 16% to $1.05, far less than expected, it has not been enough to catch a bid. At its current price, AGNC is now yielding 20.7% annually. Yet the stock is now down significantly from May 1st, 2013 when it was about $33.00 a share. Those who have purchased at $33.00 a share are now $13.00 per share in the hole to earn $4.20 annually. Thus, it will take about three years of dividend payments to recoup losses assuming the share price remains the same and the dividend is sustained. It is worth noting that AGNC is not the only mortgage real estate investment trust (mREIT) stock that has been absolutely decimated in the last month or so. It's the entire sector. The market is viewing this stocks as losing investments because many believe they will be unable to adapt to the changing environment. Some of the selling has been warranted. In this article, I will explain why some of the selling was warranted but I will further suggest that AGNC is actually a steal at current prices on today's selloff.
Why Did The Stock Deserve To Be Sold?
I recently predicted that the FOMC meeting in June, and more importantly the comments by Ben Bernanke, would weigh heavily on the mREITs. The meeting was the most important one so far for the near-term action in mREITS as we got some clarity as to when tapering would occur of the Fed's purchasing, which will be as early as 2013, but most likely in 2014. Today's news sparked further selling, but I think the effect of tapering is being overblown. Because the taper will be data-dependent, the "good" jobs number made folks believe this taper would occur faster than expected. Interestingly, when AGNC dropped 6% after this speech, it was because we had confirmation (of something we already knew would happen) that the Fed will indeed taper mortgage asset purchases and other balance sheet expansion if the data is strong. We all knew this, but I guess the market needed to hear it. So down we went. A key point is that Mr. Bernanke also stated that the Fed would not sell their mortgage backed securities (MBS), but likely let them mature. We will await eagerly the meeting minutes release.
The real reason that these stocks deserved to sell off was the rising interest rates and corresponding decrease in MBS values. This is a legitimate reason because these are the two key components which affect mREIT earnings. These rates have been impacted immediately after every piece of news regarding tapering and today is no exception. In the short-term, rising interest rates pressure MBS prices, and as MBS prices decline, so do potential earnings. Take a look at figures one and two which show rising interest rates and declining MBS values respectively. This action has led to panic selling in the REITs and has immediately impacted book value.
Figure 1. Interest Rates, Thirty Year Fixed Mortgage, In The Last 30 Days.
Figure 2. Price of The 30 Year FNMA 3.0 Mortgage Backed Security in the Last 30 Days
AGNC Likely Trading Below Book Value
I mentioned the dividend cut was less than expected which is a huge positive and a buy signal for me. A cut in general was expected because one of the most important indicators of mREIT health, the book value, has declined for many mREITs and AGNC was no exception. According to AGNC management's recent presentation, book value was around $26.44. Book value has declined in the last few quarters, and in turn the share price has moved down. However, June 7th was a month ago. Book value has likely further been pressured as AGNC has been restructuring its portfolio. However, at $20.21 a share, I would be hard pressed to argue that AGNC is trading at or above book value. As painful as the rising rates have been and the decline in MBS prices, I just cannot see book value declining $6.00 in a single month, regardless of where interest rates have gone. While actual book value remains to be seen for the quarter end, a buy at these levels is almost certainly a discount to the book value. Rising interest rates, while having pressured the companies in the short-term, is actually a benefit long-term and will help increase book value over time as AGNC repositions.
The Benefits of Rising Interest Rates
The pain from rising interest rates has been damaging to AGNC, but in the long-term, AGNC stands to gain from rising rates. One key point that I have raised in earlier articles is beginning to bear fruit now. The Fed has kept short-term buying rates near zero levels, and this is the rate at which AGNC can borrow money. Thus, for the time being, it will not cost more for AGNC to borrow relative to the last few years. In fact this was supported in the recent comments following the FOMC meeting "the Committee decided to keep the target range for the federal funds rate at zero to one-quarter percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above six and a half percent." The Fed will also keep rates lower so long as "inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's two percent longer-run goal." Further, Atlanta Federal Reserve President Dennis Lockhart recently spoke in which he said that nothing has changed in the Fed's overall monetary policy. He also said that the Fed wouldn't consider raising interest rates until 2015. This is key to the mREITs being successful going forward. By keep their borrowing rates low, while long-term rates rise, they can use borrowed money to sell longer term debt at higher rates. As this longer-term rate rises while the borrowing rate remains stagnant, the interest rate spread (that is the difference between what AGNC pays to borrow and lend) will widen, subsequently feeding the top and bottom lines. This last quarter or two have been periods of transition, where existing holdings in the portfolios have declined, been possibly sold, and the proceeds used to re-weight the portfolio.
Looking Ahead, Management is Being Tested
Looking ahead to the upcoming Q2 report, I will be anxiously awaiting to see how much leverage AGNC has to the market, what was done with existing MBS, how the portfolio was re-weighted, how any hedges AGNC had in place performed and what the quarter end book value was. Further, the conference call will be one of the most important in this company's history, as both big money managers and analysts will want clear answers on the company's plans moving forward. What I cannot stress enough for readers is that when you buy an mREIT stock, you aren't just buying a business model. You are buying the management team as well. Gary Kain and his team are among the best in the business. I have confidence that my recent decision to pyramid down in to this name is wise, despite the short-term headwinds the company has faced. I believe that management is being put to the test and will pass with flying colors.
I Completed My Position in The Stock Today
Coupled with the dividend again yielding over 20%, a marker that many investors I know stated they needed to see in order to get back into the stock, I think AGNC is exceptionally a steal right now. I have now completed a full pyramid style buying position in the name as of today, with my last purchase at $20.25
As a long-term investor, I think it is prudent to buy stocks that are on sale during times of panic provided the management team is sound and the business model still works. I have been questioned on the latter, but the evidence presented above, specifically on the Fed keeping borrowing rates low while AGNC can lend at higher long-term rates will allow the company to remain profitable going forward. There is no doubt the company is in transition and as a result, people have dumped the stock. I think the volatility in these names has led to incredible long-term buying opportunities for investors as the high dividends, which will always fluctuate over time, can be reinvested to compound one's investment over time. The best course of action is to add to holdings during times of fear, and to always take advantage of buying stock in these companies when they trade at a discount to their net asset book values. Preferably, as I have done, you purchase more shares as the stock declines (provided the underlying thesis has not changed). Do not buy at a premium, even if these stocks trade at premiums to book value for extended periods of time. Instead, on days like today where the stock trading down 7% on really nothing new, step in and do some buying. This is the key to long-term success in a dividend stock like AGNC.