Capstead Mortgage's Strategy Proved Itself Great In The Trying Times Of Q2

Aug. 2.13 | About: Capstead Mortgage (CMO)

Capstead Mortgage Co. (NYSE:CMO) is a mortgage REIT. It has a leveraged investment portfolio of exclusively Agency ARM RMBS. The ARMs (adjustable rate mortgages) reset to more current interest rates within a relatively short period of time. This results in a smaller fluctuations in portfolio values due to changes in interest rates and/or mortgage rates compared to Agency fixed-rate RMBS portfolios. CMO is recognized as the most defensively positioned Agency mortgage REIT. It is self-managed; and its management team is experienced. Its top four executives have over 85 years of combined mortgage finance industry experience.

CMO is not a newcomer to the industry. It was started in 1985. It has navigated two recessions. It has a five-year compound annual total return of 18.0%, which exceeds that of the NAREIT Mortgage REIT Index. It is currently paying a very respectable 10.5% annual dividend. Its stock ($11.85 at the close August 1, 2013) is trading at a 7.4% discount to its book value of $12.80 as of June 30, 2013.

CMO's strategy focuses on short-duration Agency ARM securities. It augments these with 2 year interest rate swap agreements (hedges). This allows for expansion of financing spreads when interest rates are falling. It allows for the recovery of financing spreads, when interest rates are rising. For Hybrid ARMs, CMO chooses only those with a maximum length of 5/1. This strategy allowed it to significantly outperform other Agency ARM mortgage REITs such as Hatteras Financial (NYSE:HTS) in Q2 2013. It also outperformed Agency fixed rate mortgage REITs such as American Capital Agency Corp. (NASDAQ:AGNC).

For Q2 2013 CMO reported net income of $29.9 million and core earnings of $0.27 per diluted common share. This compares to $34.9 million and $0.31 per diluted common share in Q1 2013. It paid a Q2 dividend of $0.31 per common share on July 19, 2013. On a strict GAAP basis it only earned $0.04 per diluted common share in Q2, 2013. Portfolio yields averaged 1.53%, which was 20 bps lower than in Q1 2013. CMO attributed this to higher premium amortization. Mortgage CPRs (constant prepayment rates) averaged 22.7%, which was significantly higher than the 19.7% for Q1 2013.

The above difference in pro forma net income and GAAP net income was due to CMO replacing all of its previously outstanding Series A and Series B preferred stock during the quarter. The redemption cost was $207 million. This included a $19.9 million redemption premium in excess of the recorded amounts (hence the subtraction from earnings). CMO financed most of this by completing a new offering of $170 million in Series E preferred stock with a coupon of 7.5%. This coupon was significantly lower than that of the redeemed Series A and Series B preferred shares. This action will benefit CMO with a reduction in its annual dividend requirements of -$8.3 million annually (or about $0.09 per common share per year). Longer term this should be a very positive transaction. Shorter term it cost -$0.28 per common share in GAAP net income.

In general I agree with the company that this transaction's costs should not subtract from the "real" net income of $0.27 per diluted common share. The book value per common share may be less by $0.28, but I would not call this -2.1% in book value a loss, especially when it will mean another +$0.09 per common share in core earnings per year. The "real" loss to book value was -$0.52 per common share (or -3.8%) due to portfolio pricing changes net of hedges as well as other operational factors. Even together these losses only amounted to -5.9% of book value.

How did CMO do compared to Hatteras Financial? Hatteras Financial had a huge book value loss of -$6.00 per common share in Q2 2013 (or a -21.3% loss to its portfolio). This brought its book value down from $28.18 to $22.18 as of June 30, 2013. While a -3.8% loss by CMO is nothing to sneeze at, it seems a very acceptable performance for the "quarter from hell". The many years experience of CMO's management showed through here.

One of the big factors contributing to HTS' huge loss was a big expansion of the basis spread for Agency Hybrid ARMs during Q2 see the chart below).

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The basis for 5/1 Hybrid ARMs rose by 30 to 35 bps; and the basis for 7/1 Hybrid ARMs rose by 50+ bps. One big way in which CMO outperformed HTS was that it emphasized short duration to reset ARMs. This meant it had no 7/1 Hybrid ARMs, which had the biggest basis widening for HTS (50+ bps). Further CMO's portfolio was more skewed toward faster to reset ARMs than HTS' portfolio. CMO's strategy seems like a winning one to me, even if interest rates continue to rise.

CMO's hedges performed well too, especially considering that the losses due to the basis spread widening by 30 to 35 bps for the 5/1 Hybrid ARMs were essentially uncovered by hedges (and really could not be easily). When you consider that the Agency ARM market had a disorderly sell off at the end of June 2013, CMO's performance is just that much more impressive.

CMO also outperformed primarily fixed rate Agency mortgage REIT, American Capital Agency Corp. in Q2 2013. AGNC had a book value loss of -$3.42 per common share. This brought its book value down to $25.51 as of June 30, 2013 from its March 31, 2013 value of $28.93 per common share (an -11.8% loss). CMO's -3.8% book value loss beat this by a long way; and AGNC did not have CMO's exposure to the huge basis spread widening in Hybrid ARMs in Q2 2013. The fixed rate Agency RMBS basis spread widened by only 6 to 8 bps.

The above relative performance figures speak very well of CMO's management. It appears to be ideally situated to profit without huge book value losses in an environment of increasing interest rates and mortgage rates. It should also do well if mortgage rates and interest rates decrease, so that is not a worry. Its dividend currently is a less than AGNC's (near 19%) and HTS's (near 14%); but for those who value their peace of mind, CMO may be the mortgage REIT for you. It seems an eminently safe investment. It is a buy for this segment.

The two year chart of CMO provides some technical direction for this trade.

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The slow stochastic sub chart shows that CMO is near overbought levels for the near term. Given that the overall market is also overbought at this time, investors may wish to average in. Some may wish to wait for a better technical entry point. The main chart shows that CMO has been in a weakening downtrend. Logically its performance in Q2 2013 should bring it out of this downtrend. It has likely been sold off with its sector rather than due to fundamentals. The selling that was done on that basis should correct itself over time. CMO may also regain some of its book value if the basis spreads for Hybrid ARMs contract a bit. Further most think CPRs (constant prepayment rates) will come down from Q2 2013 levels. This should help the net interest spread (help CMO earn more money). Given these factors, the dividend does not appear to be in danger. Remember that CMO will garner an extra $0.0225 per common share per quarter in net income due to the redemption by CMO in Q2 2013 of the higher yielding Series A and Series B preferred stock.

CMO has a PE of 11.73 and an FPE of 8.91. It has an analysts' average next 5 years EPS growth estimate of 7.5% per annum, which is quite healthy. It has an average analysts' recommendation of 2.4 (a low buy); and it probably deserves a higher recommendation. I like to sleep at might. It is a buy in my book.

NOTE: Some of the fundamental financial information above is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CMO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.