Price Appreciation Potential Key Feature For Two Harbors Investment

| About: Two Harbors (TWO)

Two Harbors Investment (NYSE:TWO) is a real estate investment trust that invests in residential mortgage-backed securities, residential mortgage loans, and other related investments, with a total portfolio of $16.1 billion. I am bullish on the company because it is well placed to minimize book value erosion in a rising interest rate scenario. Also, the company has a well diversified portfolio with mortgage servicing rights and consumer service loans, which will benefit the company in a rising interest rate scenario.

Tapering
The Fed's decision, based on weaker than expected economic performance, to delay tapering bodes well for mortgage REIT companies, as it has helped relieve downward pressure on the stock price. Another development that can cause a delay is Ben Bernanke's term as the head of the Fed Reserve ending in December. Therefore, the Fed might not make a big change in key policies. Also, the government shutdown will add further pressure on economic data.

However, we all know that tapering is inevitable; it may come now or with a delay of 3-6 months. The cutting down of $80 billion will eventually raise interest rates, but I believe the Fed will not cut down $80 billion in a single strike; rather,it will gradually reduce the buying bond program. On the other hand, economic data will also show signs of gradual improvement.

The rise in interest rates will erode the company's book value, which will reduce the portfolio asset base, and hence reduce the earning yield. However, I believe TWO will be able to manage rising interest rate pressure better than its peers in the industry. The company's management was able to anticipate the rising interest rate scenario in advance, and equipped itself with a mortgage servicing right (Pending:MSR) license. The MSR will perform well with the rising interest rate because prepayments will reduce as home owners choose not to refinance at cheaper rates; TWO will be able to enjoy premiums for the longer period of time. Furthermore, the company has also invested in credit sensitive whole loans, which perform well when the default risk is low. So, the rising interest rate due to improved economic conditions will eventually reduce default risk; credit sensitive assets tend to perform well in such situations. The company also offers better downward protection among its peers due to its better hedging strategies,which some people may argue is a defensive strategy, but I believe this is a more sensible approach, as shown in the table below.

Companies

BV per share 1Q'13

BV per share 2Q'13

% Change

American Capital Agency (NASDAQ:AGNC)

$28.93

$25.51

-11.8%

ARMOUR Residential (NYSE:ARR)

$6.72

$5.45

-18.9%

Anworth Mortgage Asset (NYSE:ANH)

$7.04

$6.01

-14.6%

Hatteras Financial (NYSE:HTS)

$28.18

$22.18

-21.3%

Western Asset Mortgage Capital (NYSE:WMC)

$20.37

$17.39

-14.6%

CYS Investments (NYSE:CYS)

$12.87

$10.20

-20.7%

TWO

$11.19

$10.47

-6.43%

Click to enlarge

Source: Companies Data

Key Highlights Financial Performance of 2Q'13
The company has failed to meet analyst expectations by reporting a core EPS of $0.21, which was well below expectations of $0.31. Lower net interest margin was the primary reason behind the negative earnings surprise, as it experienced a decline of around 13.7% QoQ and reached 2.50% because of lower yields and high funding cost. Aggregate portfolio yield experienced a decline of 30bps because of lower yields on both agency and non-agency securities. The company has also completed the purchase of two small bulk MSR portfolios, and the management is planning to further increase its exposure. Also, the company has increased its portfolio of credit sensitive loans by 256%, which has now reached $438 million.

Valuation

Click to enlargeThe company has been historically trading at its book value, as shown in the graph above. It is currently trading at a P/BV multiple of 0.908x. My price target is $10.47, based on 1xBVPS, which means price appreciation of 9.7%. Also, the company offers an attractive dividend yield of 11.80%. Overall, TWO offers a striking total return of 21.5%.

Conclusion
The company's defensive strategy has hurt its earnings in the recent second quarter, but it has also helped protect the company's book value. TWO's other initiatives, such as expanding the portfolios of MSR and CSL, will help the company's bottom line in the rising interest rate scenario. It also provides compelling total return opportunity, as the company is trading at a discount to its book value. It therefore provides an opportunity for price appreciation, along with a healthy dividend yield for yield-hungry investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.