Now before we get into this, it's only fair to say, as we have a substantial position of our portfolio in (NYSE:CMO) (less than 1% of shares outstanding), we can tell you from personal experience, that management of this company is very accessible, professional, transparent, and most always very prompt with answers to questions. We have been fully supportive of most of what management has done in recent years to make what it is. We have found them to be much more accessible than the management at many other mREITS. However the subject of this article is one area that we have the most disagreement with management's strategy.
On Wednesday October 23, reported one of its weakest quarters in recent history. Prepayments on existing assets ate into their net earnings at a significant rate. These prepayments also caused book value to take a hit as well.. I explained all these potential dangers in a previous article:
"This missed opportunity amounts to large amounts of wasted funds when prepayment rates are high and the stock trades at a discount. Yes, the overall market cap of the company decreases, but the book value and earnings per share of individual shareholders increases. The only logical reason for not doing this would seem to be wanting to maintain market cap at the sacrifice of shareholder value...."
This is exactly what occurred in Q3. Pure and simple. There's no need for tons of analysis or number crunching to figure out what went wrong. It was simply a missed opportunity for the company to buy back shares at a big discount to book value with cash from runoffs. Had they bought shares at a big discount to book the company would have been buying dollar bills for less than 90 cents each, and the earnings and book value would have been stable or even surprising to the upside depending on how aggressive the buyback was.
Going forward, the company explained in its press release that prepayment rates in the first month of Q4 had declined dramatically and if that continued, would set up for a significant increase in the spread, creating a more profitable Q4 than expected. There have already been a couple articles written on the fundamentals of why CMO has a bright outlook for Q4 and beyond so I won't rehash what others have done a good job of explaining… Instead I will focus on something different.
This brings me to the Icahn Principle. Last week I heard a fantastic interview with Carl Icahn on CNBC. He was describing that while the management at (NASDAQ:AAPL) was doing a fabulous job, that the Board of Directors was not acting in the best interest of shareholders. He explained artfully how should be using $150billion of cash sitting in Europe to buy back shares of the company, which he says are extremely undervalued. This logic also applied to CMO during the third quarter. Earlier this year, when CMO was trading at almost a 20% discount to book value... shareholders could have been richly rewarded had this policy been put in place.
There are some that would have concern with this approach because if there are opportunities to purchase new assets the company won't have the cash to do so... this is not true, since at any time the Board of Directors can re-instate the At the market share issuance program that is currently suspended. This allows the company to go into the market and sell new shares of the company at market prices to raise capital for new asset purchases at any time. This should be done with aggressive pursuit whenever the stock is traded above book value, or if there are extraordinary price opportunities for new assets to be acquired.
In conclusion… we remain confident in the strong future potential of and believe their strategy of very short duration ARMs will win out over the others in the sector when rates do begin to rise again, just as the company did in Q2. However, we would like to see management become more proactive with the share buybacks when the stock trades at a significant discount to book value. This would enhance shareholder value, and per share performance.