As many followers of the mortgage real estate investment trusts (mREITs) know, the sector has been battered. My top holdings in the space, Annaly Capital (NLY) and American Capital (AGNC), have plummeted in 2013, as interest rates were on the rise from mid spring until late summer. Only in the last month and a half have they pulled back of the 2013 highs. While both NLY and AGNC have been in the game a long time and have seasoned management teams, particularly NLY, one of my other holdings, Javelin Mortgage Investment (JMI), a little known monthly dividend paying mREIT, is absolutely beating the proverbial pants off the two big boys in terms of their recent Q3 performance. In this article, I want to highlight the areas where JMI is beating out AGNC and NLY and why some of you who are on the sidelines may want to consider purchasing shares of JMI before AGNC or NLY.
Since Many Readers Do Not Know The Company, What Does JMI Do?
Because this name is not as well known as NLY and AGNC, you may be asking just what does JMI do? I should start out by saying that JMI is a pretty young company. The team that runs JMI is ARMOUR Residential Management LLC (ARRM), pursuant to a management agreement, the same name behind the popular Armour Residential REIT (ARR). We know that ARR has done very poorly, and share price has suffered. However, things seem to be going better with JMI as I will point out. The company just hit its one year anniversary. The company went public a year ago on October 3, 2012. When shares began trading, about 6.5 million shares exchanged hands on day one and the stock closed trading at $19.60 per share. However, the offering wasn't your normal IPO, in the fact that it was a true new issue. The offering allowed management to implement a new investment strategy that protects the shareholders of one firm from way too much risk, while simultaneously attracting new investment.
It should be noted that another offering to raise cash for investments was conducted in the second quarter 2013, an offering of 6,000,000 shares, bringing the total float to 13,500,000 shares outstanding. JMI is a bit riskier than other companies in the mREIT space given its hybrid nature and the fact that it doesn't just invest in the safer agency backed securities, which are the crux of AGNC and NLY's portfolios. Rather, JMI is engaged in investing primarily in hybrid adjustable rate, adjustable rate and fixed rate mortgage backed securities and mortgage loans. Some of these securities are issued or guaranteed by a U.S. Government-sponsored entity or guaranteed by the Government National Mortgage Administration and other holdings are backed by residential and/or commercial mortgages. At the discretion of management, JMI may also invest in collateralized commercial mortgage backed securities and other mortgage related investments, including mortgage loans, mortgage related derivatives and mortgage servicing rights. This diversification has proved to be very lucrative. Recognizing the need for more than residential agency backed securities, at least NLY has increased commercial exposure up to 11% of shareholder's equity as of Q3, through its acquisition of CreXus. Despite this, JMI is beating the pants off NLY and AGNC in many key metrics.
Performance Is Everything And JMI is Emerging As A Strong Contender
AGNC reported third quarter earnings on October 28, 2013, and presented mixed results. Overall, it was an improvement from Q2, but it was still not the best quarter. In Q2 AGNC reported a $2.37 comprehensive loss per common share, comprised of $4.61 in net income per common share as well as a $6.98 other comprehensive loss per common share. This equates to an overall loss of $936 million for the quarter. In Q3, AGNC reported a $0.45 comprehensive income per common share, comprised of $1.80 in net losses per common share as well as a $2.25 other comprehensive income per common share. This equates to an overall income of $179 million for the quarter. Estimated taxable income was $0.29 per share, which is below the dividend that was paid out of $0.80 per share. Funds from operations are often a valuable metric to compare REITs. In the most recent quarter for which data are available, AGNC's funds from operations were approximately $514,000,000 but have declined for four straight quarters into this most recent quarter.
Unlike AGNC, NLY often chooses not to release its estimate of taxable income upon quarterly releases. NLY reported a Q3 GAAP net income of $192.5 billion, or $0.18 per common share which was far below the prior quarter's $1.6 billion in GAAP income of $1.71 per common share. Even more confidence crushing, the Q3 earnings were also down from the year ago quarter which saw GAAP net income of $224.8 million or $0.22 per average common share. I have repeatedly stated that I would love to see management provide quarterly estimates of taxable income as this is really key to profitability and more importantly what they have to or can afford to pay in dividends. This would make comparing mREITs performance much easier. GAAP earnings aren't all the helpful because taxable earnings and GAAP net income will always differ. What we do know is that earnings are down and trending lower. How about most recent funds from operations? NLY's most recent funds from operations were approximately -$3,900,000,000 but rebounded to roughly $826,000,000 in the most recent quarter, snapping three straight quarters of decline and losses.
Overall, JMI's third quarter earnings report looked really good. I think the numbers certainly were better than both AGNC's second quarter and NLY's, though one could argue the comparison isn't fair given that they have differing portfolios. As they are all mREITS and since I'm long the companies I respectfully disagree. JMI actually reported a slight GAAP loss of $2.76 per common share, comprised of net income of $37.2 million per common share. While this number is important and looks worse than what NLY gave us, what we really care about is the taxable REIT income, as this is how we as shareholders are paid our dividends. Remember the company has to pay at least 90% of this income to shareholders to stay in tax favored status as a REIT. JMI's estimated taxable REIT income was quite strong at $7.3 million. This is up 12% from Q2. Recall that $9.3 million was paid out in dividends because the company paid $0.23 per month. Therefore the dividends paid out exceeded taxable income for the quarter. This is ok because of estimated ordinary taxable REIT income available to pay dividends of $7.3 million in the third quarter of 2013 and $1.2 million of undistributed amounts from prior quarters. As of the end of Q3, the company had distributed dividends totaling $0.8 million more than cumulative taxable REIT income. This would have been a huge red flag for me if it was not for the fact that the company reduced the Q4 monthly payouts to $0.15 per month. As the fourth quarter is starting off very strong for the mREITs, I suspect that JMI will EASILY be able to cover their dividends WHILE both AGNC and NLY are LIKELY to slightly CUT their dividends. What about funds from operations? JMI's funds from operations have been trending higher every quarter since inception, most recently at $48,439,000.
Given Varying Age And Sizes of The Company, Comparing Just Financials Isn't Fair, What About The Spread on Interest Rates?
The interest rate spread was essentially stagnant quarter over quarter. AGNC reported a net interest rate spread of 1.37%, which was an increase over the 1.24% reported in Q2. AGNC's average net interest rate spread for the third quarter was 1.20%, a decrease of 29 bps from Q2 of 1.49%. Including estimated TBA dollar roll income/loss, AGNC's average net interest rate spread for the third quarter was 1.14%, a decrease of 72 bps from 1.86% during the second quarter. That's a massive loss to the spread. However, AGNC's average net spread income for the third quarter includes -6 bps of premium amortization cost due to changes in projected constant prepayment risk estimates, compared to 29 bps of premium amortization benefit during the second quarter. AGNC's yield on its agency security portfolio for the quarter was 2.59%, compared to 2.92% for the second quarter. This is a huge drop of 33 bps. The annualized weighted average yield on the agency security portfolio was 2.64% for the current quarter, compared to 2.63% for the prior quarter. Overall, AGNC's average asset yield reported as of September 30, 2013, was 2.70%, a single bps decrease from 2.71% as of June 30, 2013. Furthermore, AGNC's average cost of funds decreased 4 basis points to 1.39% for the second quarter, from 1.43% for the first quarter, due to lower average swap costs as a result of a smaller hedge position.
How did NLY stack up? Well there was slight improvement. The annualized yield on average interest-earning assets was 2.82%, a rise of 31 basis points over the Q2 annualized yield on average interest-earning assets of 2.51%. Yet, the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 1.81%, a rise of 28 basis points from the Q2 annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps of 1.53%. All in all, this resulted in an average interest rate spread of 1.01% for the quarter, which was stronger than Q2. Overall this was a 3 basis point increase from the 0.98% average interest rate spread in Q2.
The net interest rate spread for JMI actually dropped 1.75% to 1.72% quarter over quarter, but still is beating the pants off of both AGNC and NLY. How did JMI reach this number? First, JMI's asset yield on its agency security portfolio for the quarter was 3.04%, a rise of 5 basis points compared to 2.99% for the second quarter. Furthermore, JMI's average cost of funds (derived from the cost of repurchase agreements, other debt and interest rate swaps) increased 12 basis points to 1.22% for the third quarter, from 1.20% for the second quarter, due to higher average swap costs associated with entering into longer dated swaps during the quarter. The company has been rebalancing the portfolio very actively. As an example of the rebalancing effort, the company has sold approximately $554.5 million of agency securities resulting in the company taking realized capital losses of approximately $48.6 million. These capital losses will generally be available to offset capital gains realized in the years 2013 through 2018, but cash needed to be raised to help reshape the holdings of the portfolio.
To put this all into perspective, the cost to borrow rose while the average yield remained exceptionally high at just over 3%. Thus, earnings potential as a result from the interest rate spread alone have slightly decreased by 3 basis points, but these numbers reflect what was occurring early in the third quarter. Management has been busy reshaping the portfolio in response to the volatile environment in Q2 and Q3. When compared to AGNC and NLY, 1.72% for the overall spread is incredibly strong and in this business we want this number to be as high as possible. JMI is winning in this regard hands down.
Discount to Book Value?
I've said it before and I will say it again. For the most part, book value drives share price. For all of these companies it has been decimated in 2013. I'm going to come out and say this, and Im prepared for the backlash. I am of the opinion that it is extremely likely given the moves in the 10-year rate in October that book value of all three companies is higher now that it was as of September 30, 2013. That being said, let's compare discount to book value as of September 30th.
In the Q2 quarterly report, book value was $25.51, down significantly from the first quarter. On September 30th, the stock was trading around $22.70. For the third quarter, book value was reported to be $25.27, which was a negligible $0.24 drop from the end of Q2, or a decline of less than one percent. On September 30th, the stock was trading around $22.70. This meant that the stock was trading over 10% below book value.
In the Q2 quarterly report, book value was $13.03, down from $15.19 in the first quarter. For the third quarter, it reported a small decline in book value of 2.5% down to $12.70 per share. On September 30, 2013, NLY was trading around $11.64 a share. This represents an approximate trading discount of 8.3%.
In the Q2 quarterly report, book value was $15.12, down from the first quarter like AGNC and NLY. For the third quarter, JMI reported a small decline in book value of 2.8% down to $14.69 per share. On September 30, 2013, NLY was trading around $11.80 a share. This represents a massive approximate trading discount of 19.7%.
Thus, when we compare the three JMI was clearly the best purchase from a discount to book perspective. When you consider the fact that book value of the companies is likely up from the Q3 reported amount, JMI is presenting investors with an incredibly compelling opportunity for a value purchase.
Winning on Yield
While all the companies have cut, JMI is also beating NLY and AGNC when it comes to yield. With the cut down to $0.15 monthly, I believe JMI can easily afford to sustain this level, unlike AGNC and NLY which may have to do another small cut. As it stands now, JMI yields 15.1% compared to AGNC's 14.5% and NLY's 11.8%.
Another Reason To Really Like JMI Here
Not to discount what AGNC has done recently, as it was successful, but JMI's Board of Directors has authorized management to repurchase up to two million shares of its outstanding common stock. Why is this a good thing? Because less shares will be on the market, which artificially raises income per share. It means less dividends would have to be paid out to those existing common shares. Both of these combined translates to the potential for HIGHER dividends for current shareholders. Given the massive discount to book, management is making an extremely wise decision to repurchase shares. They will purchase shares in the open market, possibly in block trades or through privately negotiated transactions. They may also devise a trading plan that could be adopted in the future. It is at management's discretion.
At the time of this writing JMI is trading at $11.75. shares are now down 4% from where shares closed on their first day of trading in October 2012. Shares aren't heavily traded, as average volume is about 387,000 shares a day. What about the p/e multiple? This is a strong consideration when investing in any mREIT. JMI has one of the best multiples out there, only trading at 3.1 times earnings. For comparison purposes, AGNC trades at 3.6 times earnings whereas NLY also trades at 3.1 times earnings, so JMI is certainly competitive in this regard.
JMI is beating the proverbial pants off of AGNC and NLY in many respects. I am pretty impressed. I have a small position but am considering expanding into this mREIT on weakness before adding to either NLY or AGNC. JMI just looks healthy. I think the dividend is pretty safe. I love the repurchase announcement. JMI is more diversified than both AGNC and NLY, and also trades at much more juicy discount to book than does AGNC and NLY. It has a better interest rate spread than both AGNC and NLY and is taking steps to ensure its survival in this transition period for mREITs. As much as I love AGNC and NLY, and continue to have faith in the management, at the time of this writing and as you read this, JMI is likely the better buy right now.