"Hope dies last." - Unknown
Despite clear-cut statements from the Federal Reserve that low interest rates are soon a thing of the past, bullish investors seem to ignore the impact the new interest rate environment is going to have on mREITs such as Annaly Capital Management (NYSE:NLY). Annaly, just like other mREITs, relies to a significant extent on leverage in order to earn a net interest spread (which in Annaly's case stood at a mediocre 1% in the last quarter). Investors can currently witness that a variety of mREITs, including Annaly, American Capital Agency Corp. (NASDAQ:AGNC) and ARMOUR Residential (NYSE:ARR), are deleveraging in anticipation of lower earnings in the future. It also seems to be widely accepted that distributions for mREIT shareholders are going to fall in the coming quarters especially after considering that book values are declining now for multiple quarters in a row.
The anticipated tapering of the Fed and the establishment of a new operating environment for Annaly has caused share prices to correct substantially. In fact, Annaly shares are now marking a five-year Low after another. Shares currently quote at $10.73 which is just marginally above its latest five-year Low at $10.38. At the same time dividends have contracted massively from a High of $0.75 per share in Q4 2009 to $0.35 per share in Q3 2013 (a minus of 53%). Further dividend cuts will likely cause further downside pressure when bugged investors sell their shares in anticipation of lower forward dividend yields.
Biases of bullish investors
Bullish investors seem to entirely base their investment thesis on Annaly's dividend yield but fail to adequately incorporate contradictory information which speak against Annaly as a long-term investment with a sustainable dividend record (especially in an environment of rising interest rates).
Investors seem to exhibit a combination of representative-, confirmation- and regret aversion bias when it comes to investment in Annaly Capital Management.
The representative bias stipulates that investors merely extrapolate current data, such as Annaly's double-digit dividend yield, into the future even though circumstances and market conditions warrant a new and broader evaluation of the investment.
The confirmation bias basically deals with the idea that bullish investors seek out confirming evidence but fail to incorporate new information which contradicts their thesis. A current example of confirmation bias relates to Annaly's insider purchases which received quite a bit of attention in bull circles. Investors usually regard insider Buys as 'confirming evidence' that they are still on the right side of the trade. The table below shows the most recent insider Buys for Annaly Capital Management since August 2013.
However, the same officers also purchased shares back in 2011 and 2012 at substantially higher prices. The fact, that mREITs are cyclical investments should receive a higher weighting than a few insider purchases with a nominal value of less than $5 million. Annaly's consistently falling distributions since 2009, contracting net interest spreads, lower earnings and higher earnings volatility could be named as new, contradictory information. New information like this still seems to be readily ignored by large segments of Annaly's investor base.
The regret aversion bias, on the other hand, stipulates that investors hold on to their losing investments because they want to avoid the feeling of having made a bad investment decision. Annaly's shares have lost 34.5% over the last two years which is more than the annual cash flow yield. Despite a likely negative total return, investors still hold on to Annaly in hopes of a turnaround instead of facing the reality that Annaly's distributions are cyclical in nature and have been marking a downward trend for more than three years.
It appears that bullish investors are anchored on their dividends but fail to see the bigger picture and the cyclical sensitivity of their distribution stream. While investing for income is certainly a valid strategy, a portfolio concentration on mREITs should be avoided. The risk/reward trade-off for investing in Annaly is stacked against bullish investors. The consecutive, quarterly erosion of book value alone speaks volumes about the cyclical trend of mREIT value creation and their distributions.
Instead of merely buying Annaly for its dividend, investors should rather focus on the underlying developments of net spreads, book value per share and distributions in order to overcome cognitive dissonance and mitigate the biases depicted above. High-leverage businesses are going to do poorly when funding costs increase. A reliance on short-term funding also exposes mREITs to substantial risk in case of market disruptions. I expect significantly lower distributions in 2014 for both Annaly and American Capital Agency. Lower distributions bear the risk of lower share values as investors will get increasingly uncomfortable owning a high-risk business at a low yield.