A Mortgage REITs Update

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Includes: AGNC, ARR, CIM, CYS, IVR, NLY, TWO
by: James Shell

At the request of one of my followers, we are taking another look at the Residential Mortgage Backed Securities. We have done some work on the mREITs lately. We have just passed the ex-dividend dates on most of these funds, so we have a little time to let them work before we line up to collect another round of dividends in March.

To recap, the RMBSs are in the business of borrowing money, and then lending it back out as mortgages. This function was traditionally performed by the banks, but since the catastrophe in 2008, a space has developed in the marketplace into which this business has expanded. These funds are classified as REITs because they have real estate as their underlying assets and also because they distribute the bulk of their profits to their shareholders they get favorable tax treatment.

We are following a little portfolio of some of the higher yielding of these funds as follows:

Price Op Marg Div Yield
AMERICAN CAPITAL AGENCY CORP AGNC $28.37 95.43% 19.74%
ARMOUR RESIDENTIAL REIT INC ARR $7.17 92.68% 18.41%
CHIMERA INVESTMENT CORP CIM $2.64 93.33% 16.67%
CYS INVESTMENTS INC CYS $13.28 91.01% 15.06%
INVESCO MORTGAGE CAPITAL INC IVR $14.11 93.38% 24.24%
ANNALY CAPITAL MANAGEMENT INC NLY $16.06 94.00% 14.20%
TWO HARBORS INVESTMENT CORP TWO $9.23 91.78% 17.34%
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The big attraction for investors in this group is the high dividend yield, and in this era when CD rates are low and returns in other forms of investing are not particularly good, there is some merit in this. Because borrowing rates are at or near zero at the moment because of the Fed policy to keep some life in the economy, this is an extremely profitable business. I also follow some of the oil refiners, and in that industry, which everybody hates because the companies are supposedly making so much money, a profit margin of 10% is exceptional. These companies are all in excess of 90%.

The problem is that because of the problems in Europe over the last six months, long-term interest rates have been driven down. People are looking at a safe haven from the imperiled euro and have bought long-term US Treasury securities. This has had the impact of lowering long-term mortgage rates:

(Click charts to expand)

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Source

The knock-on effect of this is that most of this group is less profitable, and since most of their profits are distributed as dividends, the dividend has been shrinking:

Price Div/Share Div Growth
AGNC $28.37 $1.40 0%
ARR $7.17 $0.36 -8%
CIM $2.64 $0.11 -35%
CYS $13.28 $0.50 -17%
IVR $14.11 $0.65 -12%
NLY $16.06 $0.57 -11%
TWO $9.23 $0.40 0%
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This has had a further knock-on effect of making the nominal price of these funds either flat or negative. Chimera and Invesco are the two problem children in this group, most of the rest have been flat or moderately negative since July when all of the problems started in Europe:

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So, what's the plan going forward? I have a couple of ideas:

First of all, we are quite interested in "dividend efficiency." I've gone back through the quarterly reports and found the top line, revenue, from the income statement, and the dividend payable from the balance sheet for the most recent quarterly 10Q available and have the following:

Revs (NYSE:MM) Div Payout Efficiency
AGNC $ 326.8 $ 257,068,000 79%
ARR $ 39.7 $ 30,512,880 77%
CIM $ 177.6 $ 113,443,000 64%
CYS $ 64.6 $ 45,509,000 70%
IVR $ 131.3 $ 92,304,000 70%
NLY $ 926.6 $ 581,752,000 63%
TWO $ 65.9 $ 56,240,000 85%
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What this tells us is which of these companies does the best job of doing what we like, which is taking in money and giving it to us investors. Some are obviously doing a better job than others. There are overhead charges and other activities that are part of this business that show up in this number.

Secondly, we like revenue growth. The reason for this is, in a world where mortgage rates are going down, mortgage holders refinance to get a lower rate, and new mortgages are issued at lower rates, the companies that have revenue growth are more likely to take in enough new money to preserve that nice high dividend. Of course, we have to adjust it by the number of shares outstanding.

Shares MM YOY Rev Growth MRQ Revs MM Growth $/Share
AGNC 183.6 576% $326.8 1.471
ARR 84.758 1085% $39.7 0.425
CIM 1027 9% $177.6 0.016
CYS 59.551 296% $64.6 0.718
IVR 115.38 244% $131.3 0.672
NLY 970.1 33% $926.6 0.318
TWO 140.6 574% $65.9 0.387
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A caution here: Since a couple of these companies are greatly bigger than others, it's a lot different project for some of them to grow, so in a way, "small is good" in this business, we like companies that are on the steep part of their growth curve, except to say maybe "small is not good", as you will see in a minute.

Ideally, we would like some combination: Dividend efficiency and revenue growth and it is easy enough to plot the two together as follows:

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In this chart, the upper right is good, and the lower left is not so good, except to say that you know the two biggest companies are not going to do very well on growth, and the smaller ones probably cannot sustain growth at that rate.

A popular strategy among these companies is to try to grow by issuing additional shares. Example: Two Harbors has just today announced an additional public offering of 34 million shares, increasing the shares outstanding by something like 25% but knowing like we do that the company can take this money and turn it around in the marketplace at 85% efficiency, and if the company is able to issue that many mortgages it could send most of that to the bottom line, which at 4% is roughly an additional $12M to the bottom line. Whether that is enough to offset any decrease in TWO's current business because of refinancing of part of the company's existing portfolio is obviously the big question of the day, but at least the management is optimistic.

The management of ARR, which happens to be in the same part of the graph, is also optimistic, they announced a share issuance yesterday, with the same thought in mind. Here is a summary of share issuances over the last two years:

Company Announcement
AGNC Additional 37 million shares on October 26, 2011
ARR Additional 9 million shares on January 10, 2012
CIM Additional 85 million shares, April 1, 2010
CIM Additional 125 million shares on November 13, 2010
CYS Additional 11 million shares on February 9, 2011
IVR Additional 8.7 million shares on December 15, 2010
IVR Share Buyback 7 million shares on December 13, 2011
NLY Additional 11.2 million shares on January 3, 2011
TWO Additional 37 million shares on January 11, 2012
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Before you jump to the conclusion that optimism is good, I would also point out that it is clear what happened to Chimera. The company issued additional shares early in 2010, and again in November. Some additional digging in CIM's press releases says that the company went from $100M in revenues in the fourth quarter of 2009 to about $400M in mid-2010, quadrupling the size of the company in 18 months, issuing shares to raise some more money, but then could not sustain the growth, earnings and growth have been roughly flat since that time. Moral: Growth is finite. Maybe the Invesco alternate strategy of reducing the number of shares and decreasing the float makes some sense. Conservative.

As my followers know, I own five out of the seven of these funds in a little RMBS portfolio, and I am always questioning what adjustments to make so as to make more money and therefore sleep better. I have a year's worth of dividends available in my account and would love to deploy it in some productive way, rather than let it ferment at zero interest, and I am also still questioning my investment in Chimera, and also in Invesco which has been beaten down in the last six months as well.

I can see a couple of alternate strategies: You could go long on the optimists, ARR and TWO and maybe AGNC falls into that group as well, and hope that they can continue to pump themselves up, or at least remain stable in the environment of declining mortgage rates. You could go for security, and stay with the giants, companies that are already on the flat part of their growth curve, we are talking NLY and CIM here, and sit back and collect your stream of nice dividends and not worry about the price. Invesco falls into this group as well, the company is taking care of their shareholders by the buyback strategy. The market has already punished two of these three companies for their lack of growth, and served to make their dividend yield higher, which is not heartbreaking for some of us. Keep in mind that without growing the top line, the bottom line and dividends of these companies will shrink if, and it is a big if, long term interest rates continue to fall as Europeans look for safe places to store wealth. That is the danger in the conservative strategy.

CYS is sort of mid-herd, and it is hard to see which way the management is going, their last share issuance was a year ago, and there is a bit of a warning signal there. The company had good growth last year but it is relatively small, The more bold of us might wish to short them because the market has not punished the stock yet, but an announcement of a share issuance would put the company into the upper group. CYS's current dividend yield is the worst in this little portfolio as well. Some waiting is in order here.

Prediction: As the growth rate of this portfolio levels out, there will be a consolidation stage. Watch for the big ones to start to buy the little ones. It is probably a little too early to play that game but it is on the horizon.

Keep in mind the idea that long-term mortgage rates are already at a multi-decade bottom, the supply of limitless free money will be available at least through November, and there is still euro-peril to deal with. The landscape a year from now could be completely different.

The world is chaotic, and there are no guarantees on anything, However, both relatively conservative and aggressive investors can find a strategy that they like in this group, and at the moment, the double digit dividends can make up for being a little conflicted.

Disclosure:

I'm putting in a limit order to buy ARR on a pullback. It is still small enough to grow, they're on the high end of the efficiency scale, and you have to like optimism.