Thoughts On A Handful Of mREITs And The State Of The Industry (Week 25, Part 2)

|
Includes: AGNC, AI, AMTG, ANH, ARR, BXMT, CHMI, CIM, CMO, CYS, DX, EARN, JMI, MFA, MORT, MTGE, NLY, NRZ, NYMT, ORC, REM, STWD, TWO, WMC, ZFC
by: ColoradoWealthManagementFund

Summary

The focus for this piece: How does an mREIT analyst establish price targets?

Price targets should be set with a fairly limited duration due to the potential for changes in the fundamentals.

Lower rates are creating a real problem for mREITs that may drag down earnings for a long time.

Price movements can also be predicted to some degree by predicting dividend cuts or future headlines.

I’m including some prices where I would be neutral, bullish, or very bullish on NLY, ORC, and CYS.

This is the second part of my thoughts for Week 25. Since the first piece was fairly long and there was another topic to cover, I decided to run a separate piece that emphasizes price targets. Since there are several analysts that cover the sector and many don't provide their work publicly, I won't be able to speak for all analysts. I'll simply explain how I set price targets and argue for why it should be done this way. From there, I will demonstrate the major headwinds I'm seeing for the sector.

The mREITs (and two ETFs)

The table is demonstrated below:

(NYSE:NLY)

Annaly Capital Management

(NASDAQ:AGNC)

American Capital Agency Corp.

(NYSE:ARR)

ARMOUR Residential REIT

(NYSE:CMO)

Capstead Mortgage Corporation

(NYSE:CYS)

CYS Investments

(NYSE:DX)

Dynex Capital

(NYSE:JMI)

Javelin Mortgage Investment

(NASDAQ:NYMT)

New York Mortgage Trust

(NYSE:ORC)

Orchid Island Capital

(NYSE:TWO)

Two Harbors Investment Corp.

(NYSE:WMC)

Western Asset Mortgage Capital Corp.

(NYSE:MFA)

MFA Financial

(NYSE:EARN)

Ellington Residential Mortgage REIT

(NYSE:AI)

Arlington Asset Investment Corporation

(NYSE:ZFC)

ZAIS Financial

(NYSE:AMTG)

Apollo Residential Mortgage

(NYSE:ANH)

Anworth Mortgage Asset Corporation

(NASDAQ:MTGE)

American Capital Mortgage Investment

(NYSE:CHMI)

Cherry Hill Mortgage Investment

(NYSE:STWD)

Starwood Property Trust

(NYSE:BXMT)

Blackstone Mortgage Trust

(NYSE:CIM)

Chimera Investment Corporation

(NYSE:NRZ)

New Residential Investment Corp.

(NYSEARCA:REM)

iShares Mortgage Real Estate Capped ETF

(NYSEARCA:MORT)

Market Vectors Mortgage REIT Income ETF

Click to enlarge

Setting Price Targets

One of the major challenges in setting price targets is assessing both the path of the person and the dog. Sometimes I can deal with that challenge by using relative price targets such as the amount by which I expect one mREIT to outperform another on share price + dividend in the future. Those kinds of predictions have usually played out for me in the span of a few days to a few weeks.

The other kind of price target is one set in isolation. Such as an analyst that places a target such as $10 on Annaly Capital Management. For many investors, this kind of price target helps a great deal because it conveys the expectations in absolute terms. However, these kinds of targets should be very regularly updated and investors should be wary about old price targets.

To set price targets in absolute terms, there are a few factors that must be considered. The first factor is the fundamentals. For an mREIT that is primarily invested in agency RMBS, the important factor is the difference between the MBS yields that are currently available and the cost to hedge the duration risk using current hedge rates. One way we approximate these factors is with the shape of the yield curve, but the yield curve can occasionally become separated from swap rates and yields on different types of MBS. Ideally for investors, we would see both a steep yield curve and a significant difference in the yield available on agency RMBS relative to the rate on the LIBOR swaps that would be used to hedge such a position.

Problem From Lower Rates

The problem for mREITs from low interest rates is the low rates (and high prices) on agency RMBS. This scenario encourages prepayments and the mREITs are stuck reinvesting that capital at the new rates which generally means lower yields. Over time, this can drag down the yield on assets since new investments may have weaker yields than the old ones.

Lower Rate Examples

If an MBS can be acquired by paying precisely par value, and the coupon rate (interest income) is 3.0%, we can quite reasonably estimate that the yield to maturity on that position will be 3.0%. For simplicity sake, I'm ignoring any impacts of annual compounding. The simple math here is that the investor will receive 3.0% on his cash for as long as it is outstanding. If the MBS is prepaid, the yield does not change because there is no premium or discount to amortize. In what appears to be a lucky coincidence (I picked 3.0% intentionally), the price of the 30YR FNMA 3.0 was precisely 100% of par value on December 31st, 2015.

However, we can see that now (very early April) a bond with the same rate trades at 102.69% of par value.

The yield on the 30YR FNMA 3.0 when held to maturity will vary if it is purchased at more or less than par value. In the case of the bond being purchased at a premium to par value, we are guaranteed that the yield on the bond must be something less than 3%. I put together some excel models that would estimate the yield to maturity on MBS based on the price, stated duration, coupon rate, and prepayment rate. This won't be as strong as the models some analysts receive because it works on a single CPR (prepayment rate) that is held at a steady rate throughout the life of the loan.

If we assume a 12% annual prepayment rate, the yield on the 30YR FNMA 3.0 purchased at 102.69% of par value would be 2.56%. If we believed that 12% was the most logical estimate of future prepayments on this pool of MBS, then an mREIT receiving prepayments last week and buying this bond at 102.69% would see their asset yield on that position running 2.56%. Of course, a change in the estimate of the prepayment rate would change the yield on the bond.

Hedges

The rate on hedges in the form of LIBOR swaps has also declined materially, but those savings will only show up for mREITs that are starting new swaps. Frequently ending old swaps and starting new ones would be one technique that an mREIT could use to establish some attractive non-GAAP metrics. It is generally seen favorably when the mREIT will simply hold onto most of their hedges, but a strain on asset yields could reduce the "interest income" recorded from assets which would work its way down the income statement. When the mREIT reports Core EPS, the weaker interest income would drag down the value, and Core EPS below the level of the dividend is one sign that a reduction could be coming.

Other Factors

For an analyst to correctly guess price movements, it helps to have a firm grasp of the technical factors as well as the fundamentals. For instance, I believe the current rally in mREIT prices is heavily influenced by the rally across the domestic equity market. As the market is accepting the idea of lower rates for longer, there is a substantially higher willingness to take on significant risk. Prices are up on almost everything. I believe this been a huge factor influencing the prices on the typical agency mREIT.

There is also the potential for arguments that investors expect rates to continue falling and think the agency mREIT will give them leveraged exposure. That would generally be false since most mREITs intentionally hedge out a large portion of that exposure. It would also be dangerous since the potential for prepayments increasing creates a major problem for mREITs if rates fall too far.

The technical factors have never been my strongest area of research, but it is worth looking at them as one part of the analysis. I want to stress that analysis purely on technical factors is absurd. It can be useful as a supporting technique, but it should not be the focal point of research.

Examples of Useful Factors

When expecting a movement in share price, it is helpful to estimate the discount to book value for a given mREIT and compare that discount to peers. It also helps if investors can figure out the headlines for the next day. For example, I found a great opportunity in October when Orchid Island Capital was about to report their earnings. By using the publicly available information, I could estimate the earnings level they would report. Since they were reporting earnings under GAAP and the analyst estimates were based on Core EPS, it was easy to predict that the values would be dramatically different and that prices might diverge materially from the underlying value because some traders would attempt to trade immediately.

Another huge factor can be dividend cuts. I expect quite a few of them to be announced throughout 2016. Even though analysts should be able to uncover most of the relevant factors around the portfolio, the announcement of a dividend cut can lead to shares being punished. In my experience, there is also a significant risk for a second selling event on the ex-dividend date after the cut was announced. This can be a result of many investors holding on until shares are going ex-dividend and then leaving sell orders to exit their position. For the shrewd investor, this is a reasonable time to leave a "limit buy" order that is significantly out of the money. If the market is being rationale, the limit order won't execute and nothing happens. If the market has a temporary failure, the investor has an order ready to catch the shares. Of course, this kind of trade should still only be used after doing proper due diligence on the stock and estimating what prices would be low enough that the potential return substantially outweighs the risk.

A dividend cut may not sound like a technical factor. It is a very real reduction in the amount of cash that shareholders receive. The technical aspect here is the impact of the announcement. The problems facing the portfolio that would lead to the cut would not suddenly appear on the day of the cut.

How I Set Price Targets

I like to set price targets for the short term and make them relative to shares in other mREITs. Doing it this way allows investors to get a rough idea of how much of a price movement is based on a change in investor sentiment (bullish/bearish about the sector or economy) and how much is simply a function of share prices fluctuating.

I believe it is also important to look at how rationale the market is being. If the spread between asset yields and hedge rates is substantial, then the mREIT has excellent opportunities to invest new capital. Remember that prepayments result in a material amount of cash that needs to be reinvested, so the expected yield relative to hedging costs is very significant.

Reading My Price Targets

The price targets I set below are based on where I feel the risk adjusted return picture would be neutral or highly favorable. Don't take these price targets as being useful guidelines for shorting. I believe the most rationale investment approach is to try to avoid taking any "coin flip" opportunities. That can mean sitting on cash for a while, but the objective is to be prepared to buy when there is blood in the streets. Since a substantial portion of my readers are "buy and hold" investors, I believe this presentation is very useful for establishing where it would make sense to look for new positions.

Some Price Targets - NLY

My latest view on Annaly Capital Management indicates that I would be neutral at $9.50 to $9.60 and bullish under about $9.10.

Some Price Targets - ORC

Orchid Island Capital has quite a few differences between their portfolio of assets and hedges, but the book value on the two is very similar as of my last estimates. Since Orchid Island Capital has demonstrated a stronger tendency for price to deviate from book value, I would want to see even lower prices. This isn't because ORC is fundamentally any weaker as an investment; it simply relies on the goal of trying to catch shares at the lowest prices possible. Based on similar estimated book value, I would see ORC as a solid buy at $8.50 with neutral around $9 to $9.15. Last time it went under $8.50, I ended a "short" rating and bumped it up to neutral, but I should've tagged it with a buy. Occasionally, ORC has traded under $8, and at those prices, it would be an overwhelming buy. I don't expect to see it in the near future, but if I do, there will be an immediate buy order from my account.

Some Price Targets - CYS

I view CYS very favorably due to a positive perception of management for their exceptionally clear presentation of information and internal management structure. I also agreed with management about the most likely direction of future interest rates (which played out nicely after a fierce scare during Q4). The portfolio reflects the statements management made about the future directions of interest rates. Specifically, it is better designed to withstand low rates than many other portfolios. This was done through a combination of running lighter on hedges and using MBS that would trade at smaller premiums to par value. This structure can lead to significant book value movements if the predictions are wrong. I would be looking to buy CYS if shares were around $7.20 to $7.00. Of course, a significant change in the yield curve could change the book value or earnings outlook materially and result in some significant revisions there.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANY OF THE MREITS OR THEIR PREFERRED SHARES over 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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.