High-Dividend Capstead Mortgage Corp.'s Strategy May Be Perfect For Current Market Conditions

Jul.17.12 | About: Capstead Mortgage (CMO)

In the simplest terms Capstead Mortgage Corp. (NYSE:CMO) is a mortgage REIT with a good dividend that buys only agency secured mortgage securities. These are considered low risk. The thing that differentiates CMO is that it buys exclusively securities based on ARM loans. These ARM securities reset to more current interest rates within a relatively short amount of time. This allows for the recovery of financing spreads that narrow during periods of rising interest rates; and it means smaller fluctuations in the portfolio values from changes in interest rates compared with fixed rate securities. It also means that there should be no great increase in the prepayment rate if mortgage rates go down. For instance, if the Fed starts buying mortgage securities again as part of QE3, mortgage rates might well go down. For many fixed rate loan holders, this would mean that they would refinance (or increase the constant prepayment rate). For Capstead Mortgage such an eventuality would have only a very small negative effect on its constant prepayment rate. The loan holders would know that their ARMs would reset in time to lower rates without them taking any action. Some might feel inclined to switch to fixed rate loans, but the overall effect would be much less than if all of the loans were fixed rate loans.

As of March 31, 2012, Capstead Mortgage had a total investment portfolio of $13.01B based on $1.50B of long-term investment capital levered 8.05 times. It has a five-year CAGR of 20.9%. The securities are financed primarily with 30-90 day repurchase agreements augmented with two-year interest rate swap agreements for hedging purposes. In Q1 the repo rates ended the quarter at 0.33% (0.49% after factoring in hedging expenses). CMO keeps a variety of securities based on ARMs that reset at least annually, or begin resetting after an initial fixed rate period of five years or less. The chart shows the approximate distribution of the loans making up the RMBS.

The chart clearly shows that most of the loans making up the RMBS portfolio are short-term reset loans. These should be less susceptible to increases in prepayments if the Fed starts a QE3 program of MBS buying.

The repo borrowing is partially hedged with interest rate swaps. The chart below shows the approximate distribution.

As you can see from the chart. Most borrowings are unhedged. This is probably strategically sensible in the current market place. The IMF just lowered the world GDP estimate for FY2012 to 3.5% from 3.6% and the FY2013 estimate to +3.9% from +4.1%. Goldman Sachs lowered its U.S. Q2 GDP growth rate to +1.3% from +1.4%. In this kind of environment it does not seem likely that interest rates will rise rapidly anytime soon.

A quick look at the total financing spreads for each quarter show that there is some fluctuation, but CMO looks solidly profitable. The rates from Q2 2011 through Q1 2012 were in order: 1.70%, 1.47%, 1.46%, and 1.52%. These seem relatively stable over the past four quarters. CMO has also increased its book value significantly in the last year. It was $12.15 per share at the end of Q1 2011. It rose to $13.04 at the end of Q1 2012. This is a $0.89 increase or approximately a +7.33% increase. This increase in book value usually translates into approximately the same percentage increase in stock price over time. If you add this to the current dividend yield (11.77%), you get a total return of approximately 19.10%. This is less than the five-year average CAGR of 20.9%. The EPS gain essentially replicates the book value gain. The EPS at the end of Q1 2011 was $0.41 per diluted common share. It was $0.44 per diluted common share at the end of Q1 2012. The $0.03 per diluted share gain represents roughly the same gain (+7.32%) as the book value gain. This tends to confirm the 19.10% total gain figure for CMO in the last year.

In sum CMO is providing a good stable return to investors in a troubled time. I admire its strategy, especially considering the possibility of more QE. It should provide a good return.

The two-year chart of CMO provides some technical direction to this trade.

(click to enlarge)Click to enlarge

The slow stochastic sub chart shows that CMO is neither overbought not oversold. The main chart shows approximately the same thing. It also shows that CMO has been in an uptrend since October 2011. This trend seems to be weakening, but it has not rolled over, even in a troubled market. This is a good sign. CMO trades at a PE of 7.80 and an FPE of 8.02. It has an average analysts' recommendation of 2.2 (a buy). It has a relatively small market cap of $1.3B, but it still manages a highly stable Beta of 0.37. This is a stock to like in the current environment. Even among REITs it looks great. Its agency ARM RMBS strategy seems less risky in many ways compared with other REIT strategies. The strategy should mean that CMO will provide great returns over time. Averaging in is a good strategy, especially in this troubled economic time.

If you are interested in other good REITs, a few of the ones I like are American Capital Agency Corp. (NASDAQ:AGNC), Two Harbors Investment Corp. (NYSE:TWO), and American Capital Mortgage Investment Corp (NASDAQ:MTGE).

NOTE: Some of the data above comes from Yahoo Finance.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CMO over the next 72 hours.