There are several mREITs that garner a lot of attention from commentators and investors, and there are a few mREITs that aren't considered worthy of much attention, or at least seem to go unnoticed. One of the companies in this latter group is MFA Financial (NYSE:MFA). What is unusual is that MFA has been operating since roughly 1997 and is by no means a small company ($3 billion market cap). Why does this company go unrecognized and - perhaps more importantly - is it a mistake to underestimate this company? An examination of data will hopefully answer these questions.
There are a number of criteria by which we could compare MFA to its competitors, but I think the most relevant ones for our purposes boil down to six: market cap, the debt/equity ratio, profit margin, dividend yield, share price and year-to-date total return. I propose to compare MFA to 12 of its competitors. Doing so in one chart or table would be confusing, so I propose to perform the comparison in three groups: those companies having comparable share price to MFA; those companies that are MFA's market-cap peers; and, finally, those companies that are larger than MFA (in terms of market cap). My intent here is to try to determine why MFA might be overlooked by some investors as well as to find some clues as to whether overlooking MFA is a mistake.
Among those companies that are similarly priced to MFA I have included: Anworth Mortgage Asset (NYSE:ANH), Armour Residential (NYSE:ARR), Chimera (NYSE:CIM), Newcastle Investment (NCT) and New York Mortgage (NASDAQ:NYMT). (An asterisk, *, indicates that the company in question includes long-term liability in its debt.)
click to enlarge images
The range of market caps in this range is somewhat broad, ranging from New York Mortgage's $240 million to MFA's $3 billion. There is also a wide range among the companies' debt/equity ratio, with MFA's coming in at 3.39. Of the six companies in this group, it is interesting to note that only Armour and MFA utilize only short-term debt for leverage; some long-term debt makes up Newcastle's and Chimera's debt used for leverage (4.87 and 0.59, respectively). Both Anworth and New York Mortgage have relied upon long-term debt to provide leverage, with Anworth's long-term debt/equity at .03 and New York Mortgage's at a sizable 35.67.
The use of long-term debt is noteworthy, as it carries a higher interest rate than short-term debt, the additional interest detracting from the company's overall profitability; indeed, New York Mortgage's reliance on substantial long-term debt may account for its low profit margin of 15.39%, which is significantly lower than that of the other 5 companies, which seem to cluster around 50%, and with MFA leading the pack at 62.27%.
There appears to be little correlation between debt/equity ratios and profit margins, on the one hand, and dividend yield, on the other: MFA, Anworth and Newcastle have yields under 11%, while Armour, Chimera and New York Mortgage all offering more than 13% yields. Nor is there any clear link between the data provided and the year-to-date total return: most of the companies in this group are clustered in the 13% to 20% range, with MFA showing a good 34.74% and Newcastle leading the group with an impressive 78.84% showing.
The second group of companies all have similar market caps similar to MFA, and consists of the following: CYS Investments (NYSE:CYS), Hatteras Financial (NYSE:HTS), Invesco Mortgage Capital (NYSE:IVR) and Two Harbors Investment (NYSE:TWO). The comparisons are in the following table:
These companies have, for the most part, the same data profiles: their market caps are closely bunched and their debt/equity ratios are roughly similar, with MFA having the lowest ratio, at 3.39. The companies have similar profit margins, with MFA coming in in the middle of the pack with a margin of 62.27. Noteworthy here is CYS, which produced a profit margin of 118.20% (!). However, while CYS led in profit margin, it trailed the group in terms of total return with a 16.85% showing. Invesco had the most impressive return of the group with 53.50%; MFA is in the middle with its 34.74%. In terms of dividend yield, MFA's 10.71 is lowest, with the rest of the group offer yields above 12%.
There are some sharp contrasts to be drawn here: MFA's debt/equity ratio of 3.39% is markedly lower than those of American Capital and Annaly, and it's profit margin of 62.27% is superior to American Capital's 49.43% - and dwarfs Annaly's meager 9.50% (which is the lowest among all 13 companies considered here). Still, MFA cannot match either company in dividend yield, where Annaly posts 12.78% and American Capital comes in with 14.35%. As for total returns (year-to-date), MFA is slightly edged by American Capital's 35.09%, with Annaly at a distant 16.86%.
At this point I would like to focus on the year-to-date total return figures for the companies; I would argue that it is the total return a company offers that ultimately shows what a company has done for its shareholders. Of course, the figures we are working with here are only for 2012, but for the sake of clarity, and to keep things as uncomplicated as possible, I feel the focus should be on the "here and now," rather than on what used to be. And, here and now, I think it noteworthy that only four companies have superior total returns (in terms of share price and dividends) to that of MFA's 34.74%: American Capital (at 35.09%) and Two Harbors (at 35.81%) have marginally greater total returns, while Invesco lays claim to a much higher return (at 53.50%), and Newcastle leads with a significantly higher 78.84%.
(To be sure, on a share-to-share basis the difference between the total returns of American Capital and MFA is substantial due to the significant difference between share prices; in that case, American Capital's 35.09% even outstrips Newcastle's 78.84%. However, on a dollar-to-dollar comparison, there is only nominal difference between American Capital's returns and those of either Two Harbors and MFA.)
Table 4 gives us the five companies with the largest total returns (year-to-date) so that we may compare them directly:
Of this group, American Capital has - by far - the highest market cap; it also has the highest debt-to-equity ratio and the highest price. Newcastle, while it has the largest total return, is the only company with long-term debt; it also has the lowest yield, the lowest price-per-share and the second-lowest profit margin. It would be interesting to determine the extent to which the costs incurred through its long-term indebtedness hold back Newcastle's potential.
I think it is easy to see why MFA might get overlooked by potential investors. When one gets to the initial chart for a stock, one is confronted with the very data that makes MFA so "forgettable": low price, low dividend, low yield - at least, as far as other mREITs are concerned. Why buy MFA when one can get a 14% yield from Armour Residential, which has a lower price per share? Or one may feel that a higher-priced, large-yield company like Two Harbors or American Capital has more going for it.
For our purposes here, we can note that MFA has the lowest debt-to-equity ratio and the highest profit margin of the five companies represented in table 4. It is somewhat interesting to note that, of all 13 companies we've considered, other than the four companies that exceed MFA's total return, no other company comes close to MFA in terms of year-to-date returns. And still, we are left looking at a company that only offers a projected dividend yield of 10.71%, or $.92 per year in dividends. This strikes me as being anomalous, and I examined MFA's most recent annual financial report (2011) on file with the SEC to see if there is any indication as to how one of the more solidly performing mREITs doing business manages to pay one of the lowest yields of its brethren.
As of December 31, 2011, MFA's total assets were divided as follows: 70% Agency mortgage-backed securities (Agency MBS); 34% non-Agency MBS; 6% cash and other assets. Those mREITs that purchase both Agency MBS and non-Agency MBS are frequently referred-to as hybrid mREITs; Agency MBS are secured by an agency such as Freddie-Mac, Fannie-Mae or Ginnie-Mae, while non-Agency MBS are not secured. The advantage to Agency MBS over non-Agency MBS is that the company is at less risk of losing the mortgage principle due to default, etc., although interest income (and profits) could be lost.
MFA also has operating policies that require that no less than 50% of their portfolio consist of adjustable-rate mortgages (ARMs), 15-year fixed-rate mortgages, and "Hybrid" mortgages - mortgages that have an initial fixed-rate period and thereafter subject to adjustment according to the index rates set by the London Interbank Offered Rate (LIBOR) or the one-year constant maturity treasury ((NYSEMKT:CMT)) rate. Mortgages having adjustable interest rates are typically equipped with caps on interest rate adjustments. Non-Agency MBS are typically purchased at a discount to face or par value; at present, MFA purchases these non-Agency MBS with a greater-than-25% discount.
The reasons behind the particular strategy employed by MFA involve limiting the risk of the company to loss by prepayment or, in the case of non-Agency MBS, default or foreclosure. In the case of non-Agency MBS, a portion of the purchase discount is set aside as a Credit Reserve used to offset any potential losses; the remainder of the discount is accreted gradually to the income to be paid out in dividends. By focusing on ARMs, MFA is able to reduce the risk of prepayment, since a mortgage the interest of which is automatically adjusted to conform to rates established by LIBOR or the CMT reduces the likelihood of refinancing that would involve a prepayment. Thus, by keeping its portfolio protected from a significant number of refinances, MFA is able to maintain the interest payments that constitute the bulk of its profits.
The reliance on mortgages with adjustable rates is a double edged sword. While the interest rate of such mortgages will change according to LIBOR, if those rates decrease (as they have in the wake of the recent recession), then the interest payments MFA relies upon for dividend payments are also decreased. So while MFA's portfolio may be protected from a surge in prepayments, it is also subject to vacillating interest rates; currently, those interest rates would be dropping. Here, I believe, is the main factor currently influencing MFA's dividend yield: as interest rates on its current holdings drop, so too does the pool of resources available for paying dividends.
There is the potential of an up-side to this, as, if long-term interest rates increase, there would be a resulting increase in the mortgage interest used to supply dividends. However, there are typically caps placed on just how much a mortgage's interest rate may be changed, either over a period of time or over the life of the mortgage. If there is an up-side, then, it is one that is limited in its potential to increase profits for the company.
The key to maintaining dividend-providing profits is to take steps to limit the interest paid on indebtedness incurred by way of acquiring leverage with which to increase the company's portfolio. To this end, MFA seeks opportunities to secure short-term loans with rates favorably attached to LIBOR and collateralized with properties already held in the portfolio.
The risks a company takes with regard to its indebtedness (particularly in the sort of strategy employed by MFA) is that short-term interest rates can increase. In the event that the increase in short-term interest rates outpaced the increase of long-term rates, the borrower could be confronted with either a flat yield curve (where interest paid out is equal to the interest being received) or an inverted yield curve (where the interest paid out is higher than the interest being received). In either case, there is the distinct risk that the pool of resources for paying dividends dries up, leaving the company with no resources with which to pay dividends.
Inasmuch as the majority of MFA's holdings are of the adjustable-rate sort, MFA could be more vulnerable to either of these deviations from the normal yield curve. This would seem to make it imperative that MFA seek to keep its debt-to-equity ratio low; indeed, it would be most beneficial to take steps to decrease or eliminate the company's debt altogether by increasing the company's capitalization. Perhaps the more standard way of accomplishing this is to periodically offer secondary releases of stock. The risk here, however, is the dilution of the pool of resources available for paying dividends.
It must be pointed out, however, that the Fed has repeatedly asserted that it will maintain a zero-interest-rate policy (ZIRP) until after 2014. This would seem to give companies like MFA ample opportunity to prepare themselves before short-term rates start climbing.
The fact that MFA's management has been able to maintain a high profit margin, and has been able to provide significant return to its shareholders despite its relatively small dividend yield indicates that MFA is a reliable investment. It's steady growth overall in the past year is indicative of the solid foundation on which MFA is built, and seems to offer a solid opportunity for significant growth over the next few years.
NOTE: I do not intend to convince anyone to invest in MFA or any other company mentioned in this article. Any investment the reader plans to make should be the result of their own examination of the investment's strengths and weaknesses. The contents of this article are meant only as information to help educate investors.
Disclosure: I am long AGNC, ARR, MFA, TWO. 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.
Disclaimer: All research has been done using FINVIZ.com except where relevant data were not available or seemed incorrect. In those cases, I relied on Yahoo! and Motley Fool for additional resources.