MTGE: The Fourth Best Investment I Could've Made

| About: MTGE Investment (MTGE)
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MTGE is a solid mortgage REIT. I grabbed some shares during Brexit and they have performed very well.

The company's portfolio was intelligently designed.

Agency RMBS and legacy non-agency RMBS were a solid combination to handle prepayment risks.

Favorable macroeconomic developments support pricing for non-agency RMBS.

MSRs were a perpetual disappointment, but they shouldn't be so bad this time.

MTGE Investment Corp. (NASDAQ:MTGE) is a solid mortgage REIT. It had a bit of a rough history, but I saw it as a great opportunity during Brexit and grabbed some shares. To help investors analyze my performance, I provide updates on my portfolio and show the returns I'm achieving on individual positions. The chart below shows the performance of MTGE Investment Corp. and most of the other mortgage REITs since June 24th, 2016 up until the close on October 12th, 2016.

Source: Original image. Historical pricing data and dividend payments were pulled using MarketXLS.

All investments are modeled on the basis of collecting dividends in cash rather than reinvesting them. Not too bad so far. The investment is up 17.15% compared to 11.96% for the sector average. It lost out to only 3 other mREITs. Those were ARMOUR Residential REIT (NYSE:ARR), Arlington Asset Investment Corporation (NYSE:AI), and Western Asset Mortgage Capital (NYSE:WMC).

Before investors suggest that a better investor would've bought ARMOUR Residential REIT instead, allow me to point out that I did. I bought ARR in June and earned an 18.7% return in about 2 months. Had I bought during Brexit, the returns would've been stronger. To limit my exposure to individual names, I went with MTGE instead.

Why I Expected MTGE to Perform

MTGE was extremely attractive because I felt their portfolio was positioned well and they were trading at a larger discount to book value than peers. Finding the difference in the discount to book value is a major factor in finding the right investments in mortgage REITs. However, it isn't just that.

Intelligent Portfolio

The portfolio for MTGE was primarily based on agency RMBS, specifically fixed-rate mortgages (as opposed to adjustable rates). There was also a large allocation to legacy non-agency RMBS. I liked those securities in the portfolio because if prepayment rates increased it meant MTGE could see some gains on the non-agency RMBS to offset losses on agency RMBS.

Most agency RMBS sell at a premium to face value. If the home owner refinances, it means an immediate loss for the mortgage REIT. Because they own an interest in an enormous volume of positions, this risk is diversified. The diversification makes it easier to estimate how much impact should be occurring from high or low refinancing levels.

Unlike the agency RMBS, the non-agency RMBS trade at a significant discount to face value. If those owners are able to reach positive equity in their house and refinance the loan, it means MTGE receives more than the fair value of the loan.

In their hedging techniques, they also used investments in MSRs, which are mortgage servicing rights. Within the last few quarters, they were able to sell the small company they acquired to service the loans and outsource the servicing duty to the company. Why is that useful? It should reduce their costs as the company was inefficient internally but is now part of a larger operation.

MTGE's quarterly results were usually disappointing because their inefficient servicing operation was combined with consistent mark to market losses on MSRs as prepayment expectations regularly increases. Now prepayment expectations are declining and servicing costs should be declining. The result is a mortgage REIT that should finally be delivering stronger performance on earnings and book value after most investors counted it out.

Current Stance

I'm still long in MTGE and expecting share prices to rise, but I'm not as fiercely positive as I was when I made the initial investment. The combination of taking in the last two dividends plus a significant appreciation in share price reduced the upside potential. Where does MTGE stand relative to the sector? They are still materially better than average as an investment because they still have a solid discount to book value and I'm expecting a strong performance when they report Q3 results.

Why I Expect Strong Results

Spreads between agency RMBS and LIBOR swaps declined significantly to produce mark to market gains for most mortgage REITs. Non-agency RMBS should be doing well with favorable macroeconomic data supporting lower foreclosure rates. The decline in expected prepayments should be favorable for the MSRs, which were a perpetual disappointment in prior periods.

Based on a last closing price of $16.80, I'm going with a buy rating.

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Disclosure: I am/we are long MTGE, ANH, ZFC, NLY-D, NLY-E, AGNCB, AGNCP, NYMTO.

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. Tipranks: Assign buy rating.