The mortgage REIT market frequently has periods that should make investors question efficient markets. There are periods where things appear efficient, but there are also some incredible failures and the duration of those failures can be as short as a couple of hours or as long as a few quarters, perhaps even a few years. In our experience, something between the extremes is far more common.
One of the problems the mortgage REIT sector faces is the presence of investors trading on dividend yield with no idea what levels of dividends are sustainable or not sustainable. If those investors create a large enough group to move the market, they could influence a mortgage REIT to trade at an unreasonably high or low price compared to peers.
Remember that prices are still determined by supply and demand, so it is entirely possible for share prices to deviate from the comparable value in other similar companies. To be more precise, it is not only possible, but it is also common and uncovering those discrepancies is a major part of our work.
We invest in the mortgage REIT sector frequently.
When we invest in mortgage REITs, we want to be able to actively manage the position. While preferred shares and equity REITs can be very suitable for buy-and-hold investors, we see a huge advantage to an active approach in mortgage REITs.
We cover our positions in our Monthly Portfolio Update:
We also provide buy alerts when we see an opportunity developing:
Since we want to manage this exposure actively, updating the outlooks in real-time is important.
Two Double-Digit Dividend Yielding Mortgage REITs
We want to highlight that mortgage REITs very rarely raise dividends. They aren’t built for growth. They are built to deliver an exceptionally high yield.
Why are we picking those two? Both recently saw their share price dip by far more than the projected change in their book value. These are mortgage REITs, so over the long-term their share price is heavily influenced by book values. We spend a good chunk of time creating estimates for book value.
Stock Analysis Tools
One of the quick tools we like to incorporate when evaluating the recent performance is the $100k Chart:
When investors chart returns on a stock, they are generally picking a starting date and an ending date. This is how all investors learn to read charts. However, it is only one technique. We want to discuss another technique. Being able to read another kind of chart is precisely like learning to use another tool. Too many investors only learn one tool.
When investors become too focused on one approach, they may miss alternatives:
The Law of the Instrument
The law of the instrument is the official name for the problem. When investors have only one tool at their disposal, it can shape the way they look at problems:
Investors who are only familiar with approaching a problem from one angle will put themselves at a disadvantage.
The Concept of Charts
It may seem like a silly section, but this is another important concept. Some investors will argue that the price change is completely irrelevant (only evaluating income). We aren’t saying that investors need to monitor the share price constantly, but it is a major factor in total returns. A stock with an unsustainable dividend often sees the share price begin falling well before the dividend is actually cut. On the other hand, consistent dividend growers will often see their share price continue to rise.
When we are reviewing our prior choices, we like to measure the relative performance of similar stocks. Even if investors don’t consider themselves “traders”, they need to consider the importance of the change in value over long time periods.
If investors are interested in trading, then the change in price becomes even more important.
The Most Common Chart
Investors who are checking the price history of a stock will often use a chart like this:
This kind of chart can be quite useful if you want to check how the investment has performed since 1/1/2013. If you want to evaluate a different entry date, you’ll need to draw a new chart. That can be a pain when you want to get a quick comparison for evaluating whether a technique was working. For instance, which days would’ve been better for buying Annaly Capital Management (NLY) rather than MFA Financial (MFA)?
An investor using this charting strategy would be left plugging in several different dates to check. The weakness of this chart is that it overemphasizes the starting period. Are you really interested in 1/1/2013, or are you really interested in today? Because the lines have moved so far apart in the early years, the difference in recent performance is much harder to recognize.
Our Alternative Chart
We developed an alternative system that emphasizes today, rather than emphasizing the start point. The chart below uses the same 4 shares, but the values converge on the right instead of the left. We’re asking how much needed to be invested in any of those shares on any given day to reach $100,000 today. If we invested $100,000 today, that would clearly be worth $100,000. Consequently, we know how many shares we would need to own for the investment to be worth $100,000. We simply need to chart the value of those shares over time and adjust for any dividend payments.
We’re going to start with the simplest concept:
Which dates could an investor have purchased shares to earn a positive return, assuming they still own the shares?
See the sample chart below, which runs through early 2019:
Unlike most charts, a single glance is giving you the history for performance based on any entry date for over 6 years.
Falling Price to Book Ratios
While CHMI and ARR dramatically underperformed NLY and AGNC over the last year, the impact wasn’t built on fundamentals. Investors who are familiar with the way book value influences mortgage REIT prices might think CHMI and ARR had been thoroughly destroyed while AGNC and NLY were hardly scratched. That isn’t the case.
Instead, we witnessed a dramatic decrease in the price-to-book ratios for ARR and CHMI during that time. We warned investors that there was a dramatic risk for price-to-book ratios to fall. We couldn’t have been more explicit, or more timely. We’ve expanded the $100k chart to include highlights from two of our public articles, both shown with their original publication timestamps for 11/26/2018:
Since we published those pieces, there was massive decline in price-to-book ratios. That doesn’t mean book value was steady, but the enormous damage to the share price came from the change in price-to-book ratios.
Now we see both mortgage REITs trading at lower than normal ratios.
Don’t Blame it All on the Curve
The spread between the 10-year Treasury rate and the 2-year Treasury rate is very low. Some investors will argue that the mortgage REITs need to trade at low values because of that thin spread. We would prefer a steeper yield curve, but that argument comes off pretty weak when you consider the 10-2 spread from 11/26/2018:
As a reminder, 11/26/2018 is when we were warning investors away from these mortgage REITs.
We’re bullish on both ARR and CHMI due to the share price declining far too much relative to the change in book values. We expect to see a recovery in the share price. As we always do with mortgage REITs, we’re treating these positions as trading positions. We have no emotional attachment to the shares. We simply like to purchase them before the price rises. On the other hand, if the book value plummets again, we could close out our positions without the gain. We monitor the book values on a frequent basis, rather than just when earnings are released. By using projections for the changes in book value, we’re able to stay ahead of many other investors. That’s one of the keys to finding trading opportunities in the mortgage REITs.
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Disclosure: I am/we are long ARR, CHMI, NLY-F, AGNCN. 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: Positions in NLY-F and AGNCN refer to preferred shares from NLY and AGNC. We remain comfortable with those positions as they carry significantly less downside risk.