Mortgage REITs Should Be Analyzed Over Time

Includes: AGNC, CMO, CYS, HTS, NLY
by: John Gerard Lewis

The three-month stock market rally in Q3 left mortgage real estate investment trusts behind, with much wailing that the chickens had come home to roost. "Those outlandish double-digit yields were artificial, just as we knew all along!" scornful critics railed. "We knew they couldn't forever survive QE-whatever."

And thus did all these "I-Told-You-Sos," together with the sector's recent dividend cuts and foreboding prospect of QE3, bring the high-flying mREITs tumbling down, even as giddy talk of possible new stock market highs was all over the financial TV channels.

Then came Oct. 19, during which stocks were off nearly 2% intraday, below their closing price of Sept. 6, six weeks ago. Mortgage REITs, on the other hand, performed much better than that, with American Capital Agency (NASDAQ:AGNC) managing to pick up a gain of 0.09% on the day.

Now, this is not meant to be any kind of point-for-point vindication of the performance of mREITs over the past several months, because the intrinsic investment theses of stocks and mREITs are simply not the same, in my view. Mortgage REITs should not be expected to linearly follow the stock market. In first place, mREITs are not comprised of equity investments. Instead, they are effectively leveraged bond funds.

For investment purposes, I view mREITs collectively as a desirable component of a portfolio that can, if properly constructed, produce returns that approximate the average annual historical return of stocks during protracted periods of middling stock market performance. And despite the rally of the past few months, I think that's what's in store over the next several years.

(And in any case, mREITs, like any given investment category, should comprise only a small portion of any investor's diversified portfolio.)

Such a "properly constructed" portfolio is what I have endeavored to design and manage with our firm's Stable High Yield model. "Stabilized" by a significant short-term bond component, it is intended to provide historical equity-like total returns during desultory, or even downright terrible, stock market periods. It is designed to do this by reaping the high yields of mREITs, of course, but only with ample consideration of their expected price activity over time.

One might here note that the price movement of mREITs over the past few weeks has been lousy, with most of them falling more than 10%. Quite true. But investors, as opposed to speculators or traders, should have little truck with short-term price movements. This is especially so in the case of mREITs.

Here's why: The return on any securities investment is composed of both yield and price appreciation. We know that the yields on mREITs are high, even after the recent dividend cuts. But just as important is their normal price movement, and the price action of mREITs, as a group, is remarkably stable. For example, the beta coefficient of American Capital Agency is 0.18, meaning that it is 82% less volatile than the market. For CYS Investments (NYSE:CYS) the beta is 0.05 and for Annaly Capital Management (NYSE:NLY) it is 0.11.

Any highly liquid, tradable security is going to have a typical level of price movement. It is easy to forget that most mREITs also declined in the third quarter of 2011 by double-digit margins, and yet today their betas show that they are very stable investments over time.

And "over time" is the proper time horizon. In spite of the recent stock rally, mREITs have generally outperformed the stock market over the past 12 months. For example, the total return of AGNC is 37.28% vs. 21.62% for the S&P 500 Index - and that was before Friday's market session during which mREITs fared much better than the market as a whole. The total return for CYS is 25.25%, for Capstead Mortgage (NYSE:CMO) it's 23%, and for Hatteras Capital (NYSE:HTS) it's 23.28%.

(NLY, on the other hand, despite its reputation as a bellwether for the group, has been a laggard for quite some time with a total return of 13.97% over the past year. But NLY is an outlier in this regard, and as such it's a great example of why professional management is advisable when it comes to mREITs.)

Over time, I anticipate that mREIT prices will correspond to their low beta coefficients and, due to their still-high dividend yields (AGNC 15.4%, CYS 13.6%, CMO 11.5%, HTS 12.1%, NLY 12.5%, for example) remain attractive investments.

Disclosure: I am long AGNC, CYS, CMO, HTS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Gerard Wealth Management, Inc. owns shares of all securities mentioned. All performance data is as of Oct. 19, 2012.