If a dividend yield above 11% isn’t enough for you, mortgage real estate investment trusts, mREITs, Annaly Capital Management (NLY 3.26%), American Capital Agency (AGNC 1.72%), and Armour Residential REIT (ARR 1.58%) are all trading at significant discounts to their book value.
Annaly and American Capital Agency’s price-to-book value of 0.8 mean that these companies’ net assets (assets minus its liabilities) are trading at $0.80 on the dollar. Armour is even more dramatic at $0.60 on the dollar.
Since mREITs are essential portfolios of bonds – more specifically, residential mortgage-backed securities – gaging the value of their net assets, or book value, is particularly useful. However, whether this makes them cheap or pricey is more of an opinion than fact. So, if you are suspicious as to why these stocks are trading at such a discounts, you have a right to be.
Cheap for a reason
The market is always looking forward, so that fact Annaly, Armour, and American Capital Agency are trading below their book value suggests investors expect the companies to underperform. While there several reasons why this is could be the case, one of the most apparent is tighter spreads.
mREITs borrow based on short-term interest rates and buy longer-term assets, earning the difference, or spread, between the two. This will often follow the spread between 10 and two year treasury bonds. As you can see in the chart above, when spreads are tight, like they were in 2006, Annaly’s earnings suffer and their dividend plummets. Conversely, when spreads widen out, like in 2010, Annaly’s earnings and dividend are much stronger. The same can be said for the for other two companies.
Over the past year, spreads have tightened. If this were to continue, we could expect weaker earnings and potential dividend cuts, which ultimately makes the companies less valuable.
Why they are still a good buy
While these company are cheap for a reason, that does not mean it is a good reason.
If you take a second look at the chart above, you’ll notice that spreads have widened and narrowed over time. In fact, if we were to go back even further that remains the case. Looking forward, this should continue to happen because bond prices, by their nature, rise and fall over time. The difficulty, however, is predicting when that will occur.
American Capital Agency’s chief investment officer, Gary Kain, summed it up nicely in the company’s fourth quarter 2014 earnings release:
"At the beginning of 2014, the consensus view was that interest rates would increase and agency [mortgage-backed security] spreads would widen… As it turned out, the consensus view was wrong as interest rates fell materially throughout the year and agency MBS performed extremely well."
See, even experts can get it horribly wrong. That is why the best recipe for success is to understand that while each company’s performance will fluctuate with spreads over time, a well-managed company will provide more upside than downside over the long-term. Moreover, if you can pick these companies up during a time when the market is more pessimistic, that can only help your cause.
Who is the best?
Return on equity (ROE) is one of the best ways to judge how efficiently management creates earnings. By looking at this measure over time we can get a feel for which company has best managed differing environments.
However, instead of using the traditional measures (net income divided by shareholders’ equity) I’ll be replacing net income with comprehensive income. This is because, as investment companies, much of their earnings can come in unrealized gains or losses which is not included in net income.
A quick look at the chart and it is clear why Amour is trading at the most dramatic discount to book value. The company has underperformed Annaly in five of the last six years, and all six compared to American Capital Agency.
For me, I want a company that is not only trading at a discount, but has a management team with a proven track record of generating results. Annaly and American Capital Agency best fit the bill. So, although the road ahead looks bumpy, I believe over the long term they will perform well, and are two of the best high-yield investments you can buy today.
