If You Have the Intestinal Fortitude

 | Jul 08, 2013 | 2:00 PM EDT  | Comments
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Baron Rothschild is thought to have once said, "Buy when there is blood in the streets, even if the blood is your own." Folks will often cite the first part of the quote, though they'll often omit the arguably more important second half of that sentiment. The investment takeaway: Assuming the fundamental picture has not changed, a position that's moving against you should be increased, not liquidated.

I've written in prior columns about the mortgage real estate investment trust (mREIT) sector, and especially Armour Residential REIT (ARR) (see here, here and here, for example). Friday's trading highlighted the market's perception of mREIT fundamentals: Interest rates rise and mortgage-backed security prices fall (see chart), so mREITs must suffer, thus the stocks are sold. Before you can consider buying an mREIT stock, then, you must go against the conventional wisdom -- and that's exactly what we're suggesting, so please first make sure you're into that kind of call.

At Portfolio Guru, LLC, we are income investors at heart. So, even though lower MBS prices mean lower portfolio values for the mREITs, we can overlook such a short-term decline in book value if market conditions support increasing dividend payouts. Cash flow is key for us, and as painful as it must have been to own a multi-billion-dollar portfolio of mortgage-backed securities Friday, the recent spike in interest rates has halted the wave of mortgage refinancing (see chart). We think moreover, that the refi rate will decline further in the coming months. The refi boom, in the form of rapid prepayment speeds for MBS, has been the key factor hurting mREIT profitability -- and dividend payouts -- over the last 18 months.

So an mREIT's book value can take a hit even as its earnings power actually improves. Armour's largest expense is prepayment amortization, and if interest rates hover at current levels, that expense is going to evaporate -- which will boost earnings. Also, lower MBS prices imply higher net yields, and Armour's book-value erosion over the past nine months was caused by both higher prepayment speeds and the investing of new capital at significant premiums to face ($1.05 to $1.06 cents on the dollar).

For 30-year Fannie Mae 3.5% MBS, prices were quoted Friday at $0.99 on the dollar. So any new capital deployed by Armour -- which would come from prepayments and maturities, as the firm won't be raising capital with the stock at these prices -- is locked in at much higher rates. This is a tailwind for net interest margin, and the dividend.

I don't live in an ivory tower, and Armour's decline in book value per share must be monitored, even if that is not our controlling figure. The firm has a small, but meaningful, chunk of its portfolio -- $1.7 billion, or 7.2% of the total value at the end of May -- in adjustable-rate and hybrid mortgages. Obviously these securities perform well in a rising-interest-rate environment. By my calculations, Armour's book value of equity per share (BVPS) was just under $6 per share at the end of June, and stood at $5.65 to $5.75 Friday. With the stock trading around $4.30 in recent trading Monday, it's clear the market is applying a heavy discount despite the increased prospective earnings power.

So consider whether you have the following:

  1. a long investment horizon -- meaning years, not quarters or months;
  2. the intestinal fortitude to withstand 9% one-day declines like Friday's;
  3. and a desire to earn a yield of 20% (19.9% at Friday's closing price of $4.23 at the current monthly dividend rate of $0.07).

If so, then it's time to buy Armour and lock in a safe yield. Put another way, if this firm's yield is safe, so are its earnings, as it must pay out more than 90% of earnings in order to maintain REIT status.

A more-than-20% yield implies a forward price-to-earnings ratio of about 5x. That is ridiculously cheap, and if you want an attractive entry point for huge monthly dividend income and the potential for long-term capital gains, you should be buying Armour at these levels. It's not a popular sentiment -- in fact, it's a completely contrarian call -- but that's what we do.

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