Best to analyze mortgage REITs with a long angle lens

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-So’s, 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 Friday October 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 (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 the 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. Despite the rally of the past few months, I think this scenario is what’s in store over the next several years.

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 investable 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 or investment is composed of both yield and price appreciation. We know that the yields on mREITs are relatively 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 (CYS) the beta is 0.05 and for Annaly Capital Management (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, 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, as of 10/18/12 the total return of AGNC is 37.28% vs. 21.62% for the S&P 500 Index over the past 12 months – 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 in this period is 25.25%, for Capstead Mortgage (CMO) it’s 23%, and for Hatteras Capital (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 remain attractive investments.

Disclosure: The author owns shares of AGNC, CYS, CMO and HTS. Gerard Wealth Management, Inc. owns shares in all securities mentioned.

The investments discussed are held in client accounts as of September 30, 2012. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Any index comparisons provided in the blogs are for informational purposes only and should not be used as the basis for making an investment decision. There are significant differences between client accounts and the indices referenced including, but not limited to, risk profile, liquidity, volatility and asset composition. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry, among other factors.

Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. We believe that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions. Performance discussed is net of advisory fees.

Author profile

John Gerard Lewis
John Gerard Lewis
I am John Gerard Lewis, a registered investment adviser representative based in Olathe, KS, and the Founder and President of Gerard Wealth Management, Inc. I have over 30 years of investing experience. My investment goal is to protect the invested capital of my portfolio; I focus most of my investment decisions on that principle.