As a value investor, I’m a little frustrated these days. There is virtually nothing cheap anywhere in the public markets. Stocks are expensive, trading at cyclically-adjusted price earnings ratios higher than those before the 1929 and 2008 crashes. And the 10-year Treasury yield — even after its recent surge — is barely 0.4% above the core inflation rate.
Yet there is one corner of the market still showing signs of value: mortgage REITs.
Click to Enlarge I wrote earlier this year that mortgage REITs as an asset class were trading at some of the steepest discounts to book value in history. Well, as we round out the first quarter, very little has changed on that front.
Even as earnings and revised book values have come in, valuations haven’t changed much.
Consider the chart, which details the top 10 holdings of the iShares Mortgage Real Estate Capped (NYSEARCA:REM). The mREIT universe is small, and the top 10 holdings make up 68% of the total portfolio. Two mortgage REITs alone — Annaly Capital Management, Inc. (NYSE:NLY) and American Capital Agency Corp. (NYSE:AGNC) — make up about 30% of the portfolio.
We see a common theme throughout the top 10 holdings. This is one of the few remaining truly high-yield corners of the market, and the top 10 holdings have a weighted average yield of 10.4%.
But what interests me more are the large discounts to book value. The top 10 holdings trade for 97 cents on the dollar. But Annaly and American Capital Agency trade at even deeper discounts, 81 cents and 83 cents on the dollar, respectively.
Let me put this into perspective. You could hypothetically buy up all of the shares and close the two mortgage REITs, selling their assets as spare parts, and still make a respectable profit of 19% and 17%, respectively.
The market seems to be pricing in major capital destruction by their respective managements. But is that fair? Annaly in particular has a long operating history, and it has survived every conceivable bend and twist in the yield curve over the years. Granted, our situation today — one in which short-term rates are at zero and mortgage rates near all-time lows — is unprecedented. But at these discounts to book value, the market is practically giftwrapping a massive margin of safety for us.
Let’s take a look at Annaly’s historical price/book ratio to get a little perspective.
Click to Enlarge For virtually its entire history as a publicly traded mortgage REIT, Annaly has traded at a significant premium to book value. This makes perfect sense. Annaly can borrow much cheaper than you or I could and has economies of scale that we don’t. Investors pay for that in the form a premium to book value.
But something strange happened in early 2012. The price fell below book value, where it has stayed ever since. Investors feared that a flat yield curve and falling mortgage rates would crimp profitability and force Annaly to cut its dividend.
And this has indeed proven to be the case. Annaly cut its dividend twice in 2012 and twice again in 2013. But at current prices, Annaly and its peers have been more than adequately punished for their dividend cuts, come what may with Federal Reserve policy and mortgage rates.
In late January, I suggested that mortgage REITs should aggressively repurchase their shares. Rather than buy low-yielding mortgages or slide down the credit quality scale to chase yield, mortgage REITs trading at discounts to book value should absolutely repurchase their own shares. It’s the only sensible thing to do.
If Annaly — and the rest of the mortgage REITs trading at deep discounts to book value — care about the best interests of their shareholders, they will aggressively buy up their own shares on the open market as their portfolios of mortgage securities roll off.
If you don’t buy your own stock at 80 cents on the dollar, then when would you?
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. As of this writing, he was long NLY and REM.
