Wednesday, August 12, 2009

Volume 3, Issue #76

Also in Today's Issue...

Anything with "mortgage" in the name has spooked investors during the past year, usually for good reason. Capstead Mortgage (NYSE: CMO) is a prime example of a well-managed company that has been charged with guilt by association.

Many have begun to realize this stock has been unfairly tainted and have responded by pushing the share price to a new 52-week high. Capstead is unlike most companies in the business of selling products and services, -- the firm has no inventory or equipment. It exists for just one purpose: To buy mortgage-backed bonds. Its portfolio consists of about $7.6 billion worth of these income-bearing securities.

The company operates just like a bank: It borrows at low, short-term rates, and invests the proceeds at higher, long-term rates -- pocketing the difference.

The company is leveraged at about 7:1 with investment capital of about $1 billion and a portfolio worth $7 billion. That heavy use of leverage cuts both ways: It can magnify gains when the strategy works, but can also lead to steeper losses when it backfires. Fortunately, things have never been running more smoothly.

Capstead doesn't invest in riskier, privately issued mortgage bonds. The company sticks exclusively to debt backed by government-sponsored entities (GSE) like Fannie Mae and Freddie Mac. Debt issued by these agencies has long carried the implied backing of Uncle Sam. That guarantee against default suddenly became explicit when Fannie and Freddie fell under government control last year.

In other words, these AAA-rated bonds are about as safe as U.S. Treasuries.

Investors were afraid to touch GSE debt during the height of the financial storm last year, but the Federal Reserve stepped in with a plan to purchase $1.25 trillion of these securities on the open market. The contribution has helped prop up prices for mortgage backed securities. With demand for mortgage-backed bonds on the rise, the fair value of Capstead's portfolio has increased by $126 million over the past six months as a result.

Meanwhile, the company's core operations are benefiting thanks to unprecedented short-term interest rates near zero. Last quarter, the firm paid 1.96% on its liabilities, but raked in a yield of 4.27% on its portfolio. That net interest spread of 231 basis points looks even wider when leverage is applied.

Capstead's portfolio has a net profit of $42 million this past quarter. The firm as a REIT is required to distribute nearly all of that to shareholders. The current annual dividend of $2.32 a share equates to a yield of 17.1%.

This gravy train won't last forever. Rising rates could raise borrowing costs and pinch profits. Capstead has a more conservative approach than its peers and invests strictly in adjustable rate securities whose coupons reset frequently. So even as interest rates rise, so does the firm's income stream.

The company has a net worth of $11.84 per share, up from $9.50 at the beginning of the year. The stock was trading at a discount to that price until the end of April.

The stock still has attractive upside potential of at least +50% from its current price to my fair value of $22 a share.

Action to Take --> Ordinarily I wouldn't be terribly interested in mortgage REITs, but these are hardly ordinary times.

Between appeasing foreign bondholders and maintaining affordable mortgage rates, the Fed has a vested interest in keeping MBS yields low and prices high. This intervention means Capstead has a powerful ally on its side.

Good Investing!

-- Nathan Slaughter
Editor
Half-Priced Stocks