Editor's Note: This article was originally published at 2 p.m. EDT on
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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:
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 - Get Report)
, for example). Friday's trading highlighted the market's perception of mREIT fundamentals: Interest rates rise and mortgage-backed security prices fall, 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. 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).