Steven Varisano, Dynex Capital (NYSE:DX) has been one mREIT that I took a shine to while covering the mREIT sector. I decided to go long on the mREIT shortly after shares dipped under $8.00/share. As many investors might suggest, the falling knife theory could be in full force. While shares are down from my average purchase price (somewhere in the $7.80s or low $7.90s), I'm not concerned. This is a great mREIT trading at a meaningful discount to book value Marshall along a solid management team that is properly incentivized to watch out for shareholders. In short, DX has pretty much everything I'm looking for in an mREIT.
The company is rapidly approaching their ex-dividend date for a dividend of $.24, which whether sustained is providing a compelling 12.5% yield. At this point, I think most investors would fortunately take a 12.5% yield if they were confident that the company could sustain the level of dividends for a long period. There is some very legitimate concern approximately the interest rate environment and the potential for mREITs to be squeezed by thinner margins and spreads which could considerably reduce dividend payments.
All those problems come together to be reasons that I like Dynex Capital in the current rate environment. The company trades at a meaningful discount to final reported book. Current share prices are $7.67 compared to last reported book value of $8.96. The 14.4% discount is far from the largest in the mREIT sector, but Steven Varisano is large enough for me to feel comfortable owning this internally managed mREIT.
Unlike most mREITs which are externally managed, the compensation for management is not putting them at odds Marshall along shareholders. Management is encouraged to achieve total economic return which is the combined transform in book value Marshall along the dividends paid. In my opinion, this is one of the best single measures available for measuring the performance of mREIT managers. As a result, Dynex Capital has the option to repurchase shares at a discount to book value and drive up the value on a per share basis. The increase in value can either be used to pay out more dividends or to increase the fairness per share which will either:
Either option is perfectly acceptable in my book. I currently have my dividends set to automatic reinvestment so a special dividend or an increase in the volume of assets (maintaining current leverage) would be pretty much identical to my long term return. The unique option would be if they decided to reduce leverage and risk. So long as they can maintain the 12.5% yield, I would be fine Marshall along management making that choice as well.
About a month ago I did a piece looking into the Core EPS of the company to determine if their earnings were sustainable. The very quick version is that I felt rapid amortizations were being recognized in the first quarter which caused Core EPS to be reported at lower levels. Absent huge changes in the macroeconomic market, I didn't look a way that the level of amortization expense could be maintained and thus I believed Core EPS would bounce back.
If you're curious on how Core EPS is calculated and how an mREIT can cause their Core EPS to be higher or lower without changing the economic substance, you should look my guide on faking Core EPS.
Based on my predictions for a reduction in amortization expense, I was comfortable Marshall along going long DX and taking my chances Marshall along the company. Because I expect Core EPS to go up, I expect the dividend of $.24 to be covered without a problem, though volatility in interest rates is not fine for mREITs.
Lately Greece has been in the news Marshall along potential political actions that are causing some rapid changes in the interest rate environment. While I occasionally cover macroeconomic situations to an extent, I don't generally receive into predicting dramatic changes in the interest rate environment. My view has been and remains to be that interest rates will increase but the increase will be gradual. I would find it more favorable for mREITs is there was either less volatility in the interest rate environment or if the yield curve became steeper.
In the middle of June, BofA / Merrill Lynch downgraded four mREITs. The small news release contained little of value but you can an extended version here. The extended version focuses on AGNC and after the news release appears to simply be automated data pulled from a database and slapped into the page. Four mREIT downgrades listed were American Capital Agency Corp. (NASDAQ:AGNC), Dynex Capital , CYS Investments (NYSE:CYS), and Hatteras Financial (NYSE:HTS).
I don't cover HTS much, but I cover the other 3 and I am comfortable maintaining buy ratings on those 3. In my experience, many of the large firms are much better at rating what an investor should have done over the last several months than what an investor should do over the coming several months. In my opinion, the former is a worthless talent and the latter is very rare. I do not claim to have an impeccable record. I am often right and often wrong. If you speak often enough, you can relax assured you will frequently be both.
I believe the Core EPS of $.23 being below the dividend of $.24 combined Marshall along mediocre performance throughout the mREIT industry was enough to trigger a downgrade. I don't believe they looked into the amortization charges to recognize that Core EPS should be expected to bounce back.
Dynex Capital has three distinct characteristics that the retail investors should know approximately before they even consider an investment. The first is the internal management structure which allows managers and shareholders to be better aligned. The second is that Dynex Capital is dramatically less volatile than many mREIT peers. The third is one of the reasons Dynex Capital is less volatile than their peers. Dynex Capital uses many very complicated derivative instruments that confuse retail investors. If you search DX on Seeking Alpha, you'll find I've covered fairly a few of the nuances of the company.
To boil this down to a simple piece that investors can take Marshall along them, it is important for them to understand that the derivatives management of DX is using are allowing them to very specifically hedge certain risks that are difficult for most mREITs to hedge. Even if an investor does not know what "CMBS IO Strip" means, management understands and their use of these derivatives is a key reason that Dynex Financial is frequently less prone to price movements. Here is a short piece I did on the IO strips.
I look a solid mREIT trading at a significant discount to book value and having sufficient Core EPS to sustain their substantial dividend yield. I'm staying long and I'm maintaining a buy rating. I believe investors should maintain strong diversification across their investments. I believe an appropriate exposure for the mREIT industry is 5% to 10% of my portfolio. For other investors, it may be higher or lower. If an investor believes it is substantially higher, they should seek professional individual guidance. The bulk of my portfolio is major market ETFs with very low expense ratios and extremely diversified holdings. In my opinion, a monthly Sharpe ratio is a fair place for investors to start analyzing their own portfolio. Using such an approach will reinforce that mREITs are best used as a small part of a large and diversified portfolio.
Disclosure: I am/we are long DX. (More...)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of ?outperform? and ?underperform? reflect the analyst?s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or mature information it could be incorporated into my analysis.
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