CMO

[David Randolph]

1. Introduction

I got CMO through my Metastock technical filter and I'm attracted by its chart:



At this point this is all I know about this company, it has a bullish chart.

2. Profile

Capstead Mortgage Corporation (CMO) operates as a real estate investment trust (REIT) in the United States. It primarily invests in real estate-related assets, which include residential adjustable-rate mortgage securities issued and guaranteed by government-sponsored entities. Capstead Mortgage has elected to be treated as a REIT for federal income tax purposes and would not be subject to federal income tax, if it distributes at least 90% of its REIT taxable income to its shareholders. The company was founded in 1985 and is headquartered in Dallas, Texas.

3. General Comments

Wow, this was really a surprise, I didn't expect to read "adjustable-rate mortgage securities" in the profile of a stock rising about 100% over the past six months.

Here are the management's remarks from the 4th quarter earnings press release:



I see that the company benefits a lot from lower interest rates and it has been issuing new equity at a torrid pace to invest in more agency-guaranteed residential ARM securities.

It's a good sign that some companies in this particular sector are rising so strongly ... here's another one:



Coming back to CMO, here are analysts expectations for 2008 and 2009:



$2.42 EPS in 2008 gives me an earnings yield of 13.94%. But EPS fluctuated so wildly in the past that it seems very hard to make predictions. For example, in 1997 CMO earned $9.40 per share, but in 1998 it lost ($16.88) per share. The resulting effect on the stock price was the following:



Brutal.

4. Conclusion

I recognize that there can be a lot of money to make in CMO and I'm attracted by the idea of investing in a sector that is currently so out of favor, at least in the mind of the public. But I'm not a fan of investing in something to earn a small yield and then leverage that 10 times or more to get a decent income. I see this company as something similar to trading bond futures with different maturities to earn on the spread ... well, not quite the same, but you get my point.

I feel like I would never invest in real estate to earn a yield, regardless of the attractiveness of the opportunity. Not my kind of business. But if I were to do it I feel this would be a great timing.

It's also encouraging to see there are some stocks rising rapidly in the mortgage sector, feeling the early effects of the FED's actions, maybe the housing sector is near a bottom? A stabilization of this market would be a big plus for the stock market as a whole, even though I think that even without it we're set to move towards new highs in the second half of the year.

Good luck

[David Randolph]

CMO was doing all right until early March when something happened:



Let me copy/paste an analysis from that day, when CMO fell 30% with 10.7 million shares changing hands:



August Déjà Vu Creates Opportunities

• Buy On the Weakness: We are maintaining our estimates and ratings on the four Agency REITs (ANH, CMO, NLY, and MFA) under coverage following today's sell-off, which we believe is overdone and based on illogical conclusions being reached about the business model, in conjunction with the well-publicized meltdown in the non-agency space and funding issues with at least one private agency REIT. We believe that while the risks to business models have increased in conjunction with the deepening liquidity crisis, funding and liquidity fears are over-done and the risk/reward trade-off continues to favor Outperform ratings.

• Pinpointing the Sell-off: We believe today's sell-off is driven by a number of factors, including: 1.) Headlines surrounding blow-ups in another non-agency REIT space and one highly levered Agency REITs, which we believe could have been using 4-7x the amount of leverage deployed by our peer group; 2.) spreads on agency paper have widened to near record levels relative to treasuries; and 3.) the fear of higher haircuts from dealer along the risk of dealers exiting the repo market all together.

• Agency MBS Hanging In There: While agencies to treasury spreads have widened, dollar bond prices have remained flat as intermediate and long-term bond yields have declined. This is particularly true in the hybrid market (which represents the vast majority of the groups' portfolio assets). At last check, the vast majority of the hybrid ARM market was at trading at a premium (down approx ½ pt from last week). Additionally, fixed rate FNMAs were trading just under 101 (down ¾ pt from last week). While swaps have declined in conjunction with lower yields, we believe it is reasonable to assume that flat to higher dollar assets have mitigated this, which gives us greater confidence in book value stability (and therefore leverage levels). One management team indicated that its book values were essentially unchanged MoM.

• Advance Rates Are Unlikely to Increase Meaningfully: Management teams have indicated to us that passthrough agency haircuts are likely between 2.5% and 5% and have not increased since August. While there have been reports of dealers increasing their haircuts, we see haircuts above 5% as being extremely unlikely. For one, capital charges issues for banks would likely prevent this. Also, advance rates of about 5% would be unprecedented for assets, which are fundable under the Fed window. Whether or not haircuts change, the group today appears better positioned to handle margin calls. The average leverage was below 9x at 4Q07, which could be down post the round of capital raises completed 1Q08. We believe haircuts would have to increase 10%+ while MBS dollar prices would have fall in the mid 90s before deleveraging would take place.

• What is the Reward? We believe the FOMC will now likely cut the target rate 100 bps at or before the next meeting scheduled for March 18th. More importantly, we believe additional cuts are likely throughout the year, which  should increase net interest spreads above our models and into historically record wide levels. Ultimately we believe low cash yields will likely create a flight to spread products, which should begin tightening agency MBS by midsummer, and potentially alleviate many liquidity concerns.

Strange business ... it is probably more suitable for the bond guys, they probably love these stocks.