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Mortgage REITs Should Repurchase Their Own Shares

As I wrote recently, mortgage REITs as a sector are trading at some of the steepest discounts to book value in their histories. I consider mortgage REITs trading at eighty to ninety cents on the dollar to be a fantastic bargain. But I also know that those bargains exist for a reason. With bond yields–and mortgage rates–scraping along near all-time lows and the Fed expected to at least modestly raise rates this year, the fear is that the interest rate spreads that allow mortgage REITs to pay out such large dividends are about to get crimped…and force the mortgage REITs to slash their dividends.

chart

When mortgage REITs’ higher-yielding mortgages get prepayed by homeowners, the mortgage REITs are left with slim picking to reinvest in today’s market.

It’s a problem with an easy solution. 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 repurchase their own shares. In fact, I’d argue it’s the only sensible solution at current prices.

chart (1)
Mortgage REITs haven’t been very active on the share repurchase front. Annaly approved a share repurchase program in 2012, but it didn’t amount to a lot. Looking at Annaly Capital’s (NLY) history (see chart above), the REIT has been a lot more aggressive in issuing new shares. That made sense when interest rate spreads were wide and the high yields were there for the taking. But it certainly makes no sense at today’s prices. And to Annaly’s credit, they’ve moderated the new share issues of late.

Frankly, 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 step up the share repurchases 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.

 

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Dividend Investing Like a Billionaire

iBillionaire—the creators of the index backing the Direxion iBillionaire Index ETF (IBLN)—are at again, launching a new index that tracks the dividend stocks being bought by hedge fund masters of the universe and other financial billionaires.

The iBillionaire High Dividend Index (IBD), which was just launched today, is an equally-weighted basket of 50 high-dividend stocks held by high-profile billionaires in the financial sector. iBillionaire currently tracks the trading moves of 25 billionaire investors, and recent additions include living legends like Stanley Druckenmiller, James Dinan and Nelson Peltz.

In a low-yield world in which “high dividend” is something of a relative term, the iBillionaire High Dividend Index actually lives up to its name. Its dividend yield is a solid 5.34% according to iBillionaire.

I’ve written about iBillionaire and the Direxion iBillionaire ETF before (see “Investing Like a Billionaire”), and I’m a big fan of iBillionaire’s methodology as well as those of competitor ETFs like the Global X Top Guru Holdings Index ETF (GURU) and the AlphaClone Alternative Alpha ETF (ALFA). I don’t believe in mindlessly copying the trading moves of other investors, no matter how storied their careers, but I do consider guru-following strategies to be a fantastic source of trading ideas.

The iBillionaire High Dividend Index comes along at an interesting time. The 30-year U.S. Treasury is scraping along near all-time lows, and most income-focused investments have gotten prohibitively expensive. This is perhaps the trickiest market in history for income investors to navigate, so it’s instructive to see what the big boys are buying.

Let’s take a look at the top 10 holdings. (Note: Though equally weighted, position weights will shift between rebalancings, hence the larger allocations you see here.)

iBillionaire High Dividend Index Top 10 Holdings

COMPANYTICKERWEIGHT
Talisman Energy IncTLM2.83%
Cablevision Systems CorporationCVC2.27%
General Mtrs CoGM2.27%
Time Inc.TIME2.25%
Ameren CorpAEE2.24%
Dominion Resources, Inc.D2.22%
Extended StaySTAY2.17%
Kinder Morgan Inc DelKMI2.16%
Tronox LimitedTROX2.15%
Exelon CorpEXC2.15%

Interestingly, General Motors (GM) is a top-ten holding of both the original iBillionaire Index and the new iBillionaire High Dividend Index.

At 24%, the iBillionaire High Dividend Index has a high allocation to energy shares. Given the volatility in the sector, that very well might change once the next batch of 13F filings is released. But there are several high-quality energy names in the index worth noting, such as Kinder Morgan Inc (KMI), Williams Companies (WMB) and BP (BP).

Also worth noting is that the index has a fairly high allocation to high-yielding mortgage REITs, such as Northstar Realty (NRF), American Capital Agency (AGNC), and Chimera Investment Corp (CIM). Investors right now are scared to death of mortgage REITs, fearing that eventual tightening by the Fed will pinch their interest spread. It’s interesting that the billionaire masters of the universe appear to see value. (Incidentally, I noted that mortgage REITs were attractively priced earlier this month.)

So, what are we to do with this information? There is no mutual fund or ETF that currently tracks this index. That’s ok. In its current form, it gives us a “fishing pond” of good income investment ideas to research further.

Disclosures: Long GM, KMI, WMB BP

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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Target Stock is a Dividend-Raising Monster

There comes a time to stop throwing good money after bad and simply walk away. And that’s exactly what Target Corp (TGT) is doing in its decision to leave Canada. But while Target is walking away from Canada, dividend investors shouldn’t walk away from Target stock. After a rough couple of years, Target finally seems to have righted the ship. And I expect Target’s dividend growth—which already put it in elite company among large-cap stocks—to accelerate as a result.

After losing about $2 billion in its Canadian operations—and coming to the realization that they wouldn’t be profitable until 2021 at the earliest—Target CEO Brian Cornell made the announcement on Thursday.

Adding to the good news, Target announced that same-store sales for the fourth quarter would be up about 3% rather than the prior guidance of about 2%. Target’s stores are seeing good foot traffic, and its revamped web presence is getting good results.

Target has finally shaken off the pall that the 2013 data breach cast over the company. Shoppers are comfortable swiping their credit cards at Target stores again…or at least no more worried at Target that they would be at any other store.

Let’s talk dividends. Target stock’s current dividend yield, at 2.5% may not catch your attention on its own. But Target has been growing its dividend at a 20% annual clip for over a decade. And I’m not using dated data here; Target’s dividend growth has actually accelerated in just the past five years. A time, by the way, in which most retailers have really struggled.

Target Dividend Growth

Period Percent
1 Year 19.90%
3 Years 23.40%
5 Years 24.60%
10 Years 20.10%

Now let’s take a look at one of my favorite metrics for dividend stocks: yield on cost. This is the current annual dividend divided by your original cost basis, or the effective dividend yield you would be enjoying today on your original investment.

Had you bought Target stock three years ago and held it until today, you’d be enjoying a yield on cost of 4.7%. Had you bought it five years ago, you’d be enjoying a yield on cost 7.51%–about in line with a risky leveraged bond fund. And if you had bought Target 10 years ago, you’d be enjoying an almost too-good-to-be-true 15.61% yield on cost.

Do I expect the next ten years to look like the last? Maybe, maybe not. The picture gets murkier the further out into the future you look. But I feel pretty comfortable assuming that Target can maintain 20% dividend growth for at least another 3-5 years.  And it’s worth noting that Target has raised its dividend every year for 47 consecutive years. This is a company that takes its obligation to its shareholders seriously.

It’s also worth noting that Target rewards its shareholders in more ways than by simply paying a dividend. Target has also been aggressively buying back its shares. Over the past ten years, Target has repurchased nearly 40% of its shares.

TGT_stock

Target’s dividend payout ratio is a little high at 76%. But with Target winding down its loss-making Canadian operations and with its domestic stores seeing signs of life, I expect Target to have a lot more cash available to keep its dividend streak alive and probably accelerate it.

Add shares of Target stock to your long-term income portfolio. Enjoy its current yield—which is very competitive in a world where the 10-year Treasury yields less than 2%–and enjoy what I expect to be many years of solid dividend growth.

Disclosure: Long TGT

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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Update on Prospect Capital

I entered InvestorPlace’s Best Stocks for 2015 contest with business development company Prospect Capital (PSEC). With 2015 getting off to a rocky start, I’m feeling good about my focus on income and deep value. Prospect Capital sports a 12% dividend yield and trades for just 80% of book value. For Prospect to simply return to book value, we’d be looking at 25% returns. Add in the 12% dividend, and we’re looking at 37% returns. Chip in any special dividends–which management says is a distinct possibility–or any growth in book value, and we’re looking at returns north of 40%.

Today’s I’d like to take a quick look at Prospect’s December investor presentation and highlight a few slides I find to be particularly relevant. Let’s start with Prospect’s bad loans. As a percentage of the portfolio, they continue to trend down. In 2009, 5.8% of the portfolio was classified as “non-accrual.” Today, that number is 0.03%. The key bit of information to glean from this is that Prospect Capital has been de-risking over the past six years. I consider that a good thing. With banks essentially out of the business of lending money due to regulatory fallout and a lack of capital, BDCs like Prospect have been able to step in and make high-quality loans.

PSEC1

Furthermore, Prospect’s portfolio is diversified across industrial sector. With crude oil prices still in freefall, it’s worth mentioning that Prospect’s exposure to oil and gas is just 4%.

PSEC2

Meanwhile, most of Prospect’s lending is secured. 71.5% of its debt portfolio is secured by a first lien position. And another 26.3% is secured by a second lien position.

PSEC3

All told, about 75% of its total portfolio consists of first and second lien loans.

PSEC4

Are there risks? Sure. If we hit a rough patch in the economy, Prospect’s bad debts will creep up again. But given the massive amount of de-risking the company has done in recent years, I see that risk as being very tolerable. If anything, I would say the risk is that Prospect Capital’s portfolio isn’t risky enough. Its conservative portfolio might not allow for the kind of dividend growth investors enjoyed in previous years.

All the same, with U.S. stock valuations looking stretched and bond yields scraping along near all-time lows, Prospect’s 12% dividend is hard to ignore.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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Why I’m Bullish on Auto Stocks

December was a solid month for American automakers. General Motors Company (GM) had its best December sales month since 2007, with sales up 19.3% over last year. Full-year sales were up a respectable 5.3%. Ford Motor Company (F) had its best December since 2005, though its full-year growth numbers were actually down slightly due to, among other things, retooling to make way for its new aluminum-body F-150.

Even better, after years of haggling, Americans are paying up for their cars again. December had the highest average transaction prices on record, according to Kelley Blue Book, at $34,367.

So, what’s the story here? Are auto stocks a buy?

I would argue that they are, but not necessarily for the reasons you see in the media.

To start, auto stocks didn’t react particularly well to the sales data. GM stock was followed the broader market lower, and Ford stock dropped by more than 3%. Wall Street doesn’t seem to be buying the argument that lower gas prices will automatically mean a sustained run in strong auto sales.

I agree. Consumer behavior doesn’t change on a dime, and in any event wage growth has been sluggish since 2008, roughly keeping pace with inflation (see chart). The average American is in better financial health than they were, say, five years ago. But they’re not exactly in great shape.

CPI

Furthermore, Americans– and particularly younger Americans– drive less than they used to and are more likely to share rides or use public transportation.

So, if I’m somewhat down on the macro picture for the auto industry…why am I bullish on auto stocks?

I’ll give you three reasons: valuation, dividends, and guru purchases.

Let’s start with valuation. In an overpriced U.S. stock market, auto stocks are one of the last subsectors to find real bargains. GM trades for just 8 times expected 2015 earnings. That’s half the forward P/E of the S&P 500. Likewise, Ford trades for just 9 times expected 2015 earnings.

Slicing the numbers a little differently, GM and Ford trade for 0.36 times sales and 0.41 times sales, respectively. The S&P 500 trades for 1.8 times sales.

Furthermore, after bankruptcy wiped most of its debts clean, GM has the healthiest balance sheet it’s had in recent memory. Nearly half of GM’s market cap is cash in the bank. And while Ford has more debt on its books than GM, about 40% of its market cap is sitting in cash.

All else equal, auto stocks should trade at a discount to the broader market. Their earnings are more cyclical, and they operated in a brutally competitive industry. All the same, that’s a pretty massive discount.

Now, let’s take a look at dividends. At 3.4%, GM boasts one of the highest dividend yields among major American companies. At 58%, its payout ratio is very reasonably low, and I would argue that this number is actually inflated due to GM’s expensive recalls that dented earnings in 2014. GM’s current $1.20 dividend represents a 46% payout of consensus 2015 earnings estimates of $2.62. If GM’s sales are anything short of disastrous in 2015, there is plenty of room for dividend growth.

The same goes for Ford. Ford’s 3.3% dividend yield is very competitive in today’s low-rate environment, and its 31% payout ratio leaves a lot of room for dividend growth.

Finally, I like to who else is in a trade before I get into it. And at least in the case of GM, we’re in good company. Marty Whitman, David Tepper, Warren Buffett, Jeremy Grantham and Joel Greenblatt have all initiated or added to their positions in GM stock over the past quarter.

Disclosure: Long GM

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.

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