Fructivore Investments

On a forum I visit regularly there was a post when a novice investor asked if there was a good beginner stock that he could learn the ropes with. The general consensus was that there is no such thing as a beginner stock; all stocks were viewed as extremely complex generators of investment returns, full of capital issues, economic outlook situations, regulatory environments, etc.

The advice was to find a company in an area that interests you. However, most of the stocks on parade to the investing public are likely to be large, diverse, and to present a more complicated analytical situation than some of the smaller issues. The perennial advice is to invest in companies you understand, but there are different levels of understanding. “Of course I understand what Enron does. It trades energy derivatives.” “Of course I understand what AIG does. It’s an insurance company.” “Of course I understand what Citigroup does. Everything.”

So, even though the onus is on the investor to do his homework, some stocks are more amenable to valuation than others, and although complicated situations are more likely to have hidden value to unlock (or to have hidden traps), there is an argument to be said for finding a simple and understandable situation that allows the investor just to leap on it whenever the price is right.

Capstead Mortgage (CMO) probably qualifies as such a situation. It’s more of a fund than a company; it produces no products and has no customers. Their business plan is to purchase adjustable-rate mortgage passthroughs from federal mortgage agencies (Fannie, Freddie, and Ginnie) and to finance these purchases through short term borrowing, thus profiting on the spread the adjustable rate mortgage charges over the cost of financing. Also, since they are dealing with agency securities, and the federal government is now explicitly guaranteeing them (just as investors always thought they would), the risk of default is off the table.  Stock investors nowadays are often asking themselves “Where’s my bailout,” and here it is.

So, given these advantages, how can Capstead Mortgage lose money? Or, to be precise, Capstead Mortgage has lost money in the past and here’s how. First off, many of their holdings were until recently in the “teaser rate” phase, so their interest payments were lower than they would be once the teaser rate expires. Second, the company’s short term financing runs for a term of 30 days, while the reset period for many adjustable rate mortgages is a year or six months, and they have a “soft cap” where interest rates cannot rise beyond a certain limit per reset period. For this reason, it is possible that the interest on the mortgage will not always keep pace with rising interest rates. Capstead claims to use fixed/floating interest rate swaps to handle this, which allows them to receive the prevailing short term interest rate in exchange for them paying fixed interest payments. If their hedging is sufficient investors have nothing to worry about from rising interest rates. And when interest rates are low and declining, as they have been, the company has produced returns of about 15% on equity, which is not bad for a situation with theoretically so little risk.

So, what prevents Capstead Mortgage from being a screaming buy? The price. I mentioned the return on equity, but the investor cannot buy the equity for the same price the company paid for it. Net of the liquidation preference of its preferred stock, Capstead has a book value per share of about $10.40, and its current price is about $13. Although in theory a high cash flow producer like this is entitled to a premium, the economic situation of mortgage investing counsels against buying into a high premium situation. A mortgage borrower can refinance his mortgage at any time, and mortgage defaults also result in principal being returned to the holder of the mortgage passthrough. Therefore, a mortgage security that the market currently values at $13 will be paid back at $10.40, and the premium paid vanishes into thin air. The annualized prepayment rate was 16.6% last quarter. It is possible that even at current prices the high cash flows produced will justify the premium, and at a lower share price they definitely will. So, a significant price drop will turn Capstead Mortgage into the low-hanging fruit we all know and love.

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Investing by grocca