“$4 REIT to Hit $8 — With 18% Dividends Along the Way”

by Travis Johnson, Stock Gumshoe | November 23, 2010 12:56 pm

Bryan Perry[1] is fairly active in teasing ideas to garner new subscribers for his Cash Machine[2] newsletter (formerly called 25% Cash Machine before, one assumes, that promise got to be too much to bear), and some of them have been pretty nice high yielders over the years, so when the questions about his latest tease crossed my desk they caught my eye.

That’s not to say that I always like what I hear from Mr. Perry in his ads — I have never been able to get over my qualms about some of his “dividend capture” closed end funds [3]like AOD, for example, and my sense from hearing comments from readers is that he probably had some stinkers when real estate[4] crashed and when leveraged closed end funds took a beating … but he has touted some excellent teaser picks like Linn Energy (which has more than doubled in the year and a half since I wrote about his tease[5], along with a nice yield).

So given that — what’s he teasing us about today?

It’s another REIT, this one with an unusually high 18% yield, which is probably why the ad caught the attention of so many of the Gumshoe faithful. Here’s how he introduces this pick:

“I’ve sent you this special message to tell you about a $4 government-guaranteed mortgage REIT my readers and I own that pays 18% annually.

“If you enroll in the next 24 hours, you’ll catch the next fat 4%+ quarterly payout come December 30 for owning it less than 90 days!

“In fact, my high-net-worth readers who put $1 million in this fund last week will grab a $50,000 payout on December 30.

“Those who have been in this little-known fund since March of 2009 not only have already collected seven $42,000 paydays for a total of $297,000 dollars but also have seen their $1 million investment rise 60% for a $1.97 million total return.”

OK, so what do we note first, class? Yes, almost every single ad loves to quote returns from March 2009 for their ideas — that being a historic low in the market precisely because few people were willing to buy stocks, so performance from that date always looks good. And of course, he doesn’t specifically say that he told people to buy in March of 2009, just that those who did would have done well.

But that’s sort of standard braggadocio for newsletter copywriters — what else are we told about this high yielder?

We get a spiel about the big institutional investors …

“Insiders at BlackRock, Wellington Management and Bank of America Own Nearly 100 Million Shares

“…and will be grabbing their own collective $18 million quarterly payday come December 30, along with us, Vanguard, American Funds[6], Wells Fargo and many of the biggest mutual funds[7] on the planet.”

Which really just tells us that it’s not a small cap stock — you’d be hard pressed to find any reasonable sized stock that didn’t have at least half of those major institutions in the list of shareholders. And, of course, if we do the math a $4 stock with 100 million shares (so, $400 million) split among those institutions means that the total exposure for each of those giant banks and fund managers is minuscule. Not to say you shouldn’t buy this stock (which we’ll learn enough to name in a moment), but don’t buy it just because these institutions own it.

So how does this REIT manage to pay out such a huge dividend? Here’s Perry’s explanation:

“Once You Grab Your First Payday, You’ll Never Put Your Money in a CD Again

“That’s because you’ll not only be getting 14 times more money than in a CD, but also know that your money will be equally as safe.

“This is why Wall Street’s biggest insiders are already in on this deal!

“Once you see how your banker can pay out this kind of high dividend safely, I know you’ll never put your money in a CD again.

“Here’s how they do it:

“Frankly, it’s the old 3-6-3 rule that bankers have been living on for centuries: Pay 3% on deposits. Earn 6% on home loans. Be on the golf course by 3 every afternoon.

“However, instead of banking the 3% spread, fund managers here are using the new banking rules to leverage their government-guaranteed investments eight times—producing 24% income.

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“Because these securities funds are set up like REITs[8], the fund managers have to pay out 90% of their revenues as taxable income.”

I’m not sure how he managed to get the “equally as safe” part of this teaser through his legal compliance department, but I’d caution you to think of this as very, very different than a CD … and certainly not insured in nearly the same way. What he’s describing in that section is mortgage REITs, and the mighty, mighty Thinkolator tells me that the REIT that is being teased here must be …

Chimera Investment Corp. (CIM)

Chimera is a mortgage REIT, with some similarity to firms like Capstead Mortgage (CMO)[9], MFA Financial (MFA)[10], Hatteras Financial (HTS)[11], Anworth Mortgage (ANH), or the big daddy of the group, Annaly Capital Management (NLY). There are a few others, too, those are just some of the names I see most often — almost all of them have yields in the double digits, ranging from 9% for CMO to 15% for NLY, but Chimera is unusually high at 18%. Why is that?

Well, first I should tell you briefly what mortgage REITs do, in case you’re unaware: They raise money in the stock market by selling shares, leverage that capital up by borrowing at short term rates, and buy mortgage bonds with the money. Mortgage bonds yield only something like 3-4% right now (for standard government agency bonds[12] like Fannie Mae or Ginnie Mae that are guaranteed by the government), so the big key with mortgage REITs for current income are the spread and the leverage amount, and the key for the future, since they borrow at short term rates to fund purchases of bonds and other securities that have longer durations, is their ability to manage changes in the yield curve.

The spread is the difference between what it costs them to borrow money and what they earn on their bonds, the leverage is the multiple of borrowing they do (ie, do they borrow 5X their capital to amplify returns? 8X?), and the yield curve changes when short term and long term interest rates change in relation to one another — so if investors fear inflation and drive long term rates higher but short term rates stay near zero, then the curve steepens; if they fear deflation[13] and long term rates fall even more then they already have, the curve flattens. Generally, the steeper the curve the better for mortgage REITs, but managing the changes in that curve must be difficult.

There are also other considerations in terms of evaluating a mortgage REIT — but they basically revolve around asking how good the management is at managing through changing interest rate environments, and how well they manage prepayment risk as interest rates change and mortgages are refinanced and taken off the books (or, as recently, bought back by Fannie Mae).

And then there’s one other very major thing: What kind of mortgages, exactly, does the REIT own? And that’s where we get into really understanding why CIM is a higher yielder than Annaly or Capstead — we’ll often see mortgage REITs teased as having a “government guarantee” because many of these REITs own only agency mortgage securities, which means mortgages that are backstopped, at least in theory, by the federal government. Chimera, in contrast, owns primarily non-agency securities, which are currently considered by investors to be substantially riskier because of the lack of that government guarantee (you can see the breakdown of their portfolio in their quarterly earnings releases, the last one is here[14]).

On the other hand, owning these higher-yielding securities allows them to use less leverage and still make a lot of money, so CIM has levered up only about 1X (leverage ratio is 1.3:1 as of the last announcement[15]) whereas the standard-bearer of mortgage REITs, Annaly, reports 6.4:1 leverage[16] at the moment.

So while CIM is clearly in the same basic business as the other mortage REITs, it’s worth noting that their portfolio, leverage ratio, and strategy are substantially different, which makes comparing them difficult. For what it’s worth, Chimera is also managed by Annaly, which probably provides them with access to very experienced management and to a team of folks who have seen lots of different interest rate environments, but also may mean that NLY management is effectively using CIM to implement more aggressive strategies than would work for the much larger Annaly portfolio.

That’s about all I can tell you about Chimera — looks to me like it must be Bryan Perry’s pick, though I have to admit that the clues are mushy enough that it’s just possible that I’m wrong. It’s an interesting Mortgage REIT, I like that they’re managed by Annaly, which is a strong name in the business (and you should read Annaly’s general market commentaries[17] if you invest in any mortgage REITs), but it is clearly a specialist in a much riskier part of the mortgage market — so calling this REIT as safe as a CD is a little ridiculous. Of course, it also seems pretty ridiculous to me that folks are willing to commit money to a 5 year CD at 2%, so there are all kinds of different flavors of ridiculous out there in the market today.

If you’re one of my many readers who invests in mortgage or other REITs and has an opinion to share about one of the stocks I’ve mentioned above or another favorite, please jump right in with a comment below. And if you’ve ever subscribed to Perry’s Cash Machine, you can click here to review it for your fellow investors[18] and make us all just a little bit wiser. Thanks!

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