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Don't Let Stocks Like These Tempt You

When I'm investing, I like to have a good idea of the economic value produced by the companies I invest in.

Not because I'm a great fan of "social investing" — I'll happily buy tobacco company shares if the yield's good enough and the consumption trend is solid — but because there are a lot of dangerous stocks out there that are simply tricks of the market.

Sometimes short-term factors make a company very profitable for a while and then suddenly disappear. Those are the companies – and sectors — where investing is dangerous.

And that's what I'm going to tell you about today.

Learning How to Spot Dangerous Stocks

Granted, not all downtrends are fatal; sometimes a company can face an adverse trend, yet emerge into renewed profitability and success.

For example, in my early banking days in London, I got onto the analysts' list for the Brunswick Corporation (NYSE:BC), which in those days gave an annual dinner for a dozen analysts at the Connaught Hotel, an especially expensive and delicious venue.

Brunswick had made its name in the 1950s on the bowling boom, and each year the CEO would address analysts on how some hitherto obscure emerging market was about to launch itself into the bowling craze. Brazil, Korea, the Philippines, if you believed the Brunswick chairman they were all about to forgo soccer or their other favorite sport and embrace bowling.

Needless to say, since I loved the dinners, I would carefully prime myself each year to ask a duly supportive question, thus assuring an invite back the next year.

That was a company in downtrend. And eventually they indulged in an orgy of cost-cutting and gave up the Connaught Hotel dinners. Nevertheless, today BC, while still keeping its foothold in the world of bowling, has diversified into marine engines and, judging by the stock price chart, is a highly successful company — although at 50 times trailing earnings and 36 times book value maybe a little overpriced.

There are also dangerous stocks that are no more than scams. Like many sometimes adventurous investors, I have been burned by Chinese small-caps whose accounts turned out to be fraudulent.

There's always some risk of this when investing in exotic companies, but I have to say I didn't expect the extent of the problem, given the perfectly respectable Western auditors those firms employed and their listing on the NYSE.

I still live in hope that China Sky One Medical (OTC:CSKI) or Universal Travel (OTC:UTRA) will turn out to have a real business, since at 3% of book value and 1% of book value respectively their stocks would be tremendous bargains.

But the reality is that their survival as listed securities simply reflects the fact that bankruptcy doesn't work properly in China, either. I like the fact that the principal short-seller of these companies is called Muddy Waters; it reflects the clarity of certain corners of the market!

The Most Dangerous Sector: Residential Mortgage REITs

However, for an entire sector that has built its business model on sand, I would draw your attention to the residential mortgage REITs such as Annaly Capital (NYSE:NLY) and American Capital Agency (Nasdaq:AGNC).

There are also smaller competitors, such as Chimera Investment (NYSE:CIM) in the same business, but NLY and AGNC are the two biggies and as such are particularly dangerous stocks.

These are very substantial companies, with market capitalizations of $14 billion and $10 billion respectively, and as far as I'm aware are entirely above-board. Nevertheless, they make money by buying mortgage-backed securities and leveraging them through repurchase agreements (effectively borrowing in the short-term market).

As of their last balance sheet date, NLY had assets of 9 times capital and AGNC almost 10 times capital.

With interest rates in their current structure, this is a very good business. The gap between repo rates and mortgage rates is some 2.5%, so if you leverage that 9 times you get a return of 22.5% before expenses. That allows NLY and AGNC to pay excellent dividends – NLY shares currently yield 11.4% and AGNC no less than 15%.

The problem will come when interest rates rise and the rate structure flattens out, equalizing short-term and long-term rates. At that point, the spread between short-term and long-term rates will disappear, reducing the return on NLY and AGNC to just the mortgage rate, perhaps 5% before expenses.

Further, the value of the mortgage bonds themselves will decline, and it won't take much of a rate rise to wipe out the companies' capital value when they are leveraged 9 or 10 to 1.

Then there's the risk that they won't be able to carry out the tens of billions of short-term "repos" they need to finance themselves. Regulators worry about money market funds, but the financing risk on these two REITs is many times greater.

Of course, the companies claim they hedge themselves by very sophisticated strategies in the swaps and options markets, but the reality is these risks can't be hedged away, except by dumb luck on timing. The companies are entirely dependent on Uncle Ben Bernanke.

Of course, in a way we are all dependent on Uncle Ben, but these dangerous stocks take all the risks of today's environment and multiply them by 10.

No thanks!

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Join the conversation. Click here to jump to comments…

  1. Paul | May 7, 2013

    and what do you think, about possibility of another scenario?

    1. While QE3 will be continued, interest rates will rise – but first for long-term (connected with debt crisis, P.Schiff "Real Crash").
    2. The gap between repo rates and mortgage rates will rise.
    3. Spread between short-term and long-term rates will soar and with it – REITs incam.

  2. Mark | May 7, 2013

    I own TWO and ARR, I just added to my ARR, I have a 5% trailing stop on both, I will try to keep collecting the dividends until it costs me money. As interest rate's rise I will be stopped out, however i'm riding the train for now. We might be Japan for an extended period of time.

  3. Jeff Pluim | May 7, 2013

    If these REITs are hedging with derivatives, why can't that work. All they have to do is keep hedging as their current derivatives expire. What am I missing? I have a great respect for Martin so if I am wrong, and the REITs are wrong, how and why is that so?

    • Martin Hutchinson | May 7, 2013

      Hello Jeff, and thank you for your kind words.

      It's difficult to work through every possible hedging strategy. However if they hedged themselves completely, using interest rate swaps, the "gapping" profits from holding mortgages would be eaten up, because they'd have gapping losses on the swaps that would fluctuate, but on average would be equal to them.

      If, on the other hand, they use options, then the cost of the options must also be offset against the return from gapping, wiping it out if they're to get a complete hedge – and they need to buy new options as the options expire.

      There are no free lunches in hedging, so they can't hedge the risk completely without wiping out their profit. Only by luck (or exceptional forecasting skill, if you want to call it that) can they predict interest rate movements so accurately that their hedges protect them against the events that actually occur.

      My guess is, their hedges protect them against modest movements but leave a huge gap if there's a big move – they rely on Bernanke to keep them alive.


  4. John | May 7, 2013

    I've owned CIM for some time and am quite happy with mid-term results. I pump my dividends into GE.

    I understand dividends will drop with a rise in interest rates but…..when rates rise, REIT holdings will increase in value no? Especially if holdings include ARMs.

  5. Fabian | May 7, 2013

    Like the author writes in the last sentence, we all depend on Ben. If AGNC collapse because of a flattening of the yield curve, make no mistake, the stock market will go down as well. What matters now for mREITs is the quality of the management. It's difficult to asses.

  6. peter | May 8, 2013

    cim rocks

  7. carlo pecchio | December 19, 2013

    Any news today about China Sky One? Do they still exist?

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