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This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

And speaking of the worst...
One of the worst places you could have put your money in 2012 was America's REIT industry. Over the past year, shareholders of industry standard bearer Annaly Capital Management (NYSE: NLY  ) have watched 7% of their market cap disappear, as their stock underperformed the S&P 500 by a whopping 20 percentage points. And for good reason.

On Friday, ace investment banker Wells Fargo (NYSE: WFC  ) described the headwinds facing this industry in stark detail, a staccato list of nightmares that's been dragging down mortgage REIT (mREIT) stocks across the board. Wells' list of woes includes:

  • "30-year mortgage interest rates reaching 2.5%," spurring mortgage refinancing at lower rates
  • Worry that a "fourth round of quantitative easing" will push these rates even lower
  • Fears that the tighter net interest margins (from which REITs derive their profits) that result from falling interest rates will continue "in perpetuity"
  • Worries that fixing the "fiscal cliff" may require higher tax rates on REIT dividends, which are "taxed as ordinary income"
  • And perhaps most serious of all, suggestions that the Obama Administration will soon remove Edward DeMarco from his position as head of the Federal Housing Finance Agency -- paving the way for widespread write-offs of homeowners' mortgage debts, and ruining the holders of this debt.

Should all of this come to pass, it would truly be a perfect storm that would devastate the mREITs. But Wells argues that these fears are overblown, and the sector "oversold." And matching actions to words, last week Wells upgraded a raft of mREIT stocks on the theory that they're now selling at prices "not seen since the height of the financial crisis," and bound to rise.

And so it was that Annaly and Capstead Mortgage (NYSE: CMO  ) , Hatteras Financial (NYSE: HTS  ) , Invesco Mortgage (NYSE: IVR  ) , and MFA Financial (NYSE: MFA  ) all received upgrades to "outperform" on Friday. As Wells describes it: "the mREITs trade at approximately 0.88x to Q3 [book value] and have traded at such levels only three times since 2001" -- July 2007, December 2005 before that, and of course, March 2001 -- during the Great Bubble Burst. Assuming a return to more normal valuations, these stocks seem bound to outperform going forward, or at least receive valuations more in line with their book values.

Which of the five have the most to gain from a reversion to the mean? Actually, they all carry similar potential. In order, price-to-book valuations at the stocks run from a low of 0.82 at Capstead, up through 0.84 (Hatteras), 0.86 (MFA and Annaly), and top out at 0.89 (Invesco) -- a valuation range all of 0.07 wide.

With prices so cheap, and valuations so uniform, it almost seems an investor can't go wrong by buying mREITs -- any mREITs at all -- today. Assuming, that is, that you think Wells Fargo knows what it's talking about, here. But does it?

Let's go to the tape
At first glance, there's every reason to believe that Wells is right about its mREIT picks. After all, Wells ranks in the top decile of the investors we track on CAPS, outperforming more than 90% of ranked "players." It's doing particularly well with its REIT recommendations right now, too. In fact, nearly 60% of its recommendations in this industry are beating the market.

Then again, though, we've been tracking Wells for more than six years here on CAPS. And as it turns out, while Wells has done pretty well in REITs lately, its longer-term record is a bit more suspect. Roll the record back toward 2006, and it turns out that over the past six years, only 44% of Wells' REIT recommendations have actually outperformed the market over the long term. Worse still, the combined record of Wells in REITs is a staggering 606-percentage point underperformance of the market.

Foolish takeaway
That's spread out over a collection of 63 separate picks, granted. But it still works out to about 9.6% percentage points worth of market underperformance per pick. A record like this one has to give investors pause.

In short, yes, Wells' argument in favor of mREITs being historically undervalued makes sense. And yes, a lot of these stocks look awfully cheap -- Hatteras, Capstead, and Invesco in particular all sell for little more than seven times earnings, for heaven's sake, while paying dividend yields of 12% and up.

Before following Wells down the REIT rabbit hole, though, make sure to keep in mind that there's a common factor between (1) Wells' record of underperforming the market on its REIT picks, and (2) the high dividend yields on these stocks. Remember that the fastest way to double a dividend yield ... is to cut the stock's price in half.

When you get right down to it, a dividend is only as good as the company's ability to keep paying it. In our new report, "Secure Your Future With 9 Rock-Solid Dividend Stocks," we'll tell you about nine stocks with dividends built to stand the test of time. Get your copy of the report today at no cost! Just click here to discover the winners we've picked.

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Rich Smith

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.

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Related Tickers

5/24/2016 3:50 PM
WFC $49.26 Up +0.56 +1.14%
Wells Fargo CAPS Rating: *****
CMO $9.67 Up +0.05 +0.52%
Capstead Mortgage… CAPS Rating: *****
HTS $16.23 Down -0.01 -0.06%
Hatteras Financial CAPS Rating: ***
IVR $14.17 Up +0.07 +0.50%
Invesco Mortgage C… CAPS Rating: *****
MFA $7.08 Up +0.04 +0.57%
MFA Financial, Inc… CAPS Rating: *****
NLY $10.75 Down -0.03 -0.28%
Annaly Capital Man… CAPS Rating: ****