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This Just In: Upgrades and Downgrades

Rich Smith
November 19, 2012

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),