Leave your price-to-earnings ratio and PEG ratio behind because today we're talking mortgage REITs Chimera Investment (NYSE:CIM) and Two Harbors Investment Corp. (NYSE:TWO), and to evaluate these high-yielding stocks we'll need a new bag of tricks.
By digging into each company's price-to-book ratio compared to peers, the ability of their portfolio of assets to weather environmental pressures, and the strength of management, investors can make a better determination of which company has the more attractive valuation.
One of the tried and true value investing metrics is the price-to-book ratio, or (P/B). This gives investors a theoretical idea of how much they're paying above or below a company's net worth. As a rule of thumb, a P/B below 1 suggests you're paying less than the company is worth if it was liquidated, and above 1 would indicate you're paying a premium.
As asset-heavy businesses, P/B a popular measure for mortgage REITs, and comparing peer companies is a simple way to gain a relative valuation.
A quick look around the neighborhood and Chimera falls in the middle of the pack, while Two Harbors is sporting the cheapest valuation.
It should be noted, however, the chart above is a great example of why looking at companies in isolation can lead to problems. While in many sectors a price-to-book ratio of 1 is often considered a bargain, as basically just a portfolio of residential housing debt, mortgage REITs rarely trade much above book value. Although, with three of the four like-mined companies trading well below book value, it could indicate something wrong with the industry as a whole.
What's going on?
When mortgage REITs trade below book value it normally indicates that the market believes the value of their assets is overstated, or they're worth less than advertised – and the opposite goes for when they trade above book value.
At the end of the second quarter, Two Harbors and Chimera's portfolios were 73% and 70% "agency" mortgage-backed securities (MBSes) -- pools of mortgage debt packed by Fannie Mae, Freddie Mac, or Ginnie Mae -- respectively. Because rising interest rates can lower the market value of these assets, as well as the company's book value -- and considering interest rates appear likely to rise in 2015 -- it's not too surprising the market is undervaluing mortgage REITs as a sector.
The remaining portion of their assets are invested primarily in residential loans and non-agency securities. Unlike agency securities, these assets are not protected against default, and therefore their performance is tied less to prevailing interest rates and more heavily to the health of the mortgage market. This is why "hybrid" REITs like Two Harbors and Chimera are currently trading at a stronger valuation than pure agency REITs -- those that invest solely in agency securities.
This doesn't explain, however, why Chimera is trading at a slight premium to Two Harbors. It could be because Chimera nearly doubled the size of its portfolio -- from $6.5 billion to $12.4 billion -- during the second quarter of this year alone, while Two Harbor grew assets by just $390 million. However, despite the growth there is nothing about Two Harbors or Chimera's recent financial performance that would significantly separate the two companies.
But what about management?
It may seem like an odd transition to bring up management when discussing valuation, but because mortgage REITs are managed portfolios of debt, I'm willing to pay a premium for management teams with a proven track record, that clearly communicate vision and strategy.
Due to an accounting blunder which involved understating deterioration of some assets back in November of 2011, Chimera needed to restate all of its company filings dating back to the company's inception in 2007. Ignoring what this incident alone says about management, with Chimera just starting to report on time, it's been difficult as an investor to keep track of what's going on with the company.
On the other hand, Two Harbors – with a total return of 115% -- is not only one of the best performing mortgage REITs of the last five years, but its management team does a fantastic job clearly communicating strategy.
Most importantly, I want a management team that follows through on opportunity, and being among the first mortgage REITs to have access to the Federal Home Loan Bank – which gives Two Harbors a lower cost funding option – as well as expanding into loan securitization and mortgage-servicing rights, which perform well despite rising interest rates, are great examples of that.
The cheaper dividend stock
Considering both companies invest in very similar assets, and have a similar exposure to rising interest rates impacting their book values, I see no clear reason Chimera should be trading at a great price-to-book ratio than Two Harbors.
Moreover, because I trust the management team at Two Harbors' and their smoother track record more than Chimera, I think it make the valuation look even sweeter. Ultimately, for income investors looking for a high-yielding stock trading for cheap, I think Two Harbor is a solid buy.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.