Anworth Mortgage’s Value Creation Since Its IPO May Offer Insights Into Its Future Returns (NYSE:ANH)

Anworth Mortgage Asset Corporation (ANH) is a mortgage real estate investment trust, or mREIT. The company invests in residential mortgages as well as mortgage-backed securities, or MBS, securities whose income is based on the performance of pools of residential mortgages. Those securities include both agency-backed MBS whose performance is guaranteed by Fannie Mae (OTC:FDDXD) and Freddie Mac (OTCQB:FMCC), as well as non-agency MBS whose performance is not guaranteed. According to the company’s most recent quarterly report, over 70% of Anworth’s investments were in agency MBS.

By several metrics, Anworth’s stock looks cheap. The company’s price to book ratio on August 13th was 63%. This means each share of the company’s stock is trading at $1.81 corresponding to around $2.85 of the company’s equity. Anworth also has a dividend yield of around 11%.

Anworth is cheap because of the COVID-19 pandemic. Many of the mortgages the company is invested in may default due to the crisis. The fear of default caused the company’s investments to decline sharply in value in the first quarter of 2020. This led to a decline in equity, or book value, of $1.91 per share. This was about a third of the company’s equity, meaning that shareholders had a third of their underlying investment wiped out.

That said, today, the company seems to be weathering the situation. The company’s book value recovered by $0.16 per share in the second quarter of 2020. Anworth also sold off a large portion of its investments in the first half of 2020. This reduced the company’s borrowings and thus its risk. Anworth is now borrowing $4.10 for every dollar of its capital, compared to $6.10 at the end of the first quarter of 2020.

It is still hard to say how COVID-19 will affect the residential mortgage market. According to an August 2020 report, mortgage delinquency rates have more than doubled from May 2019. According to the company’s most recent earnings call, payments on its non-agency MBS investments have gone down by 20%, primarily due to the mortgage forbearances many lenders are offering customers.

That said, non-agency MBS are only a small part of the company’s investments. As mentioned above, over 70% of the company’s investments are guaranteed by Fannie Mae and Freddie Mac, which means they are shielded from losses on the underlying mortgages.

Another 14.6 of the company’s investments are “residential mortgage loans held-for-investment through consolidated securitization trusts.” These loans are funded through non-recourse financing, meaning that the company is not obliged to pay back the debt used to buy these mortgages if they go bad. Additionally, the performance on these mortgages has been quite strong:

Source: Anworth Mortgage Asset Corporation Q2 2020 10-Q

As can be seen above, only around 1.5% of the principal of these loans is delinquent, much lower than the national average.

In this context, there is some room for optimism for the future of Anworth Mortgage Asset Corporation. A significant majority of the company’s investments are shielded from losses by a government guarantee. A large portion of the rest of those investments are performing much more strongly than the overall mortgage market. If Anworth can weather the current crisis, the company’s stock might be a bargain.

If the company’s stock is a bargain, though, it is necessary to consider what type of bargain it is. As I wrote in my recent article about Prospect Capital (PSEC), downturns offer two common types of opportunities for investors:

  1. High quality companies trading at a modest discount from normal prices.
  2. More average companies trading at a much larger discount to their intrinsic value.

Average companies trading at a significant discount often offer the highest immediate returns after a crisis. After all, a company trading at a small fraction of its intrinsic value can double, triple, or more an investor’s money in the short run. All that is necessary is for the crisis to end and for valuations to return to normal. This often takes only a couple of years.

However, in the long run, high quality companies compound an investor’s capital far more than average ones. This is true even when those high quality companies are purchased at more expensive valuations.

In that context, Anworth’s cheapness raises a question. Is it a high quality company I can “buy and hold” forever while it compounds my investment?

Or is it an average company? An average company, bought cheaply, might rise quickly in price in the first few years after a crisis. However, I would probably need to sell it once it reaches a more normal valuation. This is because, at that point, it would be unlikely to go up further due to a change in valuation. It would also only be compounding my capital at an average rate. Thus, I’d want to sell and look for better opportunities.

This need to sell creates risks. It creates a timing risk since I might sell at the wrong time. It also creates reinvestment risk since I’d need to find a new investment after selling. By that point, valuations would be higher. Thus, there’d be a higher chance I’d pick a bad investment and lose money.

Thus, it’s much better to invest in high quality companies that can be held for a long time while they create value.

To see if Anworth Mortgage Asset Corporation is a high quality company, we can use the same methodology I used in that article about Prospect Capital. We can look at how much value the company has created for shareholders since its 1998 IPO. This will help us predict the company’s future value creation, and thus the company’s possibilities for future share price growth and dividends.

How Does a REIT Create Value for Shareholders?

There are two ways an investment company like a REIT creates value for shareholders:

  1. Increasing equity (book value) per share.
  2. Paying dividends.

This is because an investment company’s earnings power is directly tied to its equity, or book value. Each extra dollar of book value usually means several extra dollars of assets for the company. This is because each dollar of book value lets the company borrow several dollars to buy additional assets. Those assets, specifically mortgages or MBS in Anworth’s case, can generate earnings. Thus, an increase in equity means an increase in earnings power. A company’s value comes from its earning power. Growth in equity, or book value, per share, thus logically represents growth in earnings power per share, and thus growth in value per share.

In addition to growing book value per share, an investment company like Anworth can create value for shareholders by paying dividends. Paying dividends doesn’t increase a company’s value. It does, however, represent value generated by the company that is transferred to shareholders.

Book Value Per Share Growth

We can calculate Anworth Mortgage’s annual growth in book value per share since it first sold shares to the public in its initial public offering, or IPO.

That IPO was in March 1998. According to Anworth’s first ever quarterly report, the company’s equity (book value) was $17.9 million at the end of March 1998. The company had 2.2 million shares outstanding, resulting in a book value per share of $8.15.

The company’s latest book value per share at the end of June 2020, 22.25 years later, was $2.85 according to the most recent quarterly report.

Source: Moneychimp Return Rate Calculator

This means the company’s book value per share fell an average of 4.61 percent per year in the 22.25 years after its IPO.

At this point, some readers may question the value of looking all the way back to 1998 in calculating Anworth’s value creation for shareholders. After all, much has happened since then. However, the company has had a continuity in its leadership since its IPO. The Chairman of the Board and President at that time, Lloyd McAdams, is still a company director and owns 47.4% of the company that manages Anworth. His son, Joseph E. McAdams, is the CEO and owns another 47.4% of that management company.

For Anworth’s entire history since its IPO, the same people have been in charge. The company’s strategy – investing in mortgages and mortgage-backed securities – has also been the same. Thus, it seems reasonable to evaluate the company’s entire history to understand its ability to generate value for shareholders.

Dividends

Anworth Mortgage’s dividends since its IPO are below:

Fiscal Year

Dividends Per Share

1998

$0.37

1999

$0.53

2000

$0.51

2001

$1.53

2002

$2.00

2003

$1.56

2004

$1.25

2005

$0.55

2006

$0.08

2007

$0.27

2008

$1.00

2009

$1.18

2010

$0.97

2011

$0.94

2012

$0.69

2013

$0.50

2014

$0.56

2015

$0.60

2016

$0.60

2017

$0.60

2018

$0.56

2019

$0.43

2020

$0.10

Total

$17.38

Per Year

$0.78

Per Year Yield on IPO Book Value

9.58%

Source: Anworth Mortgage Asset Corporation 2000 10-K, 2002 10-K, 2004 10-K, TIKR

At its IPO, Anworth Mortgage’s book value was $8.15 per share. Since then, the company has distributed $0.78 per share in dividends on average each year. For each dollar of the company’s IPO book value per share, the company generated an average dividend of 9.58 cents per year.

I think this “yield on book value” is better than the usual dividend yield in calculating Anworth’s dividend generating power. Dividend yield is a percentage of a company’s share price, which is largely outside management’s control, at least in the short term.

In contrast, yield on book value is a percentage of book value. It represents how much in dividends each dollar of that book value generates. This is something management is responsible for maximizing. In that context, I use yield on IPO book value to measure Anworth’s average annual dividend generating power since its IPO. I think this is a good measure of the company’s ability to create shareholder value through dividends.

Additionally, we previously measured the annual change in Anworth Mortgage’s value per share as a percentage of its book value per share. By also calculating the company’s yield as a percentage of book value per share, we can add the two to get the company’s total annual value creation since its IPO.

How Much Value Has Anworth Mortgage Created for Shareholders Since Its IPO, and How Does It Compare to the Market?

Adding up Anworth Mortgage’s two forms of value creation gives this result:

Value Created by Anworth Mortgage Since Its IPO

Average Annual Book Value Per Share Change

-4.61%

Average Annual Yield on Book Value Per Share

9.58%

Total (Annual Value Creation Per Share)

4.97%

4.97% is our approximation for Anworth Mortgage’s average annual value creation for shareholders since its IPO.

I feel this method is a better measure of the company’s annual value creation than return on equity. This is because it is a per share value. That means it includes changes in the company’s share count due to repurchases and new share issues. As an REIT, Anworth Mortgage raises large amounts of capital through share issuances. According to the company’s most recent quarterly report, the company has raised almost $984 million in common equity capital in its lifetime. The company has also raised almost $115 million in preferred equity. Almost all of this has occurred since its IPO, which raised only $18.4 million. Because of that, it is important to calculate the company’s value creation with a metric that considers these large capital increases.

Slightly under 5% annual value creation is fairly modest. It is roughly equal to the annual total return of a conservative portfolio that was 40% stocks and 60% bonds between 1999 and 2018, a period that largely overlaps Anworth’s post-IPO history. It dramatically underperforms the total return of REITs over the same period, which was around 9.9% per year:

Source: Annualized Returns By Asset Class From 1999 – 2018

That said, this 4.97% calculation is based on Anworth Mortgage’s book value at the end of June 2020, which means it takes into account the COVID-19 crisis. The comparison period does not.

If we calculate the company’s annual book value per share change based on asset values at the end of 2019, before the COVID-19 market collapse, the picture is more flattering. Anworth Capital’s book value per share at the end of December 2019, according to its 2019 annual report, was $4.60. This translates to a 2.01% higher average annual book value per share change:

Source: Moneychimp Return Rate Calculator

Recalculating Anworth’s annual yield on book value per share to exclude the first six months of 2020 gives a yield of 9.75%. Adding that to -2.60% gives an average annual value creation of 7.15%. This does significantly outperform the stock and stock/bond portfolios shown above. However, it still significantly underperforms REITs as an asset class.

These comparisons are inexact. For one thing, they compare the change in Anworth’s value as a company to the change in the price of various portfolios. As value investors know, the price of an investment can diverge drastically from its value.

That said, they do generally point to the same conclusion. If one takes into account the current crisis, Anworth Mortgage’s value creation since its IPO has been fairly average. If one does not, then the company’s value creation is somewhat better, but is still below the average total return for an REIT portfolio.

How Much Value Might Anworth Mortgage Create for Shareholders Going Forward?

Since its IPO, Anworth Mortgage’s average annual value creation as a percentage of book value per share has been between 4.97% and 7.15%, depending on if you include the COVID-19 crisis. The company’s IPO book value per share was $8.15. Thus, the annual value creation was between 4.97% and 7.15% of $8.15, or between $0.41 and $0.58 per share.

Anworth Mortgage’s IPO price was $9.00 per share, according to its first quarterly report. The company’s IPO investors paid a premium over book value for shares. The $0.41 to $0.58 per share in value they have received on average each year since then has been 4.50% to 6.47% of what they paid. Their annual value increase was 0.47% to 0.68% less than what they would have received if they had not paid a premium to book value.

Today, Anworth Mortgage’s shares are not trading at a premium to book value. The company’s share price on August 13th, 2020 was $1.81. Its most recent book value per share was $2.85. This means the company’s shares are trading at a 36.5% discount to book value per share.

If the company can still generate an average return on book value per share of 4.97% going forward, its annual value creation will be $0.142 per share. This is because 4.97% of $2.85 is $0.142. By buying shares at a 36.5% discount to book value, investors can get an annual per share value increase of 7.83%. This is because $0.142 is 7.83% of $1.81.

If the company can still generate an average return on book value per share of 7.15% going forward, its annual value creation will be $0.204 per share. This is because 7.15% of $2.85 is $0.204. By buying shares at a 36.5% discount to book value, investors can get an annual per share value increase of 11.26%. This is because $0.204 is 11.26% of $1.81.

This latter value uses a historical rate of value generation that ignores the company’s losses from COVID. To use this rate, it is necessary to assume that Anworth’s losses from the COVID crisis aren’t predictive of future losses. I feel that to make this assumption, one of three facts must be true:

  1. Anworth’s losses from COVID are “paper losses,” meaning that the company’s true book value per share is significantly higher than its current book value per share. If that is true, then presumably the company’s stated book value per share will rebound as the market improves. This seems unlikely, given that the company realized many of its losses in March and April by selling assets at reduced prices. Also, there isn’t much room for the company’s assets to rebound in price, given that their prices have already increased significantly since the start of the crisis.
  2. There will not be another crisis like the current one in Anworth’s future, and thus it doesn’t make sense to use the losses Anworth has suffered in the current crisis to predict the company’s future returns. This also seems unlikely, given that this is the second mortgage market crisis Anworth has experienced in 12 years, which implies there will inevitably another one sooner or later.
  3. Anworth will manage the next crisis better than this one, and thus the losses from this crisis aren’t predictive of the losses in the next crisis. That is possible. In the Great Recession, Anworth’s book value per share actually rose from $6.15 at the end of 2007 to $7.40 at the end of 2009.

Thus, if one of these things proves to be true, Anworth’s long-term rate of value creation based on its book value per share may be closer to 7.15%. Otherwise, it will probably be closer to 4.97%.

Conclusions

We have calculated that Anworth Mortgage Asset Corporation has created value for shareholders since its IPO at an annual rate of 4.97% to 7.15% of book value per share. If the company continues creating value at the same rate, buyers today might anticipate yearly value creation of around 8 to 11 percent of the current share price. This value creation is driven by future dividends, offset by a likely fall in book value per share.

This yearly value creation is not a prediction of how the company’s stock price will change. The company’s stock price could rise much faster than 11% per year, at least for a year or two. This might happen if the company’s valuation returns to what it was before the downturn. The company was trading at 0.76 times book value at the end of 2019. It is trading at 0.63 times book value today. Returning to the earlier valuation would mean an increase in the company’s share price of over 20%. Given the volatility of the markets, such an increase could happen quickly and without warning.

Of course, this estimated value creation assumes Anworth Mortgage can pay dividends as it has in the past. It also assumes the company’s most recently stated book value is its true book value. The true book value could be lower if the company’s assets are less valuable than their listed value. This would mean a reduction in the company’s book value, and thus its ability to create value.

On the other hand, the company’s true book value could be significantly higher than what is currently stated. As mentioned above, this is fairly unlikely, given that prices for mortgages and mortgage-backed securities have recovered significantly since the start of the crisis. That said, on Anworth’s most recent earnings call, one of the company’s portfolio managers noted that interest rate spreads for the company’s investments are still “not [at] the same tight levels as [they] were at previously.” Thus, there is still room for asset values to increase, thus increasing the company’s book value per share.

Regardless, the company’s ability to create value for shareholders is probably between 5 and 7 percent a year. This is acceptable, but not extraordinary. In his 2010 letter (PDF) to Berkshire Hathaway (BRK.A) (BRK.B) shareholders, Warren Buffett described what a good return on net tangible assets might be. Return on net tangible assets is a similar measure to return on book value. Buffett said “good returns” on net tangible assets are “in the area of 12-20%.”

In that context, Anworth Mortgage’s 5 to 7 percent average return on book value per share does not make it a particularly good business. We discussed two types of companies at the start of this article. Of those types, Anworth is much more likely to be an average company trading at a discount to intrinsic value. It is much less likely to be a high quality compounder.

That said, the company could still be a good investment, especially for an investor looking for yield. Though Anworth Mortgage only creates value at an average rate of 5 to 7 percent a year, it pays out all that value (and more) as dividends. This results in a dividend yield higher than the stock market’s long-term average return. Moreover, since the company is trading below book value right now, an investor gets an especially high yield. That said, for me personally, I’m looking for more in my investments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The content here is not meant as investment advice. Do not rely on it in making an investment decision. Do your own research. The content here reflects only the author’s opinions. Those opinions might be wrong. This content is meant solely for the entertainment of the reader and its author.

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