ARMOUR Residential REIT Inc. (NYSE:ARR) is a residential mortgage company that invests in hybrid adjustable rate, adjustable rate and fixed rate mortgage backed securities. I am bullish on the company because it offers a significant potential for price appreciation, as it is trading at a significant discount to its book value. Also, the company continues to offer a healthy dividend yield of 14.74%. So, I believe ARR presents a good buying opportunity as the price has bottomed out.
The company has been historically trading at a premium to its book value, as shown in the figure above. Currently, it is trading at a P/BV of 0.701x, which is way lower than its peer companies, which means we can expect significant price appreciation. The company has been reducing its portfolio duration by selling off 30-year MBS and by increasing the exposure of 15-year MBS, which reduces its portfolio duration and reduces its interest rate risk. So, a rising interest rate will have a minimum impact on the company’s book value. My price target is based on 0.90Xbvps, which comes out to be around $5.22 with a price appreciation of 28.2%.
Also, ARR offers an attractive dividend yield, which provides a compelling total return of 42%.The management is expected to keep dividends at $0.05 per month for 2014. Another encouraging sign for investors is that the company is also repurchasing its shares, as it has been authorized to repurchase $80 billion worth of shares as of Sept. 30, which means that the management also confirms that the shares are undervalued.
The Fed is meeting again now to decide whether it should continue to taper or not. Once again they are facing mixed results, as the unemployment rate fell to 6.7% in December 2013. However, the labor force participation rate fell to 62.8% from 63%. It also failed to meet expectations of 197,000, as only 74,000 jobs were added in a month. I think the Fed will continue to cut down on its asset purchases because the disruption in the job data was mainly due to severe weather conditions in December, and the numbers are expected to rebound as the weather eases up.
There are two reasons why tapering should not be a serious concern for investors. Firstly, a gradual cut down on asset purchases will bring certainty to mortgage REIT companies. It will result in an increase in interest rates and deterioration of book values. But the decline in book values will be more manageable as the market has already overcompensated in the last year. Also, companies could shape up their portfolios accordingly. Second, in the past, mortgage REITs have managed to perform well in rising interest rate scenarios in a growing economy, and the Fed has made it clear that its support will only end if the economy continues to show positive trends.
The Fed has also given some targets before it makes changes to short-term interest rates, which include bringing the unemployment rate to 6.5% and inflation to 2.0%. But Bernanke has made it clear that these are not triggers; rather they are guidelines for the future. I believe that the Fed will wait to complete the cut down on monthly asset purchases before making any decision on short term interest rates. So, I believe 2014 will paint an encouraging outlook for mortgage REIT companies.
There are some risks as the company has been funding its long term assets with a short-term repo agreement, so volatility in short-term rates could cause liquidity problems. Another important risk is the rapid rise in interest rates, which will shrink the company’s book value.
I believe that if investors are willing to take the exposure in mortgage REITs, then ARR presents an excellent opportunity. It is currently trading at the bottom end of the 52-week range and at a significant discount to its book value, which means that it presents a significant upside potential. Furthermore, the interest rate environment seems to be very stable and certain, so I expect book values will remain stable and hence will positively impact the bottom line of the company.