Dynex Capital’s Historical Value Creation May Offer Insights Into Its Future Returns (NYSE:DX)

Dynex Capital, Inc. (DX) is a mortgage real estate investment trust, or mREIT. The company invests in mortgage-backed securities, or MBS, securities whose income is based on the performance of pools of mortgages. Those securities include both residential mortgage backed securities, or RMBS, backed by residential mortgages, as well as commercial mortgage backed securities, or CMBS, backed by commercial mortgages. As of the end of June 2020, 97% of Dynex’s MBS investments were protected from principal loss by Fannie Mae (OTC:FDDXD) and Freddie Mac (OTCQB:FMCC).

I’ve written two recent articles about mREITs Ladder Capital (LADR) and Anworth Mortgage (ANH). Both those articles were written because those mREITs look cheap. The companies trade at steep discounts to their book values and have high dividend yields.

Dynex Capital does not look cheap. The company trades at a price to book ratio of 94%. In contrast, Anworth and Ladder have, respectively, P/B ratios a little over 60%. This means each dollar of their stock buys far more of the book value, or equity, of those companies. Those companies also have double digit dividend yields compared to Dynex’s yield of around 8%.

That said, as in life, in investing you often get what you pay for. In several recent articles, I’ve described two common types of investment opportunities:

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

Average companies trading at a large discount often offer the highest immediate returns. 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 whatever is causing the undervaluation to end and for valuations to return to normal. This often takes only a couple of years.

In the long run, though, 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, I want to see if Dynex might be one of those high quality companies. The market certainly seems to think it is a higher quality company than other mortgage REITs, given how much higher its valuation is.

To see if Dynex Capital is a high quality company, we can use the methodology I used in my previous mREIT articles. We can look at how much value the company has historically created for shareholders. 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 an REIT Create Value for Shareholders?

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

  1. Increase equity (book value) per share.
  2. Pay 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 lets the company borrow several dollars to buy additional assets. Those assets, specifically MBS in Dynex’s case, have the power to generate earnings. Thus, an increase in book value means an increase in earnings power. A company’s value comes from its earning power. Growth in book value per share thus 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 Dynex can create value for shareholders by paying dividends. Dividends don’t increase a company’s value. They do, however, increase the value owned by shareholders by transferring value generated by the company to them.

Book Value Per Share Growth

In my recent articles, I’ve looked at REITs’ change in book value per share since their IPOs. For Dynex, though, I’ll only look at the company’s book value change since 2008.

This is because Dynex’s business model changed dramatically at the start of 2008. Between 1992 and 1998, Dynex was a mortgage originator. This caused large losses for Dynex in 1999 and 2000, which led the company to stop originating mortgages. Due to those losses, the company spent the next few years managing its existing investments and did not make any new investments until February 2008. For the same reason, the company also did not pay any dividends on its common stock between 1999 and 2008.

In 2008, the company began investing almost entirely in mortgage backed securities, especially securities backed by Fannie and Freddie. This has been the company’s focus ever since. Since Dynex has only engaged in its current line of business since 2008, it makes sense to look at the company’s book value change since then to estimate its future value creation.

Dynex views its history the same way. The company’s most recent earnings presentation showed its total return from January 1st, 2008 to June 30th, 2020 to emphasize the strong results of its current line of business. Perhaps not coincidentally, this period also roughly represents the time Dynex’s current CEO, Byron Boston, has been a leader of the company. Boston became Chief Investment Officer in April 2008, presumably after being hired to manage the company’s new strategy, before becoming CEO in 2012.

Dynex’s book value per share on December 31st, 2007, shortly before the company began its current business strategy and its current CEO joined the company, was $24.66 (adjusted for its 1 for 3 stock split in June 2019), according to the company’s 2007 10-K annual filing.

Source: Moneychimp Return Rate Calculator

Since the company’s most recent book value per share was $16.69, that means book value per share has fallen by an average of 3.07% per year since then.

Dividends

Dynex Capital’s dividends over that same period are below:

Fiscal Year

Dividends Per Share

2008

$2.13

2009

$2.76

2010

$2.94

2011

$3.27

2012

$3.45

2013

$3.36

2014

$3.00

2015

$2.88

2016

$2.52

2017

$2.16

2018

$2.16

2019

$2.01

2020

$0.88

Total

$33.52

Per Year

$2.68

Per Year Yield on Book Value Per Share

10.87%

Source: TIKR

At the end of 2007, right before it began its current business strategy, Dynex Capital’s book value was $24.66 per share. Since then, the company has distributed $2.68 per share in dividends on average each year (again, adjusted for the June 2019 1 for 3 stock split). For each dollar of the company’s book value per share at the end of 2007, the company generated an average dividend of 10.87 cents per year.

I think this “yield on book value” is better than the usual dividend yield in calculating Dynex’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. Because of that, I use yield on book value to measure the average annual dividend generating power of Dynex’s current strategy. I think it is a good measure of the company’s ability to generate shareholder value through dividends.

Additionally, we previously measured the annual change in Dynex’s book value per share as a percentage of its 2008 book value per share. By also calculating the company’s yield as a percentage of 2008 book value per share, we can add the two to get the company’s total annual value creation under its current strategy since 2008.

How Much Value Has Dynex Capital Created for Shareholders, and How Does It Compare to the Market?

Adding up Dynex Capital’s two forms of value creation gives this result:

Value Created by Dynex Capital Since 2008

Average Annual Book Value Per Share Change

-3.07%

Average Annual Yield on Book Value Per Share

10.87%

Total (Annual Value Creation Per Share)

7.80%

7.80% is our approximation of Dynex Capital’s average annual shareholder value creation under its current leadership and with its current strategy.

I feel this is a better measure of the company’s annual value creation than return on equity. This is because it is a per share value. Thus, it takes into account changes to the company’s share count due to repurchases and new share issues. As an REIT, Dynex Capital raises large amounts of capital through share issuances. Between the end of 2007 and June 2020, the company’s additional paid-in capital rose from around $367 million to over $858 million. This increase of around $491 million was equal to around 87% of the company’s total equity at the end of June 2020. Because the company’s share issuances have had such a large impact, it is important to calculate the company’s value creation with a metric that considers these issuances.

An annual value creation of 7.80% is reasonably strong. However, it underperforms the total return of the S&P 500 in the same period between December 2007 and June 2020. In that period, the S&P 500 had a total return, including dividends, of 8.35%, according to a S&P 500 return calculator. Dynex underperformed this by around 0.55%.

That said, this comparison is inexact. It compares the change in Dynex’s value as a company to the change in a stock portfolio’s price. As value investors know, an investment’s price often diverges drastically from its value. Still, I think this comparison is a useful benchmark for Dynex’s ability to generate value for shareholders compared to a diversified stock portfolio.

How Much Value Might Dynex Capital Create for Shareholders Going Forward?

Since it began its current strategy, Dynex Capital’s average annual value creation as a percentage of book value per share has been around 7.80%. The company’s book value per share when it began its current strategy was $24.66. Thus, the annual value creation was around 7.80% of $24.66, or around $1.92 per share.

Dynex Capital’s share price was $26.61 per share at the end of 2007, according to Marketwatch. The company’s investors at the time paid a premium over book value for shares. The $1.92 per share in value they have received on average each year since then has been 7.23% of what they paid. Their annual value increase was about 0.57% less than what they would have received if they had not paid a premium to book value.

Today, Dynex’s shares are not trading at a premium to book value. The company’s share price on August 21st, 2020 was $15.76. Its most recent book value per share was $16.69. This means the company’s shares are trading at a 5.6% discount to book value per share.

If the company can still create value at an annual rate of 7.80% of book value per share going forward, its annual value creation will be around $1.30 per share. This is because 7.80% of $16.69 is around $1.30. By buying shares at a 5.6% discount to book value, investors can get an annual per share value increase of around 8.26%. This is because $1.30 is around 8.26% of $15.76.

Conclusions

We have calculated that with its current business strategy, Dynex Capital has created value for shareholders at an annual rate of about 7.80% 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 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 8% per year if the company’s valuation changes. That said, the company is trading at around the same valuation (about 94% of book value) as it was before the crisis. According to TIKR, the company has historically generally traded below book value. Because of that, it would be optimistic to hope the company’s share price will rise significantly due to a change in valuation. The price could even go down, especially if the market goes down or if the prospect for mortgage REITS worsens.

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, Dynex Capital’s 7 to 8 percent average return on book value per share is reasonable, but not extraordinary. We discussed two types of companies at the start of this article. Of those types, Dynex is much more likely to be an average company than a high quality compounder.

That said, Dynex could still be a good investment, especially for an investor focused on yield. Though the company creates value at an average rate of 7 to 8 percent a year, it pays out all that value (and more) as dividends. This creates a dividend yield higher than the stock market’s long term average return. Also, since the company is trading below book value right now, investors get an even higher yield. This may matter more to many investors than whether the company creates value at an extraordinary rate.

Moreover, Dynex’s ability to preserve capital during the current crisis has been “remarkable as compared to most of its peers,” according to Zain Zafar’s April 2020 article about the company. That article describes how the company took major steps to preserve its capital in February, when many of its peers were still downplaying the risk of COVID-19. As a result, the company’s book value fell by only around 11 percent in the first quarter of 2020, compared to 20, 30, or 40 percent or more for the company’s mREIT peers.

In that context, it is worth considering another of Buffett’s quotes-that “Rule No. 1” of investing is “Never lose money.” In the current crisis, Dynex has shown an ability to avoid losing money that its peers have not.

I personally am looking for higher returns in my investments. That said, if I were looking to invest in a mortgage REIT, Dynex would be high on my list of choices.

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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