You can be a Crony Capitalist
Patrick is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Newcastle Investment Corp. (NYSE: NCT) is a real estate investment trust that, like its more famous cousins Annaly Capital Management, Inc. (NYSE: NLY) and Chimera Investment (NYSE: CIM), makes some good money by dealing in various ways with residential mortgages. In addition, it is still mostly under investors' radar screen, with only three analysts providing coverage and relatively low institutional ownership. Does that explain Newcastle's low P/E, and does Newcastle therefore represent a bargain-priced investment opportunity? Consider the following table:
As my regular readers know, I believe that a dividend is an investor's best friend, so this group of stocks was bound to attract my attention. Unlike Annaly and Chimera, Newcastle's dividend is sustainable, grow-able, with a payout ratio of only 13% and an extremely healthy profit margin of 72%. With payout rations of greater than 100% (much greater, in Annaly's case), the dividends of the other companies probably will not last. Indeed, it seems likely that the only thing holding Annaly's and Chimera's stock prices up is their book value.
Newcastle's price/book ratio is no doubt so out of line with its fellows because of it's aggressive use of leverage. Looking at the balance sheet from its latest annual report, I calculate a debt/equity ratio of about 25. The current D/E, as shown on Fool.com, is about 19, no doubt reflecting the recent secondary stock offering. This shows that Newcastle is able to raise money despite its debt. What's more, I think it sets a reasonable floor under the stock price, in that Citigroup and Credit Suisse bought big blocks at about $6.22/share.
Newcastle holds a clear advantage in price/earnings, and price/cash flow. And it's got a massive profit margin. Good companies on the cheap, that's what we're after, right? But why is it so cheap? Back to the annual report, under Risk Factors:
"We do not know what impact the Dodd-Frank Act will have on our business... We do not know what impact certain U.S. government programs intended to stabilize the economy and the financial markets will have on our business... Legislation that permits modifications to the terms of outstanding loans has negatively affected our business, financial condition and results of operations."
Part of Newcastle's success has been its small size, its nimbleness, its immunity to some of the regulations weighing on its bigger competitors. On the other hand, many of the regulations have not yet been written, and will be the product of bureaucrats, not Congress (but that's a rant for another day). It's hard to play by the rules if you don't know what the rules are, or what the penalties might be. In a sense, a bet on Newcastle is a bet on politics, a bet on the current election cycle, and requires the assumption that a new administration would actually do something (another rant, another day).
"There are conflicts of interest in our relationship with our manager... We may change our investment strategy without stockholder consent, which may result in our making investments that entail more risk than our current investments."
Whoa, those are some big risks! Newcastle is a company of one person, CEO Kenneth M. Riis. Other employees are his employees, not the company's. What's more, those employees are also the company directors! That's right, the people that are supposed to represent the stockholders' interest are dependent on the man that they're supposed to be watching. Yes, the rules at Newcastle could change at any time, the board won't say "boo", and you won't know until you next get a quote on NCT.
That being said, I have no reason to think that Mr. Riis is planning anything untoward. He has a long history in this business, and tangled business relationships are part of this game. That's crony capitalism. He's moved up because of his long history, because big money knows him. Kudos to Newcastle for at least spelling it out so clearly in their report. And how often do you get to play the same game as the underwriters at Citigroup and Credit Suisse? Besides them, Mr. Riis and his directors hold sizable positions, so while the risk is there, it doesn't seem likely to be realized any time soon. Still, if you invest in Newcastle, keep an eye on the political situation, and insider holdings.
SlowThought has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. 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. If you have questions about this post or the Fool’s blog network, click here for information.