What follows is a reprint of an article on Friedman, Billings, Ramsey Group (FBR $12) I penned for Canadian MoneySaver in May of 2004.
My, how times have changed. Since this was written, the stock price traded between $18 and $21, until it cratered to $12, starting in March 05.
In the Spring 05, FBR experienced a series of missteps and misfortunes – over spending on golf sponsorship, weak investment banking business, a rising interest rate environment, SEC investigations, and the resignation of one of its founders. Year-over-year quarterly earnings comparisons were devastating, driving its few followers to cry foul. Then, the talking heads took notice, and stirred up even more negative karma. Discussions of dividend cuts became the mantra of short sellers. Add this to high retail ownership (institutions own only 47% of outstanding shares), and it is easy to see why the stock may become a favorite “tax-loss sale” candidate come this winter.
Nonetheless, FBR offers an interesting structure for a corporation in some very complicated financial markets. Investment banking, along with money management, can be a very profitable business in times of underlying economic expansion. Mortgage-backed securities (MBS) are historically much more interest rate sensitive, but can provide consistent cash flow. However, most MBS firms are very susceptible to changes in the yield curve.
Keep in mind MBS represents only about 25% of FBR’s revenues: this company is mainly a capital markets underwriter, money manager, and merchant banker. Using the tax advantages of a REIT structure due to its MBS exposure should be viewed as a huge prospective advantage to investors seeking income. Wrapping the REIT investment structure around the potential long-term cash flow growth of its non-MBS business, in my opinion, is brilliant.
FBR takes a niche approach to its businesses and focuses it efforts on a few markets. Within their targeted markets, FBR has developed a good track record. In addition, I think FBR has maintained one of the more conservative approaches to MBS investing with short-term, variable rate, and US government guaranteed assets. Its recent acquisition of sub-prime mortgage interests, however, has raised some concern, especially in the face of rising interest rates and potential economic slowdown.
Long-term, I believe FBR may provide an interesting opportunity to reinvest, or collect, a nice dividend as the company recovers from its troubles of early 05. FBR’s missteps and the shrinking MBS yield spreads are not insurmountable, and FBR’s business fundamentals are improving. As a “retail stock” with below-average institutional ownership, FBR stock price may continue to be volatile for the next few quarters. As year-over-year earnings growth takes hold once again, retail investors should return, but at a higher valuation.
In the course of conducting your due diligence, I suggest reading the article below and investing the time to update the information using the most recent quarterly press releases. This exercise should assist you in better understanding FBR and its potential opportunity.
Friedman, Billings, Ramsey – A Financial Services REIT
May 11, 2004
George C. Fisher
Friedman, Billings, Ramsey Group (FBR $18) is an intriguing company with a shareholder-friendly corporate structure. FBR is a financial services firm providing investment banking, institutional and on-line brokerage, asset management, private client services, and the company invests in mortgage-backed securities. FBR concentrates on research and investment banking in six major economic sectors: consumer, financial services, real estate, technology, health care, energy and diversified industries. FBR is divided along operating businesses: Capital Markets Group, Asset Management Group, Merchant Banking Group, and Mortgage-Backed Securities Group. In 2003, revenues totaled $628 million and FBR earned $1.63 per share.
In 2001, the US Congress eased requirements to qualify as a real estate investment trust (REIT) and allowed for the establishment of non-real estate REIT subsidiaries. FBR has taken advantage of this change by structuring their company as a mortgage-backed securities REIT with subsidiaries for their financial services operations. Prior to 2003, Friedman, Billings, Ramsey Group operated as a REIT structure for the mortgage-backed securities business and a separate non-REIT company for the balance. In March 2003, FBR merged its operating units into one corporate entity and utilizes the tax-advantages of a REIT structure for all its business. The REIT structure is unique for an investment banking company.
Capital Markets - 41 percent of 2003 revenues
FRB is a major player in the IPO and secondary offering underwriting business. In 2003, FBR was ranked 3rd by dollar volume in lead management of IPOs and 10thby dollar volume in lead management for all public equity offerings. FBR ranked 1st in 2003 for investment performance of their IPOs over a 1-, 3-, and 5-year periods. In addition, FBR raised approximately $2.5 billion in equity from institutional private placements. As of the end of 2003, FBR had a pipeline of business valued over $5 billion for lead managed equity capital placements, and merger and acquisition transactions. In 2003, investment banking revenues totaled $278.6 million versus $143.9 million in 2002. FBR’s institutional brokerage and investment research revenues totaled $74.1 million during 2003, an increase of 17 percent. Institutional trading volume increased by 32 percent. Historically, FBR has focused on small and mid-cap stock offerings and research. However, in response to client’s needs, institutional research is beginning to become involved in larger capitalization companies as well. FBR also offers a low-cost Internet based brokerage service for retail investors.
Mortgage-Backed Securities – 24 percent of 2003 revenues
Of interest to many investors is their mortgage-backed securities (MBS) business. FBR’s approach to investing in MBS is tailored to low risk. The company historically buys US agency-backed securities from Fannie Mae, Freddie Mac, or Ginnie Mae, which do not carry the risk of borrower default, and securities with short effective durations remaining. In addition, FBR historically purchases variable rate mortgages. As of Dec 2003, FBR owned $10.6 billion in MBS, with an average mortgage life remaining of 2.0 years and, after anticipated early prepayments, an estimated effective duration of 0.96 years. The yield to FBR on this portfolio is 4.0%. FBR carries repurchase and short-term commercial paper debt of $9.5 billion to finance their portfolio, with a weighted average interest rate at the end of 2003 of 1.27% and average duration of 152 days. This calculates to an effective overall portfolio yield spread of 2.8%
Merchant Banking – 25 percent of 2003 revenues
FRB offers merchant banking services to small and mid size companies. Merchant banking services usually include financing for private companies and purchasing of private placement secondary stock offerings. Structured as corporate debt and equity, FBR has developed a portfolio of merchant banking and long-term investments totally $379 million.
Asset Management – 10 percent of 2003 revenues
One area of potential growth is asset management services. In 2003, net assets under management increased to $2.1 billion from $1.5 billion at the end of 2002, a 34 percent increase. Total base and incentive fees increased by 47 percent to $30.6 million. As with all money managers, growth in assets under management will generate higher management fees and profitability as fixed overhead is spread out over more assets. FBR has offered hedge funds and alternative asset management products since 1989. In 1996, the company began offering a family of no-load open-end mutual funds and currently offers: FBR Large Cap Financial Fund (FBRFX), FBR Small Cap Financial Fund (FBRSX), FBR Small Cap Value Fund (FBRVX), FBR Large Cap Technology Fund (FBRTX), FBR Small Cap Technology Fund (FBRCX), and FBR American Gas Index Fund (FBRFX). Annual management fees for their asset management business range for 0.75 percent to 2.5 percent, depending on the fund. In addition, some hedge and private client funds include performance bonuses based on achieving specific benchmarks.
As a REIT structure, FBR is required to distribute 90 percent of taxable income to shareholders. In their 2003 Annual Report, management’s stated long-term goal is to distribute 100% of taxable income. In 2003, FBR earned $1.63 per share and paid out $1.36 in dividends. In 2004, FBR is anticipated to earn around $2.25, and in 2005 could earn at least $2.20 per share. Based on the 2003 payout ratio, dividends could grow to an annual rate of at least $1.86 per share.
The stock price had a great run since its merger in 2003, rising from a post-merger low of $17 to a high of $27. In the low-interest rate environment of 2003, most MBS companies performed well. What interests me is management’s low-risk approach to MBS investing. While other MBS stocks may be anticipated to falter when interest rates climb as the market value of their portfolio decreases and the prospects of defaults grow, FBR has insulated their portfolio using agency-backed, short duration and variable rate mortgages. In addition, MBS represents only about one quarter of FBR’s total revenues. As shown by the current stock market weakness of interest sensitive investments leading up to inevitable interest rate increases, FBR may offer an interesting income selection over the next few years.
I bought 200 shares in January and added to my position in March of 2004. I like the potential growth of the investment banking and asset management business, added to the low risk approach to MBS. An added bonus is the high distribution of profits to shareholders. I am not expecting stellar earnings growth, but rather seek steady dividends in the future. The opportunity to reinvest a current yield of 7.0%, and the potential for a dividend increase, satisfies my need for long-term income. FBR offers a dividend reinvestment program through American Stock Transfer administrator, but investors need to first purchase a minimum share and take delivery of share certificates to enroll in the dividend reinvestment program.
Friedman, Billings, Ramsey Group does not have a large following on Wall Street, yet. As with all investments, it is important that you conduct your own research and due diligence to determine if a specific investment fits your portfolio risk levels.
George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.