REITS, also called mortgage trusts, were subject to special tax provision in America: if they distributed more than 95% of their income, they can do so free of income tax. This was largely unexploited until 1969 when they really started to take off. Recognising the boom/bust potential, in February 1970 Soros published a research report in which he said that the conventional method of security analysis should not apply to REITs:
‘The true attraction of mortgage trusts lies in their ability to generate capital gains for their shareholders by selling additional shares at a premium over book value. If a trust with a book value of $10 and a 12 per cent return on equity doubles its equity by selling additional shares at $20, the book value jumps to $13.33 and per share earnings go from $1.20 to $1.60.’ (‘The case for mortgage trusts’ research report, written by George Soros, February 1970)
Say there are 10 million shares to start:
Book value Dollar return Per-share earnings
Originally (10 million shares) $100m $12m $12m/10m = $1.20
New shares (5 million shares sold at $20 each) $100m $12m
Totals following new share issue $200m $24m $24m/15m = $1.60
Book value per share $200m/15m = $13.33
Why would investors be willing to pay above book value for new shares? Because of the high yield and the anticipation of per-share earnings growth. The more the premium goes up the easier it gets for the trust to fulfil this expectation.
The whole process is a self-reinforcing one. Once it is started, the trust can keep showing growth in eps despite distributing 95% of all its earnings as dividends. Those investors who buy into the process early enough gain the benefits of a high return on equity, a rising book value, and a rising premium over book value.
It was pointless trying to predict future earnings and (through discounting these) work out a price investors are willing to pay - the conventional approach - because the price investors are willing to pay also determines the future course of earnings. It is important to recognise the self-reinforcing nature of the process. Investors can only try to predict the future course of the entirely initially self-reinforcing but eventually self-defeating process.
He sketched out four stages to the drama that was to unfold over the forthcoming three years or more:
In 1970 there was pent-up demand for housing and new houses found ready buyers. Because of a shortage of funds going into housing companies and REITs, those that do get funding will achieve high returns. Also, suppliers (builders, labour and materials) are reliable and available in this slack time. Investors are starting to recognise the mortgage trust concept, permitting the creation of many more and the rapid expansion of existing ones. Thus the self-reinforcing process begins.
A housing boom begins and bank credit is available at advantageous rates. Mortgage trusts take on higher leverage. The premium of mortgage trusts’ share price over book value increases as investors anticipate high returns in………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Prof. Glen Arnold
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