Keep It Simple, Buy Apple and Google

I tend to write about smallish and mediocre companies on this blog, but those are just a portion of my portfolio. In fact, about half of my portfolio are highly liquid large caps that I consider high quality and intend to hold over the long run.

The problem with this mixed approach of "cigar butt" versus quality at fair price is I end up spending most of my time on the former. Built to last companies just don't require as much attention as risky ones. When I buy a "quality" company my intention is to let it cruise along, check in once in a while to see if the thesis still holds, and perhaps add on the dips. This has all worked out very well so far. The problem is there's a strong temptation to equate "large" with "safe", and perhaps run the risk of complacency. I hope writing this blog will help prevent that.

I'm under no illusions that I have any unique advantage when investing in these names. The thing is you don't always need an edge. Investing is not a zero sum game. Nor do you get points for creativity. I think some people read Joel Greenblatt and obsessively ask themselves "whats my edge? is this obscure enough?" But sometimes the crowd is right, and the best opportunities are the obvious ones. (more that here.)

With the market being volatile the past few months, I took the chance to get into Google and Apple at the lows. At today's prices (GOOGL at $565 and AAPL at $126), I would still buy them if not for the fact that they're already full sized positions.

Google

There's a decent chance this can double in 5 years. The way this works out, I think, is earnings double in 5 years (implying a a highly achievable 14% earnings CAGR). If earnings are still growing > 10% at the end of that period, then the market will put on a high P/E which doubles the share price.

For a company that grew its net revenue at 20% in 2014, Google is priced very reasonably, (I look at this in terms of GAAP earnings, and back out the value of net cash, which gets me to <20x 2016E earnings). This deal is available due to worries about what mobile means for Google. Google still makes most of its money from text searches, the fear is that with the world shifting toward mobile and "apps", Google's earnings growth will slow or even decline.

That seems exaggerated to me. Google owns Android and YouTube, so they do have a strong presence in mobile. Ok, they have not really monetize those two yet, but is it that hard to imagine they eventually will? Also, there are 2 trends that converges "mobile" together with traditional internet, where Google clearly dominates. One is that websites increasingly serve up the "mobile" versions, which are getting so sophisticated that there's no difference between normal internet site and an "app". Second, as phones get bigger and tablets more functional, there's less of a difference between the "mobile" world and the "desktop" world. In that sense cell phone, tablet, laptop...etc are all just screens where people interact with the internet.

In 2014, gross profit grew 20%+ while adjusted pretax profit was up only 11%. This is due to Google's high R&D and other investments. These are discretionary investments though. If they just keep expenses under control, they can easily "show" a much higher earning growth.

I'm no expert in tech, but Fred Wilson is. In this recent interview (around 37th minute), he was asked "Can YouTube be bigger than Google search?" to which he exclaimed "Yes! Easily!". Wilson also pointed out that Google's strength in data and the fact that it's still run by its founders.

Apple

For years I had a hard time getting comfortable with Apple. With technology changing so fast, I have no idea what products they will be selling in 10 years, so how can I put anything more than a 10x multiple on this? My thinking has changed into this: it doe not matter. Sure, eventually there is going to be tougher competition from Asia, but I just need to make sure 1) in the interim they will rake it in the next 2 years so that cash is worth something, 2) there are no close competitor in the upscale product /ecosystem / "fashion tech" segment.

Apple made an absurd $18bn in the quarter ending December 2014. In one quarter alone, they made more than the entire market value of some large cap companies! Surely this is peak earning, no? I think there could be more. Growth opportunity could come from 1) higher iPhone penetration in emerging market. Apple's market share in China was only 16% at Oct 2014. Could have doubled at this point, but certainly there's some room to run. Similar idea with France, Germany, Italy..etc. 2) the bigger iPhone 6+ has higher price points. 3) Apple Watch opens another revenue stream that could offset iPad weaknesses. 4) Upside options such as Apple Pay, partnership with IBM, healthcare initiatives could all work out. 5) Apple solidifies itself as a "fashion tech" brand and sells eye glasses, hats, or whatever to fanboys for $400 a pop.

What's the upside? Say earnings grow another 30% in a few years, put on a higher multiple and we could see 40-50% gain from the current price. There's a technical aspect that could accelerate the gains. With Apple being some 3.5% of the SP500, fund managers who are underweight Apple (and implicitly shorting it) could face a short squeeze, especially if iPhone 6 continues its spectacular run and Apple start doing some buybacks.

The downside is Apple Watch turns out to be a flop, which not only fails to replace iPad sales, but also disproves the "Apple as fashion/luxury tech" theory and demoralize Apple boosters. Also, if iPhone 6 sales stalls later this year, the market would reasserts that this is a cyclical business unworthy of a high multiple. This is not a stable buy and hold. The downside is real and I would have to risk manage this if prices fall below my cost basis.



Of the two, I like Google better and will allow it more time to play out.

Welling Holdings - Mediocre Business At A Great Price

Welling Holding Limited (382.HK) is a manufacturer of motors used in air-conditioners and washing machines. It has 4 manufacturing plants in China, including 3 around the Yangtze River Delta area, and one in Guangdong. In terms of revenue mix, roughly 60%/30%/10% of revenue in 2014 came from air-conditioning (A/C) motors, washing machine motors, and other products, respectively. Although Welling gets almost 40% of its revenue from white goods giant Midea (000333.SZ), it also has a diversified international customer base including Panasonic, Haier, LG, Indesit…etc. As of December 2014, Midea owned 68.7% of Welling.

What Caught My Attention, and Key Questions

What caught my attention? The company trade at about at eye popping 6x LTM P/E, yet it has solid free cash flows, ROIC > 20%, and little debt (in fact, a net cash position). Some cursory research showed that Welling is a global leader in its motor business (albeit a fragmented and commodity one). This is a small/micro-cap with little analyst coverage.

Stock has been beaten down since mid-2014 and approaching its 52 week low. When something trades this cheap, the natural questions are 1) if I’m looking at some peak, non-recurring earning? 2) earnings/cash flows are about to fall off a cliff? 3) the business is facing some existential issues?

After digging through the numbers and filings, my answers to the above questions are “no”, “possible but temporary in any case”, and “no”. The company actually looks ok. Now, the industry is facing some competitive headwinds due to price competition, but I would say this is more cyclical then structural.

Attractiveness of Business and End Market Outlook

I can understand why Welling is cheap (although not THIS cheap). Making motors used in A/C and washing machine is just not a great business. The end market is commoditized, so you got the usual problems of price competition, excess channel inventory…etc. Being a parts supplier is probably even tougher – Welling is steps removed from seeing end user demands, and market signals get through the value chain with some delays. In Welling’s 2014 earnings release, it alluded to some of the industry problems and adopted a negative tone for its 2015 prospects.

Over time though, it comes down to end market demands and industry structure. And it’s not all bad for Welling. It helps that main customer Midea is one of the top players in white goods (along with Gree and Haier). Here I did a quick run through of Welling’s 3 markets: residential A/C commercial A/C, and washing machines.

• Residential AC is the largest market segment here and has high penetration rate in urban areas, but low penetration in rural areas. Industry unit sales growth was 5% in 2014 (down from 7% in 2013). There’s currently a price war going on, with Gree doing some tough talk and signaling its resolve to retain market share. It seems to me the price war is due to excess inventory in the channels and slower housing market. Once that works though the next year or so, there should still be some runway for slower, but steady growth. The fact that Gree/Midea combines for 2/3 of the market makes it more likely to stabilize eventually. 

• Commercial A/C market is a growth area. Industry volume grew 12% in 2014 and is expected to continue in the next few years. It has a high presence of foreign players, while the Chinese 3 (Haier, Midea, Gree) only a combined 35% market share. In the next few years I can see Midea, and by extension Welling taking more market shares in a larger market. This is an opportunity.

• Washing machine competition is another weak spot, and possibly structural. This is under <30% of Welling’s revenue. Industry volume increased less than <1% in 2014. The sector already has a high penetration rate (98.0% in urban and 67.2% in rural in 2012, according to NBS) and suffers from fragmented competition. Amazingly, Welling’s revenues here actually increased 12% in 2014, mostly to higher prices. So perhaps they can mitigate some of the industry headwinds through higher value-added products. 

I would be more worried if this is a situation where the industry 1) is showing no growth and 2) suffers from highly fragmented competition. But that’s not the case for Welling’s sectors (with the exception of washing machines sector where Welling is actually doing fine). The current industry headwinds are real, but not insurmountable - China is still growing after all. Sure, 2015 could be an ugly, but longer term industry outlook and competitive structure is not awful. Looking out 2-5 yrs, Midea and Welling should be able to get through this and survive as one of the top players.

Other Reasons Why the Stock Is Cheap

• Relationship with Midea. If Midea starts feeling some price pressure, it may be tempted to force some price cuts from Welling. Keep in mind Midea does account for 40% of Welling’s business. Even if transactions between the 2 are true arms-length transactions, Welling would have very weak bargaining power and likely get stuck with disproportionate share of margin pressure.

• On the other hand, motors are a small part of the cost structure for A/C (average price for an A/C motors is 50-60 HKD, while an AC sells for as low as 2000RMB (~2500HKD)). Midea does not have strong incentive to cheat Welling above and beyond its normal share of pricing cuts.

• The other potential is if that relationship with Midea prevents Welling from getting other customers. Apparently this has not happened – for example Haier is a customer.

• Small size and lack of diversification

• Some better technology for motors could develop that eliminates the need for Welling’s products (or worse, make its plant investment obsolete)

• Threat of losing clients is a problem (perhaps due to their relationship with Midea)

• Lower cash flows in near term. Due to rising labor cost, Welling has plans to speed up capital expenditure and install more automation. This would depress cash flows in the next couple years

• Small market cap, no bulge bracket sell-side coverage. 

Upside

Despite all the issues listed above, at 6x P/E it’s not hard to see some upside. If this thing just plod along and survives, and earnings prove to be sustainable (say low single digit EPS growth next 5yrs), at some point this could get revalued to a modest 10x P/E. Johnson Electric (179.HK), another manufacturer of motors, trades at much higher valuations, but that is larger and more diversified so some discount is fair.

Give it a 2-3yr investment time frame, I can see 2017E EPS of 0.26 HKD per share * 10x P/E = 2.6/share. This would be a 70%+ return from today’s 1.47/share.

There’s a high probability this could work out. Survival should not be a problem given Welling’s low debt levels. Low single digit EPS growth is also realistic, as management’s target of 10bn RMB in sales by 2017 would imply 10% revenue CAGR.

Establishing a Position

There is no hurry to establish a full position. There are no near term catalyst and 1H15 could get ugly. Ideally you want the bad news to flush through first.

I got in with a starter position after the full year 2014 earnings came out and stock gapped downward. I want to see how the market reacts after 1H15 before making this a bigger position. The current trading price of 1.47 /share is not that far from the 52 week low of 1.3, a major support level for the past 2 years. If it breaks to say 1.28 (a 12% drop from current price), then I would stop out and wait for another entry point. For a 2% position that's a max loss of ~25bps to the portfolio.

Soros versus Buffett on Working

From Soros on Soros:

"Generally, we followed the principle of investing first and investigating later. I did the investing and he (Jim Rogers) did the investigating"

 "...But I don't like working. I do the absolute minimum that is necessary to reach a decision. There are many people who love working. They amass an inordinate amount of information, much more than is necessary to reach a conclusion, and they become attached to a certain investment because they know them intimately. I am different.  I concentrate on the essentials. When I have to, i work furiously because i'm furious that i have to work.  When I don't have to, I don't work."

I find these quotes interesting, and a bit surprising. Now contrast the above with Munger's description of Buffett's job as the chairman of Berkshire Hathaway. This is from Berkshire's 2014 report.

"His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became."

The Munger/Buffett idea of investing is what I imagine great investors do. It is what attracted me to investing in the first place, and what I aspire to do. Nonetheless, the 2 approaches are not mutually exclusive and Soros' does have some advantages:

1. Invest first and investigate later. Actually, Buffett's value investing classmate Walter Schloss does this too. He would have a smallish starter position just to get the work going. 
2. Not spending too much time on a specific name - at least in the initial cut - could help you avoid being "married to an idea".  But then again, Buffett's idea of investing IS to be married to the company forever. 
3. Accumulating information. I believe Buffett's reading activities, while surely targeted to answer investment related questions, also have an element of learning for learning's sake. This is one of the reasons he's good friends with Bill Gates - the two just love to learn new things. I would actually find it hard to believe Soros does not accumulate knowledge this way. Soros said: "...I don't play the game by a particular set of rules; I look for changes in the  rule of the game.".  It would be a bit hard to recognize changes to rules of the game without accumulating some minimum amount of knowledge over time.

Sizing up the Tankers - Supply and Demand in the Medium Term

“Reminiscences of a Stock Blogger” is one these blogs I regularly mine for ideas. The writer “Lsigurd” has an amazing track record of picking cyclicals upturns. Because he traffics in some of the crappiest companies out there, he not only covers the fundamentals, but also tends to be very opportunistic and flexible. This is what I imagine Michael Burry in his days would do. Anyways, after reading LSigurd’s idea on tankers here, I did some research into the sector and ended up buying Teekay Tankers (TNK), Frontline Ltd (FRO), and Capital Product Partners (CPLP).

Of the three, TNK is my biggest position. And I added more after the strong earnings today. Unlike some of its peers where earnings are mostly eaten up by depreciation charges, TNK actually has a solid earning, not just cash flows. Taking into account new ships and higher rates, Teekay can get ~$1 of EPS in 2015 and cash flows (before capex) of ~$1.5/ share. Those cash flows give TNK the option to pay a higher dividend and be valued on that basis. The stock is trading at $6.1/share. Put a modest 8-10x multiple on cash flows and I see 100%+ upside.

The Industry

Beyond TNK and consider the tankers industry as a whole, these are just about the most leveraged companies you can find. You got a cyclical industry, high fixed cost/operating leverage, and on top of that high financial leverage. Clearly, I want to make sure the industry is on the upswing. For that I tried to separate out short term vs. longer term factors, and then define my investment time frame – Is this a trade or an investment? Can I take a 2-3 year view? Or is this quarter to quarter?

The media tend to focus on the shorter term positives: lower bunker costs, China accelerate their ramping up of strategic crude oil reserves, and the “contango trade” – the use of tankers as storage, which limits the supply of ships and increase prices. These are all great bonuses but not necessarily sustainable beyond a couple quarters.

Intermediate/Longer Term dynamics – How Far to Look Out?

What’s more interesting to me are the intermediate/longer term supply and demand dynamics. On the supply side, these companies just went through years of depressed economics and capacity rationalization. For the next year or 2, fleet growth now look well under control at low single digits or even negative. I would not project earnings out more than 2 years, and even that might be a stretch. The industry is not known for supply constraints and firms can convert their other ships to tankers.

On the demand side, increases look to be structural:

1. Vast demand. China consumes roughly 11.1mm barrels per day (mmbd) of crude oil, and but produces only about 4.6mmbd. The rest have to be plugged by imports. Put this in context, the U.S. consumes ~19mmbd, with 1/4 the population. China’s crude oil demands have a long way to go.

2. Longer trade routes. Crude oil from Middle East and Africa are increasingly going to east Asia instead of say United State. The longer routes mean higher utilizations for tanker fleets. This is not just because U.S. is increasingly energy self-sufficient. Refineries capacities too have increased dramatically in East Asia the past few years. In China you actually have over-capacity of refineries. Those trade routes should be there to stay.

For me, what limits the time frame on the demand side is the threat of competition from other types of infrastructure. For example, a China-Myanmar oil pipeline just opened recently. Under this scheme (see maps below), tankers would arrive at Maday Island in the Bay of Bengal; oil would then travel via a pipeline through Myanmar into China. This would cut short tanker routes from the middle east, which currently travels through the Straits of Malacca and then northward along the coast of China. Another potential source of competition is China getting more oil from Russia through pipelines. I’m sure there are many other examples, but the point is for tanker demand I wouldn’t look out more than a couple years, as these things change.

Current Middle East to East Asia route

An example of a threat for tankers - The new Myanmar-China pipeline could cut that trip shorter

. 
Source

So yeah, from a fundamental perspective, I can only look at the tankers one year at a time. It’s simply not possible to get hold a long term, 5-10 year view on these things. This is why I hesitate to put more than an 8-10x multiple on cash flows. Also, given my lack of experience in this area - there will be days when stocks are down 5%, 7% without any news, and I will have to respect the market and cut my losses when necessary, and add on the upswing – a bit of a momo play. Definitely a trade, not an investment. Tankers are currently 6.5-7% of my portfolio.

McDonald's Articles that Don't Stink

The worst thing about investing in McDonald's is getting bombarded by hundreds of sophomoric articles. Cliches abound: "I'm not lovin' it", "simply the menu", "trend toward organic food"...etc. Half of these are written by either a) Captain Obvious, b) yuppies who babble on about organic, rather wait 40 minutes in line at Shake Shack, and hate fast food in general. The latter were never potential customers and never will be. The fact that they somehow have to weigh in is especially annoying for me - a customer of McDonald's for the past 18 years, and a fast food addict in general.

A wise man once said: "Opinions are like assholes. Everybody's got one and everyone thinks everyone else's stinks". That said, here are three that DON'T stink.

Fixing McDonald’s Isn’t Rocket Science

and this

How to Revive McDonald’s

and yes, those Mighty Wings were great!
Fallen Arches: Can McDonald's get its mojo back?

Mercury General (MCY) Has More Room to Fall

Mercury General Corporation (MCY) is an auto insurer that traditionally focused on California. It took a beating the past couple days after the latest earning release, dropping from $60 to $53 per share. I think it has more room to fall.

Anyone who followed this company even peripherally can te­ll it was (and still is) way overvalued. The only thing propping up the stock price is the high dividend payout, and that is hardly sustainable. The last 2 days of price action shows that dividend investors may finally be coming to their senses. If MCY finally get valued on earnings like its peers, we could see a ~40% drop.

Mercury General is obviously a less attractive business compared to peers Progressive (PGR) and Allstate (ALL). I will provide a list of reasons here.

• Unattractive business model. Mercury General relies on independent agents, which I consider less attractive compared to the direct channel or using captive agents. Independent agents can sell other brands, which means MCY will pretty much have compete on price, provide much better service or advertise to build brand equity. This puts MCY in a tough spot versus the big boys. Clearly, it's no easy task for them to compete on an ultra-low cost structure against GEICO and Progressive. On the other hand, if they go for better service and brand name, that will exert pressure on margins due to higher expenses. This brings me to the next point. Judging by MCY’s combined ratios, this is simply not working.
• Above average combined ratio of high 90 to 100% (PGR and ALL both in the low 90%’s). Mercury General is the high cost producer in the group, with expense ratio approaching 28% of premium earned, compared to Progressive at ~20%. Lower expenses allow insurers to give a better price to consumers as well as bear higher losses. On the loss side, MCY has a history of adverse reserve developments - obviously there are worse insurers out there but this is no PGR.
• Geographic concentration in California. The company is trying to expand to other states but that does not seem to be working too well, particularly in NY/New Jersey. In the near term they plan to ramp up advertising, which gets us to the next point..
• Lack of advertising fire power to compete effectively against the insurance giants. This is important as auto insurers are pretty much in a constant advertising war. How is Mercury General going to compete with the Geico gecko and Flo?? 
• Investment portfolio has high exposure to energy sector which is clearly not well in this environment.
• Insiders have been selling more than buying 
• Founder/Chairman George Joseph is highly respected in the industry but he is 92.
• Stock trades at 19x forward P/E and 1.6x P/B. 
• Dividend is not sustainable. They have about $135mm of annual dividend obligation, I calculated 2014 normalized net income (adjusted for non-recurring items) of $125mm 

So yeah, I have been eyeing this one as a short for a while. The only reason I did not short this sooner was the high dividend yield, and the lack of a catalyst to shut off that dividend (debt to capital is only 12% so they can keep borrowing to fund dividends, even in the absence of any cash flows from opco). The catalyst to start a short position would have to come from signs of business deterioration. Only then the dividend investors might wake up and see this is a bad deal.

The latest earning provided that. 4Q14 combined ratio was over 100%, even adjusting for prior year developments, catastrophes, and non-recurring expenses. In the conference call, management basically acknowledged that dividend payout is unsustainable if current performance continues. Analysts questioned how Mercury can compete on the advertising front. With some of the weaknesses I listed above being exposed, the stock price dropped 5%. I started a short position then. Today it dropped another 6% and I added more to my short. Hopefully, this is the start of a change in how the market values MCY.

MCY still trades at 19x P/E even after the latest drop. Progressive and AllState trade at 14.5x and 12.2x 2015 earnings, respectively. MCY deserves a discount, not a premium to these better run, better positioned competitors. Taking consensus 2015E earning of $2.7/share at 12x multiple would value MCY at $32.5 a share, a 39% drop from its current level of $53.

The other way to play this is to a pair trade: short MCY and long PGR or ALL (or both). I am also long PGR - although not intended as a pair trade.

** Updated 2/12/2015

KBW find it hard to justify MCY's stock price. So, people whose job is arguably to justify high valuations are struggling to justify those valuations. If you still own MCY you need to take a serious look.

Adding to American Capital Agency (AGNC)

Summary

• At 84% of book value, AGNC is trading near its historically low.
• Upside is collect 14% dividend and perhaps more with a pull to par. 
• Downside is controlled. There are many risks, but they are mostly uncorrelated. The biggest threat in the near term is book value decline due to rising rates and mortgage spreads. 
• Comparing the current environment to 2Q13 (the worst quarter in AGNC history), book value hits should be limited. 
• I added to my positions this past week.

Situation

American Capital Agency Corp (AGNC) is a mortgage REIT. It earns a spread by buying mortgage backed securities (MBS) with low cost funding, and then magnifying that spread with leverage. In the past few years this allowed AGNC to pay a consistently high dividend yield.

AGNC’s stock price has declined steadily the past 2 months, with price to book now at 84%, among the lowest in its history. My base case outlook is a 12% dividend in the next year, while a P/B recovery (less likely) would add 16% for a total return of 28%. But what is the downside, and the likelihood of that downside?

Many Risks, But Uncorrelated

AGNC is cheap for a reason. Many reasons actually. Among its many risks, the main three are: 1) book value hit due to rising rates and mortgage spreads, 2) flatter yield curve leading to spread compression and threaten the mREIT business model, 3) dividend sustainability with dollar rolls. The last point about dollar rolls is really a unique subset of spread compression. It is relatively obscure and deserves a separate discussion, but for now I want to focus on the first two risks.

The worst case would be a bear flattener, which is a combination of 1) and 2) - rising rates and compression spreads. Rising rates would hurt asset prices and decrease book value in the near term, while compressed spreads hurt P/B multiples by lowering future income. Theoretically, these can happen at the same time. For mortgage REITs though, these are conflicting risks that are unlikely to happen at the same point in time:

o Unlike other financial institutions that constantly have money coming and risk investing with lower spreads, a mortgage REIT’s exposure to spread compression mostly comes from mortgages prepayments, where investors have to re-investment into a lower spread environment. However, if rate/ mortgage basis are shocking upward, prepayments would likely to be muted.

o For AGNC, the most relevant rates are repo funding cost and MBS yields, where repo funding costs are unlikely to spike upward short of a banking crisis. High prepayments (both voluntary and involuntary) are unlikely in that scenario, given the current state of housing markets.

Since these risks are unlikely to happen at the same time, I will focus on the risk of rising rates and spreads hurting book value. This is the more immediate risk, and is also the one that hurt AGNC more historically.

Quantifying the Downside

Historically, AGNC’s worst performance came during 2Q13, when the stock dropped 31% in the quarter. About 2/3 of that price drop was simply due to market multiples. Price to book ratio flipped from a premium of 110% to a discount of <90%, which magnified a 12% decline in book value.




The ~12% in book value (both on a total and per share basis) was due to a confluence of multiple factors:

o A violent 63bps up move in 10yr UST, while mortgage yields were up more than rates.

o A collapse in specified pool pay-ups. AGNC owned prepayment protected MBS such as low loan balance and HARP loans. Normally, these trades a premium (“pay-ups”) to more generic MBS, but as rates go up and people are less worried about prepays, those premiums shrank dramatically.

Here’s an old 2Q13 presentation slide explaining the collapse in pay-ups. Note that the 30year, 4% coupon pay-up dropped from 3.28 in 1Q13, to 0.91 in 2Q13. A decline of 237bps!




As of now, many these factors are simply not present. Comparing the present situation to end of 1Q13 (the start of 2Q13 meltdown), AGNC already trades at ~15% discount to book value as opposed to a 10% premium. Yes, it’s very possible that rates may shock upward, but probably not as violently as in 2Q13 when talks of Fed “tapering” dominated news headlines. Finally, as the below table from Markit shows, specified pool pay-ups are nowhere near where they were in 1Q13, which could be greater than 3 points. As of January 2015, the higher pay ups are for 30 year low loan balance (LLB) pools with >4% coupon, and those are under 3% of AGNC’s portfolio.

Therefore I believe AGNC’s downside is limited - any book value deterioration from rate increases should be less than the 12% drop as seen in 2Q13, and thus well within the current 84% P/B buffer. I do not think P/B will drop much further because that would have to come from spread compression, which as I explained previously, is incompatible with a “rate up” scenario.

Finally, if all else fails management always have the option to do buybacks, as they have done before.