An Undervalued Mortgage REIT With A Sustainable Dividend

Dec.17.12 | About: AGNC Investment (AGNC)

For the Mortgage REIT sector, 2012 has been far from a banner year. Between January and June things were looking good for names like Annaly Capital (NYSE:NLY) (up 4.42%), Hatteras Financial (NYSE:HTS) (up 7.08%), Anworth Mortgage (NYSE:ANH) (up 12.44%), and American Capital Agency (NASDAQ:AGNC) (up 19.33%) as returns for the four averaged a return of 10.82%.

NLY Chart
(Click to enlarge)

NLY data by YCharts

Between July 1st and December 14th things haven't been looking so bright as names like Annaly Capital (down 15.63%), Hatteras Financial (down 12.17%), Anworth Mortgage (down 20.11%), and American Capital Agency (down 10.01%) as second half returns for the four averaged a negative return of 14.48%.

NLY Chart
(Click to enlarge)

NLY data by YCharts

By examining the charts a bit closer we'll see that American Capital Agency demonstrated the best returns during the first of the year, and although negative, outperformed its peers during the second half of the year. That being said, the company's performance isn't the only thing potential investors should consider before establishing a position in the company. In this article I plan on going a bit further by examining not only the value proposition AGNC presents to investors but examining the company's dividend behavior and potential countermeasures against the Federal Reserve's recent action.

Dividend Behavior

On December 14th American Capital Agency set itself apart from many its fellow agency-based Mortgage REITs by announcing a significant development with regard to its dividend that will go ex-dividend December 24th and be paid to existing shareholders on January 28th.

The company noted it would make no change to its quarterly dividend. I know what you're thinking, what's so significant about a company maintaining its dividend? The answer is simple. Many of American Capital Agency's peers have been lowering their dividends and are expected to continue to do so. While AGNC has maintained its current distribution since December 20th, 2011, many of its peers have lowered their respected dividends multiple times.

For example, over the same period Annaly Capital has lowered its distribution by a total of $0.07/share (multiple cuts since 12/2011), Hatters has lowered its dividend by a total of $0.20/share (multiple cuts since 12/2011), and Anworth which has lowered its dividend by a total of $0.06/share (multiple cuts since 12/2011).

Heavily Undervalued

When discussing the subject of how undervalued a company may or may not be, I tend to refer back to Benjamin Graham and a mathematical formula better known as Graham's Number.

According to Eben Esterhuizen the Graham Number is: "a figure that measures a stock's fundamental value by taking into account a company's earnings per share and book value per share. The Graham number is the upper bound of the price range that a defensive investor should pay for the stock. According to the theory, any stock price below the Graham number is considered undervalued, and thus worth investing in. It is used as a general test when trying to identify stocks that are currently selling for a good price."

American Capital Agency presents a very nice value proposition when using Graham's Number. AGNC's diluted TTM earnings per share at 2.46, and a MRQ book value per share value at 32.51, implies a Graham Number fair value = SQRT (22.5*2.46*32.51) = $42.41. Based on Friday's closing price of $30.20, this implies a potential upside of 40.43% from current levels. In a perfect world, the upside potential based on Graham's Number could actually exist, however we don't live in a perfect world, and given the fact the Federal Reserve has strengthened its hold as a pseudo-Mortgage REIT, it could be some time before returns of that magnitude actually become reality.

Combating The Fed's Behavior

On December 12th it was announced by the Federal Reserve it will expand its pre-existing asset purchase program by buying $45 billion a month of Treasury securities starting in January to spur the economy. These purchases will be in addition to $40 billion a month of existing mortgage-debt purchases. When the Fed buys up MBS and various other types of mortgage-debt it obstructs any progression the Mortgage REITS have made in terms of revenues and subsequent profits. Such an obstruction directly affects a company's profits and in most cases dividends tend to suffer.

How can American Capital thrive in an environment where the Fed is buying up a good portion of the existing supply?

In my opinion, a company like American Capital Agency needs to take a page out of Annaly's book and consider the possibility of diversification through an acquisition. The acquisition itself should enhance the company's preexisting strategy and offer an element of diversification given the fact the Federal Reserve, by acting as a pseudo-Mortgage REIT has virtually bought of a large portion of the country's existing supply. Smaller, non-agency firms such a Chimera Investment (NYSE:CIM) or Newcastle Investment (NYSE:NCT) offer non-agency-based assets, and although seemingly disproportionate to the current holdings of AGNC every step toward diversification should help especially if we consider the current state of agency-based Mortgage REITs.

Final Analysis

Unless you happen to be a Washington insider, there is no way to predict how, if or even when the Fed will ease up on its current mortgage purchase program. Given the fact AGNC has been able to maintain its dividend during such volatile times could be a sign of things to come.

I strongly believe American Capital Agency will be able to survive much longer in terms of dividend sustainability then such names as Annaly Capital, Anworth, and Hatteras. Such names as Annaly, Anworth, and Hatteras could continue to cut their respected dividends over the next 6-12 months, and as a result I'd look to establish a position in AGNC rather then Annaly, Anworth or Hatteras.

Disclosure: I am long AGNC, NLY, HTS, ANH. 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.