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Financial services has been one of the best performing sectors in the past year as banks have gone to great lengths to improve their financial positions and reduce risk. When most people hear about investing in financial services they instinctively think about the mega-cap banks but there are many other types of financial services. Not only are there regional banks but there are insurance companies, private equity firms, and real estate investment trusts (REITs) available for investment. These smaller entities are less complex and are far easier for investors to understand than the likes of Citigroup (C) or Bank of America (BAC). These entities are unique in that they can offer high dividend payments as well as growth prospects. Below I will discuss five such financial service firms and provide some background for future research.

For details of the strategy and my screener details, please consult my methodology on the topic (last modified 1/21/2013). In brief, the screen focuses on relative stable equities with a concentration on liquid companies at affordable valuations. This is summarized below:

  • Dividend Yield ≥ 4.0%
  • Ex-Dividend Date = Next Week
  • Market Capitalization ≥ $1B
  • P/E Ratio: 0-20
  • Institutional Ownership ≥ 15%
  • Ideally Modest YTD S&P 500 Underperformance
  • Minimal European Exposure
  • Utility Company

After applying this screen, I arrived at the financial service equities discussed below. Depending on your belief in the investment hypothesis, you may decide to hold long enough for the dividend or to hold for long-term. The information presented below should simply be a starting point for further equity research in consultation with your professional financial advisor before making an investment decision. My goal is to present new companies to you and provide a brief overview of their recent developments; this should not be considered a substitute for your own due diligence.

ARMOUR Residential REIT, Inc. (ARR): 14.29% Yield; Ex-Dividend 3/13

ARMOUR Residential REIT is a company that invests in various agency mortgage-backed securities ("MBS") which are issued or guaranteed by U.S. government affiliated agencies. As of the most recent annual report, ARR has $19.1B in agency securities opposed by $18.4B in repurchase agreements. ARR is currently levered about 8X (debt/equity) which means its relatively low return on assets (1.64%) is magnified eight times. Portfolio Management 101 has an excellent overview of ARR and its risks. As I discussed in a recent mREIT article, in addition to leverage, an important metric for mREITs is book value. ARR has a book value of $7.46 and a price/book ratio of 0.90. The book value has declined 5.6% QoQ but the book value per share has held steady. This indicates that ARMOUR is valued at a modest discount to its financial statement value, thus the market is generally cautious about the company. I suspect general uncertainty in the mortgage market is depressing the stock's price. Additionally, concerns regarding the sustainability of the dividend (discussed below) have been weighing on the stock. This discount is generally comparable with peers American Capital Agency Corp. (AGNC) and Annaly Capital Management (NLY).

December 2012 was a very active month for ARMOUR. The dividend was cut from $.09 to $.08 per month, an 11% decline. This should not be a total surprise as the dividend has declined at least once per year every year since 2010. This dividend decrease was partially offset by the authorization of a $100M stock repurchase plan. At the time, this represented approximately 4.6% of the company's current market capitalization. ARMOUR has declined 5.3% the past month as it announced it would be offering 65 million shares to the public, or approximately $435 million. Share offers are not uncommon for mREITs, but this is an odd decision given the recent repurchase announcement and scale of offering. I am still bullish on quality mREITs due to the robust yields but ARMOUR is on thin ice now. With this information in mind, I believe ARMOUR is reasonably priced at 6.7 forward P/E and has a high enough yield to compensate investors for the risk assumed. Note that ARR distributes dividends monthly.

Fifth Street Finance (FSC): 10.57% Yield; Ex-Dividend 3/13

Fifth Street Finance is a financial services firm that specializes in middle-market buyouts and other related financing services. The company makes strategic, generally non-controlling, investments in diverse companies and profits from the related fees. The company recently reported a record December quarter with $422M of investments closed. Two-thirds of income are derived from cash interest income with fee income comprising the bulk of other revenue. Over the past year investments have grown approximately 25% and the company has been a solid performer; however, there has been significant share dilution. Weighted average common shares outstanding have risen by over thirty percent in the past year so net investment income per share actually declined. Another red flag are the number of investments with losses and the overall portfolio has a fair value of $1.58B and cost of $1.57B. For example an investment in Coll Materials has a cost of $12M and fair value of $1M. Fifth Street profits primarily from income/service revenue, so this is not overly concerning but is a situation that requires monitoring.

FSC is cheap with a 9.5 forward P/E and has no long-term debt in its capital structure. The stock has been on a steady uptrend since May of last year and stock has risen from $8.50 to $11. The stock has traded in a much tighter range in 2013 but is mere pennies from its 52-week high. UBS raised its target from $11 to $11.50 in February and the stock is currently trading less than five percent from the updated target. The monthly dividend has also been reduced in each of the past two years, so another decrease is possible as early as June if the trend holds. I would avoid FSC for dividend capturing due to the red flags mentioned above. Even if you are optimistic about FSC's prospects, it appears that the upside is limited at this level.

MFA Financial Inc. (MFA): 8.61% Yield; Ex-Dividend 3/14

MFA is $3.3B REIT that invests in agency and non-agency residential MBS. As of December 31, 2012, approximately 57% of the portfolio ($7.3B) was invested in agency securities with 43% in non-agency securities ($5.4B). MFA does a great job of providing transparency in its financial reports and I highly suggest all mREIT investors read the latest 10K. One important concentration risk to note is that nearly 50% of the underlying mortgages are for real estate in fragile California.

(click to enlarge)

(Source: MFA 10K)

As you can see from the above chart, yields have been declining steadily since 2011 and that trend will likely continue as the mortgage markets stabilize. Despite the negative trend, I do not anticipate any radical change in the short-term that should concern investors. Tim Plaehn recently wrote a solid overview of MFA and concludes that the stock has strong potential returns due to its non-agency portfolio's conservative book valuation. MFA trades at an 11.39 forward P/E multiple and only a 1.03 price/book ratio. To extrapolate on Mr. Plaehn's comments, if he believes the non-agency securities are undervalued then MFA should be trading at a higher premium to book value. The dividend has exhibited volatility throughout MFA's history and has rarely stayed the same quarter-over-quarter. The dividend has been sliding throughout 2012 and is a penny shy of a low set in July 2010. This quarter MFA declared a special $.50 dividend but note that MFA recently revised the record date for the special dividend. That implies a 5.35% dividend yield for just this quarter, making a dividend capture even more attractive.

Ares Capital Corporation (ARCC): 8.28% Yield; Ex-Dividend 3/13
Ares Capital Corporation is a specialty finance company that provides services to diverse middle-market companies with unique financing needs. The underserved nature of the market makes this a highly lucrative segment but it is not without risk in this economic climate. This risk is mitigated by having a P/E under nine which provides a margin of safety. For the longest time, the yield was greater than the P/E but Ares's seven percent rally this quarter has lower the yield by forty basis points. Please note that ARCC is one of the largest Business Development Companies ("BDC") under the Investment Company Act of 1940. A nice overview of BDC is provided by IndieResearch but the primary point is that BDCs must distribute 90% of their earnings as dividends. Ares is similar to Prospect Capital Corporation (PSEC), which I covered recently.

The dividend history is a little volatile but the dividend appears to be safe for at least the near-term. There are signs that ARCC is planning to magnify operations as it has been raising equal capital and expanding its revolving lending facility so the situation requires close monitoring. Lending additional support to this hypothesis is Ares's 19M share offering which should raise over $300M in additional equity. Ares declined on this dilutive news but has bounced back as it reported another solid quarter in which it made over one billion dollars in new investments. The portfolio yield stands at 11.3% which has declined from 12.0% in 2011 as the company has focused more on higher priority debt lending. The portfolio yield is substantially higher than the stock's yield so concerns about the payout sustainability are negligible. Remember that is normal for these types of companies to continually raise new capital via equity or debt to finance investing activities. Short-term dilutive news is often a buying opportunity.

KKR Financial Holdings (KFN): 7.37% Yield; Ex-Dividend 3/12

KKR is a specialty finance company that operates primarily in the private equity and specialized investment categories. As with many of the companies that appear in my dividend screens, it appears that KKR is depressed because it is a financial services company and now has a P/E below six. Private equity firms have been in the news since Mitt Romney ran for president and the carried interest tax debate continues to rage on. This is a dark cloud hanging over the entire industry.

Private equity companies are attractive dividend producers because they often either turnaround or improve existing companies and are able to return excess cash quickly. These can be volatile companies since their ventures can fail but once they have successful investments, they can pay above-average dividends. The dividend was suspended in 2008 when the market crashed, but was reinstated in late 2009 and has been steadily rising ever since. As a limited partnership, there are special tax implications for this investment that also need to be considered on an individual basis with your tax consultant.

(click to enlarge)
(Source: Finviz.com)

KKR is also similar to PSEC and ARCC mentioned above; however, KKR focuses more on European opportunities and macroeconomic interest trends. PSEC specializes in finding companies with robust cash flows and making strategic investments. Having said that, KKR's 7.4% yield and low P/E ratio still makes it a compelling investment opportunity. The company recently reported fourth quarter earnings that pushed the book value to $10.31, indicating that shares are trading at a ten percent premium to financial statement value. With the stock trading near book value, I am not overly concerned about the shares declining significantly in the near-term. It should be noted that last quarter the shares were trading at a three percent discount around the dividend date so there are signs of overheating. The stock has been in a nearly unbroken positive channel since June and the stock has risen 36% in the past year. The stock is near the low-end of its channel, so there should be technical support that makes a dividend capture even more attractive. The distribution was raised to $.21 per quarter in 2012, up from $.18 per quarter. This month KKR is paying a special $.05 dividend for shareholders of record 3/14 - this implies a return of forty-four basis points for anyone attempting a dividend capture. KKR is ordinarily a strong ex-dividend candidate but it does not make sense to try to capture this quarter in isolation given the small special dividend.

The information presented has been summarized below. I make no warranties regarding the information in the chart as industry classifications are frequently imperfect. Orange and green represent "avoid" and "consider" classifications, respectively.

(click to enlarge)

Please refer to profile page for disclaimers.

Disclosure: Long PSEC.

Source: Which Financial Dividends Are Best This Week?

Additional disclosure: Please refer to profile page for disclaimers.