The Mindset Needed To Be A Successful American Capital Agency Investor

Jul. 8.14 | About: American Capital (AGNC)

Summary

Brutal self honesty: What is your risk tolerance? You need to have a high risk tolerance.

Book value is a key metric.

Increasing one's position when AGNC trades well below book value (BV).

Understanding that dividends will fluctuate.

High income is the investor's main goal.

Was 2013 a nightmare for American Capital Agency (NASDAQ:AGNC) shareholders or a golden opportunity? In my opinion, it depends on the investor's emotional makeup, their understanding of what they own, their plan of action and their discipline to execute it. The investors and shareholders who increased their position by reinvesting their dividends and/or purchasing new shares at a large discount to the company's BV, took advantage of a golden opportunity and had a gratifying experience. The shareholders who bought shares above BV and panicked out as AGNC's share price tanked experienced realized losses because they lacked the understanding of what they owned. They did not acknowledge their true tolerance for seeing their capital erode substantially. They were not mentally prepared for the dividend cuts that occurred. Personally, I was prepared for dividend cuts and a drastic drop in the share price.

Patience and a disciplined plan paid off for me. Even though AGNC's share price declined almost 50% from its 2012 high to its 2013 low, by buying shares in lots as the price declined and reinvesting the dividends, I have realized gains (trimmed my overweight position and bought PSEC and KMR several weeks ago) and unrealized gains. I also feel my current AGNC position (30% of my portfolio, held in my ROTH IRA) is a good investment going forward.

I have read too many comments from SA members who sold AGNC and lost money. They blamed the management team, the FED tapering, interest rates spiking and anything else they could think of. They did not blame themselves. They did not take the personal responsibility for buying a stock they had no business owning.

High Income (11% + Yield):

The compounding benefit of reinvesting the dividends when AGNC's price dropped almost 50% exponentially increased the share count. The lower the share price when the dividends are reinvested the more shares one will receive. More shares = more income. In my opinion, the current $0.65 dividend has stabilized and eventually will be raised. Therefore, one's current income generated will continue to grow, and eventually the income will double.

If you are very shortsighted and crave price appreciation, do not invest in AGNC. If one can't stand to see price declines of 30% or more, do not invest in AGNC.

Strategy:

Since AGNC is currently trading (in my opinion) at a minor to modest discount to its current BV, I am HOLDING my shares and will reinvest the dividends. I was overweight AGNC starting 2014. AGNC comprised 65% of my entire portfolio.

As AGNC's stock price rose from $18.84 to $23.50 +, I sold approximately half my shares and purchased PSEC and KMR with the proceeds. AGNC currently comprises about 30% of my entire portfolio.

What is my current plan? Eventually, AGNC will trade at a 15-20% discount to BV again. That will be the time I load up on shares. I will buy shares in lots, not all at once. I will sell a portion of my shares as the stock price gets closer to BV. Eventually, AGNC will trade at a 10% premium to BV, that will be the time I will sell more of my AGNC shares.

If you have a high risk tolerance and can withstand AGNC dropping in price 25%-30% from the current level (in my opinion the worst case scenario) then initiating a modest position at the current price of $22.75 is a good investment in my opinion. Do not buy all at once. Personally, I see the downside risk in price to be approximately 15%. So, with a stable dividend yielding 11.4% and a downside risk of 15% ( price volatility, only temporary), I see AGNC as a solid high income investment.

I am long AGNC because I have concluded that there is a high probability that my dividend income will increase over time.

I believe the dividend has bottomed and dividend increases will occur in the future. Additionally, the income generated from AGNC will meet my personal income goals. I also believe the probability of AGNC going bankrupt is extremely unlikely. I like the fact it is an Agency mREIT guaranteed by GSEs (Government-Sponsored Enterprise). GSEs carry the implicit backing of the U.S. Government, but they are not direct obligations of the U.S. Government. For this reason, these securities will offer a yield premium over Treasuries. Examples of GSEs include: Federal Home Loan Bank, Federal Home Loan Mortgage Corporation (Freddie Mac), Federal Farm Credit Bank and the Resolution Funding Corporation.

AGNC has no credit risk, however there is interest rate risk.

Conclusion:

If you have a high risk tolerance and understand that AGNC's dividend will fluctuate, you might have the mindset needed to own AGNC. Book Value is a key component in determining one's entry points and exit points. I want to buy shares well below BV (the big opportunity has passed for now, as it traded about 20% below BV during Q42013) and sell a portion of my position as the price gets closer to BV. When the price trades at a premium to BV, I will sell more shares. The exact percentage of selling shares is an individual decision based on each investor's goals and portfolio allocation. At this point in time AGNC's dividend is stable and most likely has bottomed.

This has been my first attempt to describe the mindset necessary in order to own AGNC. I have written from a psychological perspective.

I do realize that there are no guarantees of a successful outcome investing in any stock. I have personally chosen to HOLD a large AGNC position within my ROTH IRA. This strategy is not for everyone.

I welcome all comments conveying your thoughts on this topic.

For anyone who is not familiar with Scott Kennedy's excellent accounting and financial analysis regarding AGNC, I highly recommend reading his articles. His accuracy projecting their book value and dividend ranges/sustainability is exceptional. Here is a link to his latest article.

Disclosure: The author is long AGNC, KMR, MO, PSEC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.