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In the wake of the financial crisis, many income investors are flocking to a new class of companies that offer market-crushing yields: mortgage real estate investment trusts. This is one of the hottest, fastest growing sectors in the market, and it's not hard to see why. Mortgage REITs are structured so that they must pay out at least 90% of their earnings to shareholders in order to reap special tax benefits, so they've always offered investors a higher quarterly payday than your run-of-the-mill dividend company. The trade-off has always been that the company has almost no earnings to retain to grow its business, so mREITs traditionally rely upon secondary stock offerings to expand operations.

However, after the financial crisis, the Federal Reserve lowered the federal funds rate to near zero percent in order to stimulate the economy, and rates continue to be low to this day and for the foreseeable future. This has created the ideal environment for mREITs to flourish, since these companies make their money from the spread between the interest rates of their short term borrowings and long term mortgage-backed securities. As a result, when you take a look at some of the companies in the industry, you find staggering yields that cannot be seen anywhere else in the market. Annaly Capital Management (NYSE:NLY) offers a yield of 15%. American Capital Agency (NASDAQ:AGNC) clocks in at 20.2%. Invesco Mortgage Capital (NYSE:IVR) one ups them both with a 23.1% yield.

Investors have been pouring into this sector due to the lure of these massive yields. As each day passes, there seems to be a growing divide between income investors of all stripes. There are those who have embraced mREITs and point to their huge yields as proof of investment-grade quality. And there are the traditional dividend growth investors, who are wary of these newfangled instruments and prefer to keep their money in reliable old standbys like Johnson & Johnson (NYSE:JNJ) and Intel (NASDAQ:INTC).

The traditionalists claim that they're happy to settle for a lower, sustainable yield that increases every year, driving up their yield-on-cost over time. These investors favor stocks that have earned the coveted "Dividend Champion" title from maintaining an uninterrupted streak of annual dividend hikes for the past 25 years. The mREIT crew argues that even with an unstable year-to-year payout, mREITs offer a superior total dividend package than their traditional counterparts.

Unfortunately, there have been precious few studies comparing these two very different kinds of dividend stocks up until now. In this article, we'll be looking at one Dividend Champion and one mortgage REIT and compare their returns, both dividend and total, over the past ten years. I should note that I don't have a dog in this fight, so I'm fairly confident that I can remain objective. While I do incorporate many dividend-paying companies into my portfolio in the pursuit of an absolute return strategy, I don't own any mREITs or companies that strictly qualify as a Dividend Champion.

My interest is purely academic. After witnessing countless debates both on Seeking Alpha and other forums about the merits of mREITs versus traditional dividend growth stocks, I thought it'll be interesting to run a live fire exercise to evaluate these two classes of companies over a long-term horizon. We'll be looking at only one company in each category, so this study is by no means comprehensive. Hopefully it'll provide one small piece of the puzzle that others can use as a springboard for their own research.

That said, shall we meet our contenders? In the red corner, representing the Dividend Champions, is Procter & Gamble (NYSE:PG), a core holding in many dividend growth portfolios and one of the all-time great success stories of American business. In the blue corner, representing the mortgage REITs, is Annaly Capital Management, one of the oldest and most experienced veterans in the industry.

Why Procter & Gamble?

Procter & Gamble is a titan of its industry and one of the bellwethers of the broader economy. It controls many of the most recognized brands in the world of consumer staples, and has proven itself to be an extremely savvy international operator over the years. Among dividend growth investors, it's an old favorite, but the main reason I chose this company was that it was one of the few in its class that actually provided a decent return to investors over the past decade, where the overall market moved sideways. Unlike many of its compatriots, its valuation wasn't as inflated by the stock market fever of the 90s, and so PG investors got to enjoy both dividend income and capital gains during this so-called "lost decade," a privilege few dividend investors received.

Why Annaly?

Although many mREITs are new entrants into the space, Annaly has been in the business for over ten years, a claim that few of its competitors can make. Many of its fellow mREITs have only experienced the best of times for the industry, but Annaly has experienced some of the worst as well, and it has survived them. It is run by CEO Michael Farrell, one of the most seasoned and respected leaders in the industry. If you're a Jim Cramer fan, you'll be pleased to know that Cramer has constantly referred to Annaly as his top pick in the sector. Most importantly, Annaly's MBS portfolio consists almost entirely of agency-backed securities, which means that it has no exposure to default risk, unlike other mREITs like Chimera Investment Corp (NYSE:CIM). For income investors, who often gravitate to dividend stocks for the safety and stability they offer, this last trait is extremely important - the last thing they want to see is their company's book value get wiped out due to a string of mortgage defaults.

What Are the Rules of This Bout?

For this exercise, we'll be looking at a hypothetical investor who has $10,000 to invest. In the first trial, he'll be putting that money into Procter & Gamble at the beginning of fiscal year 2002, which starts in July 2001. PG was trading at roughly $31.25 at that time, so our investor would be able to buy 320 shares. He'll be holding the stock for ten years. Dividends will not be reinvested - he'll be spending all of it.

In the second trial, our investor will be buying $10,000 worth of Annaly stock, or 740 shares at $13.50. He'll be reinvesting half his dividends and spending the other half. The reason I chose this model is because the main argument against mREITs is that they don't grow their dividends over time. Theoretically, a traditional dividend growth company would eventually catch up to them no matter what. However, since mREITs have a much higher payout ratio than your standard dividend stock, investors can afford to reinvest the excess back into the company. By doing so, they would be able to increase their dividends over time, not through the organic growth of earnings but by growing their own claim on those earnings. As such, they would be able to simulate the growth effects of a Dividend Champion.

After the ten-year period has elapsed, we'll examine the total dividends paid and total absolute returns of both stocks. Are you ready? Let's do it.

(Click charts to enlarge)

It's clear from these results that Annaly has smashed Procter & Gamble over the past decade, both in terms of dividend return and absolute return. According to this study, Annaly and its mREIT brethren should be the clear winners, right? Maybe, maybe not. Before you rush out to load up your portfolio with mREITs, consider the following:

  • Although Procter & Gamble may have been one of the cheapest Dividend Champions back in 2002, it still opened the fiscal year at a P/E of 30.5. The stock was a bargain compared with other dividend darlings like Wal-Mart (NYSE:WMT) and Cola Cola (NYSE:KO), which reached P/Es in the 50s and 70s, respectively, during the height of the bubble, but it was by no means a cheap stock by historical measures. Procter & Gamble's yield at the beginning of the test period barely cleared 2%. Compare that with the stock today, which trades at a P/E of 16 and sports a yield of 3.4%. Buying the stock at half the price effectively allows you to double your return, both dividend and total. At today's valuations, PG investors are getting a much, much better deal than investors did ten years ago.
  • While Procter & Gamble investors have had to suffer through an unusually bad decade, Annaly investors have experienced an unusually lucrative one. The financial health of Annaly and other mREITs is tied to the interest rate environment, which has been very tame for the large part of the decade. The federal funds rate opened at 1% in 2002, stayed low for the next few years, peaked at 5% in 2006, and promptly plunged to near 0 after the financial crisis. As a result, Annaly investors have reaped massive helpings of dividends every single year besides a couple of lean years in 2006 and 2007. However, there is no guarantee that macroeconomic conditions will remain as favorable to mREITs for the next ten years as they have been for the previous ten. How will mREITs fare if interest rates spike up to the high teens like they did in the early 80s? Will these companies even survive? It's impossible to know, because none of these companies existed back then, so the data required for analysis just isn't available.

As it turns out, although Annaly may have emerged the victor, it wasn't a fair fight in the first place. In more balanced market and economic conditions, which kind of company is the superior investment vehicle for dividend investors? It's difficult to say. In the end, for investors who view dividend stocks as safe harbors in times of turbulence and volatility, it would probably be best to stick with the old guard: companies with proven business models that have an unblemished track record for returning profits to shareholders. Even in a decade that gave its opponent a massive edge, Procter & Gamble didn't make too poor a showing. Looking forward, I expect today's Dividend Champions, now shed of the handicap of an outsized valuation, to be much better investment opportunities than they were at the turn of the millennium.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Dividend Showdown: Dividend Champions Vs. Mortgage REITs