American Capital Agency (AGNC) recently announced the commencement of an underwritten public offering of shares of its Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Shares") and this event was the catalyst for this article.
American Capital is a real estate investment trust (REIT) investing in residential mortgage pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by government-sponsored entities or by a United States government agency. In the case of American Capital, these government sponsored entities are Freddie Mac, Fannie Mae and Ginnie Mae.
Pass-through securities, as we all know, are basically a portfolio of mortgages from which investors receive payments at regular intervals consisting of principal and interest. At first blush, this may seem like a remarkably safe investment, given the government guarantees. However, this is not entirely the case. There are no guarantees in place to cover cash flow and volatility that can occur as a result of principal prepayments typically arising from mortgage rate drops triggering mortgage refinancing by homeowners. In other words, an investment in mortgage REITs of the type proffered by American Capital require the investor to be constantly alert to mortgage rate fluctuations in particular and the housing market in general. American Capital is currently favoring its investors with a dividend yielding 18.2%. That said, with risk comes reward. Normally a yield in the teens would suggest a substantial risk for the investor, but mortgage REITs are calculated to provide dividend yields at a rate that substantially exceeds utilities, telephone companies and investment-grade bonds. Managing for high yield is what these companies do, and it's their primary business to manage the attendant interest-rate, inflation and regulatory risks.
Fundamental analysis is not entirely reliable when analyzing a REIT, which by definition, must return 90% of its income to trust unit holders. There are other tax and accounting considerations that impact fundamental analysis as well. I think it is prudent to learn what you can about the management team of any company you choose to invest in and particularly so with a REIT. In the case of American Capital, Mr. Malon Wilkus is the CEO and founder. He enjoys an excellent reputation in the financial community and has had extensive experience. Mr. John R. Erickson is the CFO and has been teamed with Mr. Wilkus almost since the inception of the firm.
In a head-to-head comparison, American Capital comes off rather well against rivals Anworth Mortgage (ANH) and MFA Financial (MFA). Anworth, with a market cap of around $864 million offers shareholders a dividend yielding 13.1% on a trailing twelve month basis. MFA, with market capitalization of $2.56 billion provides shareholders an identical dividend yield of 13.1%, some 39% below the yield of American Capital. Anworth and MFA are both substantially smaller than American Capital with its market capitalization of $6.74 billion and this may play into the equation, as American Capital has a larger and therefore more diverse portfolio of mortgages.
The analysts view of these companies are similar, with all ranging between 2.0 and 2.3. American Capital at the high and Anworth at the low end of the range. If you compare American Capital to industry averages, it truly shines in the earnings per share column, reporting around 5 times the average.
In fairness, not only American, but Anworth and MFA all sport operating margins that are nearly 3 times the industry average. Yield is the significant difference among the 3 companies.
American trades at a premium with a price to book of 1.03, whereas Anworth and MFA are available at slightly below book value in terms of per share cost. It seems a small price to pay for the increased dividend yield. American's recent offering is going to push that higher still and this may or may not result in some pullback. To date, it has not. Also of note...the board reduced the dividend from $1.40 to $1.25 per quarter which is a decline of around 12%. Although this reduces the dividend yield to around 17%, it remains a higher yield than any offered by American's competitors. Mike Maher offers additional insights in his thought-provoking article, especially with regard to the obvious question of possible future dividend cuts.
Mortgage REITs enjoy a significant degree of price stability, meaning total return on investment relies almost totally upon the dividend yield. Beta measures this volatility, and clearly Capital's is the highest (most volatile) of the 3 we have discussed here. Anworth and MFA have betas of 0.16 and 0.20, respectively. That said, American is some 70% less volatile than the overall market. In fact, the price stability of American and other mortgage REIT's means you need to create your own opportunity to buy at a bargain price. The best play is to buy the stock at ex-dividend. This event usually depresses the stock price in an amount roughly equivalent to the pending dividend. There is no point in trying to catch a falling knife.
I am hoping that your takeaway from this is that 1.) mREITs should be some percentage of your portfolio as a boost to dividend income, 2.) mREITs consisting of collateralized mortgage securities guaranteed by the federal government are relatively safe and 3.) it is imperative that attention be paid to interest rate volatility and housing market trends as these have the greatest impact on yields.
I strongly urge you to pursue your own due diligence and arrive at independent conclusions. I think one of Buffett's best admonitions is that you should not invest in that which you do not understand.