During American Capital Agency Corp's (AGNC) annual meeting on 1 May 2012, Mr. Gary Kain gave a brief powerpoint presentation, at the end of which he discussed three macroeconomic scenarios and implications for the company. This article reviews the 3 scenarios as follows:
Scenario 1: Continued, gradual economic improvement (High probability)
In this scenario, the economy continues to improve gradually, a third Fed quantitative easing (QE3) becomes unlikely, interest rates remain low, mortgage backed securities prices trend up gradually, and returns on future investments gradually diminish. This scenario basically assumes the same market environment as for the past 3 years, and is the path of least resistance, assuming the Fed continues to keep interest rate low for the near term, hence most probable.
Implication for the stock:
- Book value will go up.
- Dividend rate will go down gradually (because returns on future investments go down).
- Stock price will likely go up, supported by the increasing book value.
Scenario 2: The economy recovery falters (Medium probability)
In this scenario, the economy tumbles over and enters into another recession, QE3 occurs, with the Fed buying mortgage backed securities to keep their prices up and keep interest rates down, prepayment rates go up, and returns on future investments are low because of low interest rates, but the spread between interest earned on mortgage backed securities and borrowing costs may still provide adequate income in a mild recession. This scenario may occur, for example, if the European debt crisis escalates and spreads globally.
Implication for the stock:
- Book value will go up as interest rates go down, but in a severe recession, book value can go down significantly due to defaults, credit losses, and liquidity concerns.
- Dividend rate will go down due to prepayments.
- Stock price will likely go down, which may provide a great buying opportunity if the price drops significantly below its book value, and the company is able to manage its risks to keep prepayments down.
Scenario 3: The economy rebounds strongly (Low probability)
In this scenario, the economy rebounds strongly and the current recovery develops into a rampaging bull market, there will be no QE3, the Fed begins to tighten to prevent or counter run-away inflation, interest rates go up significantly, prepayment rates go down, and returns on future investments become very attractive, if the company is able to take advantage of them.
Implication for the stock:
- Book value will go down as interest rates go up.
- Dividend rate will go up due to lower prepayments and higher returns on future investments.
- Stock price will likely go down as book value goes down and spread narrows due to high borrowing costs, but may offer a great buying opportunity if the company is able to deleverage safely and take advantage of the higher returns on future investments.
While Mr. Kain did not give the exact probability for each of the three scenarios, it would not be unreasonable to estimate them as 50%, 30%, and 20%, for scenarios 1, 2, and 3, respectively. Mr. Kain emphasized that AGNC is well hedged overall for all possible scenarios.
In summary, I think AGNC is still a solid hold as a stock, although the value is not as attractive as its initial public offering price of $20 in 2008, which provided a spectacular cumulative return of 239%, assuming reinvestment of dividends. While the company's leverage of 8:1 currently is higher than the industry's average, it appears acceptable given the high probability of scenario 1 and low likelihood (for now) of scenario 3.
Disclosure: I am long AGNC.
