Is American Capital Agency Corp. The Best REIT?

 |  Includes: AGNC, TWO
by: Paul Zimbardo

The 2012 European situation has caused extreme market volatility and has forced investors to seek safer stocks. With the economic and political climates becoming more tumultuous, I have been concentrating on high-yield opportunities. Blue-chip dividend companies are well known, but there are attractive equities with high yields going ex-dividend every week. This strategy can work in one of two ways: either you buy before the ex-date to receive the dividend or buy after if the stock declines far below the after-tax amount of the dividend. Regardless of your short-term strategy, these equities can be attractive longer-term investments depending on your individual circumstances.

Buying the stock to receive the dividend is intuitive, but many have contacted me requesting further details on the second strategy. Investopedia has a great example of how this works. To explain this, I will use AT&T (NYSE:T) as an example. AT&T declared a $0.44 dividend to shareholders of record on July 10, 2012. On the ex-dividend date, the stock price should decline by the after-tax dividend amount, with an assumed tax rate of 15% because many dividends qualify for a preferential tax rate. It is true that you can personally avoid immediate taxation by owning the security in an account with beneficial tax treatment, but this serves as a benchmark.

As a result, an investor would expect the stock price to decline by $0.37 = [$0.44 * (1-.15)]. If AT&T declined by more than $0.37 in the absence of negative news, you might have an attractive opportunity. For the sake of added conservatism, you may consider ignoring the tax aspects and only trade if the stock price declines by the full dividend amount. Executing this strategy can generate returns over short periods of time but should only be performed on companies that you would be comfortable owning.

To focus on these opportunities, I ran a screen with a focus on relative safety for the investments, as the objective is to concentrate on liquid companies that are affordably priced. I began with a specification of a dividend yield greater than four percent and an ex-dividend date within the next week. To provide some layer of safety, I narrowed down the environment by looking at companies with market capitalizations greater than $1B, P/Es between zero and 20, and institutional holding percentage in excess of 15% (except ADRs).

While not a precise requirement, I prefer companies that have underperformed the S&P 500 year-to-date, as it indicates reduced downside relative to peers. With the impending European crisis, I now avoid companies with significant European exposure. 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 S&P 500 Underperformance
  • Minimal European Exposure

After applying this screen, I arrived at the mREITs discussed below. Although I envision these as short-term trading ideas, you still need to exercise caution. The information presented below should simply be a starting point for further research in consultation with your professional financial advisor before you make any investment decision. My goal is to present new companies to you and provide a brief overview of their recent developments, and this should not be considered a substitute for your own due diligence.

American Capital Agency Corp. (NASDAQ:AGNC): 13.83% Yield - Ex-Dividend 9/19
Two Harbors Investment Corp.
(NYSE:TWO): 12.04% Yield - Ex-Dividend 9/20

Both of the companies in the screener are mortgage real estate investment trusts. From "An mREIT is a Mortgage REIT ... which is an entity that specializes in investing solely in mortgage products (e.g. purchasing and selling mortgage-backed securities). Like other REITs (Real Estate Investment Trusts), an mREIT can only deal with mortgages and 90% of earnings must be paid out to its investors annually."

Since these companies are required to distribute such a high percent of earnings to investors, the yields are significantly higher than you find with more traditional companies; however, the stock prices and dividends can both be quite volatile. Not all mREITs are created equal as the mortgages can be for residential, commercial, healthcare or many other underlying purposes. Both American Capital and Two Harbors focus predominately on residential mortgage investments.

The two REITs above both have yields in excess of 12% and are going ex-dividend in the next few days so you might think they are no-brainer dividend captures, right? As I have said in the past, I do not have a wholesale blessing on this sector because there is still so much uncertainty surrounding real estate and the related political environment. These companies can make for profitable longer-term investments but since this area is not my forte, I cannot recommend them without you doing significant additional research. I am simply reminding investors that these super high yield companies are going ex-dividend this week and to conduct further research. Fortunately for investors and homeowners, the Federal Reserve has taken unprecedented action to provide some certainty and help solidify the mortgage market.

Out of these two mREITs that appeared in this week's screen, I wanted to focus on American Capital Agency Corp. as it is one of the largest mREITs, trades at the low forward P/E, and has the most robust cash flows. American Capital is a mREIT that invests in agency securities for which the principal and interest payments are guaranteed by either a U.S. government agency or a U.S. government-sponsored entity. The company focuses on residential pass-through certificates and collateralized mortgage obligation, both of which relate to pools of residential mortgages. To provide an overly simplified summary of the investment hypothesis, low current interest rates allow these companies to profit from historically low prepayment speeds as well as the ability to borrow cheap money immediately and invest it long-term at higher rates. While investors may be scared to see the word mortgage anywhere in their portfolio, AGNC is one of the higher quality mREITs and entails less risk due to its reliance on government/quasi-government backed securities. Major shareholders include BlackRock, Fidelity, Bank of America, UBS, Morgan Stanley, Barclays, and other large financial institutions indicating that you are in good company.

The consensus opinion is that QE3 announced last week will be a strong positive for the mREIT industry as low short-term rates indicate profits for these companies. Barron's published an article summarizing these bullish sentiments and I believe AGNC is the best positioned to capitalize due to its scale. If Bernanke follows through with his pledge to keep rates low through 2015 I believe AGNC can continue to be a winner. Additionally, I highly suggest reading the company's recent 10K as management's comments provide excellent insight into the condition of the overall economy and mortgage market.

Two Harbors offers more diversity over American Capital as it invests in non-agency mREITs as well as "other financial assets". Despite assuming additional risk, American Capital offers a higher yield and has a modestly lower P/E as a bonus. For these reasons, I prefer AGNC over TWO for dividend capture and investment purposes. If Two Harbors offered a higher yield to compensate for the greater assumed risk, I would consider it, but I would stick with the obvious pick here.

The information presented has been summarized below. Yellow and red represent "avoid" and "consider" classifications, respectively.

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Disclosure: I am long T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Additional Disclosure: Author may initiate a long position in AGNC in the next 72 hours.