Capstead Mortgage Corporation (CMO) is a real estate investment trust (REIT) that invests in residential mortgage-backed securities. Companies in this sector are able to offer shareholders a very generous dividend yield because of a few factors. First of all, a company that is set up as a REIT must legally pay most of its earnings to shareholders in the form of a dividend. Plus, many of these companies use leverage to amplify returns. For example, Capstead Mortgage can borrow money at low rates and then invest those funds in investments that offer a higher yield.
Since companies in this sector pay a high percentage of earnings out in the form of a dividend, a drop in earnings can quickly lead to a dividend cut. Ever since the Federal Reserve announced plans for QE3, mortgage rates have been dropping and that makes consumers more likely to refinance. This can lead to lower profits for mortgage REIT companies like Capstead, as mortgages at higher rates are replaced with ones at lower rates and that can lead to a dividend cut. Capstead and a few other REIT stocks recently cut the dividend and that has led to a buying opportunity.
Capstead had been paying 40 cents a share per quarter in dividends, but recently cut the payment to 36 cents. However, buying the dips is a strategy that has paid off over time because there are very few stocks that can generate yields of about 12%. For example, let's say an investor buys a stock like Capstead and collects about 12% yields from the dividend over the next four years. That could add up to about a 48% in total return over that time period. Even if the stock were to drop by 10%, because of a dividend cut, the investor would still be up about 38%, which sure beats collecting yields of about 2% annually in some bonds and many stocks.
After a pullback in the stock price over the dividend cut, the stock looks too cheap. Capstead shares trade below book value which is $13.88. The Board of Directors seem to think the stock is undervalued and it has authorized the repurchase of up to $100 million of its outstanding common shares. Since the market capitalization is about $1.2 billion, a $100 million buyback is significant as it represents around 8% of the market cap.
Dividend stocks have been one of the best investments over the last several years and they have also performed relatively well in recent market corrections. This trend should continue and that's why buying the dips in stocks like Capstead should lead to outsized gains in the coming years.
Here are some key points for CMO:
Current share price: $12.13
The 52 week range is $11.66 to $14.59
Earnings estimates for 2012: $1.56 per share
Earnings estimates for 2013: $1.43 per share
Annual dividend: $1.44 per share which yields about 12%
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.