2 Sectors With 9 Stocks For Outstanding Potential Results

by: Marc Courtenay

"If a person does not keep pace with their companions, perhaps it is because they hear a different drummer. Let them step to the music which they hear, however measured and far away". Henry David Thoreau (1817-1862)

While Wall Street and the stock market moves higher on the back of the incredible monetary policies of the Federal Reserve, there are a small group of investors who "...perhaps...hear a different drummer". The before-February 9th market correction was not fully realized, and that's mainly because the biggest stock market participants were determined to keep it buoyant for the time being.

The five year chart of the S&P 500 demonstrates the more-than-100 percent run-from its March 2009 low of 666 to its current 1350 closing on February 8th. This depicts the most powerful comeback of the past seven cyclical stock market recoveries. It's nothing shy of impressive!

In an eye-opening article by CNBC it was disclosed that the Federal Reserve is definitely behind the current stock market exuberance. The article stated that:

"... Fed Chairman Ben Bernanke this week emphasized to a Senate committee that the unemployment rate is still too high and the numbers mask a worse jobs picture.

"San Francisco Fed President John Williams, in a speech Wednesday, also held out the prospect of more QE. He said if the economy loses momentum and inflation remains well below 2 percent, the Fed could do more asset purchases, specifically aimed at mortgage-backed securities."

Now we're getting some guidance and insight to one of the sectors that may offer the potential for some great total returns in the weeks and months ahead.

Stuart Freeman, chief equity strategist for Wells Fargo Advisors, said the Fed's ongoing easing programs-- besides the improved economy-- has definitely been a factor driving stocks (this according again to the above referenced CNBC article).

It's what Mr. Freeman also was quoted as saying that offers a more specific clue:

"Freeman said the market is now factoring in a "QE3" program. The market has been expecting a program aimed at housing, with the Fed buying billions of dollars of mortgage securities."

That does seem very possible, especially given the comments that Dr. Bernanke and President Obama have recently made in speeches.

Guess Which Sector Will be One of the Big Beneficiaries?

If you guessed the sector that invests in discounted mortgage securities, you're probably 100% correct. And that sector went on sale Wednesday, oddly the day before the treasuries next 30-year treasury auction.

The nucleus of this sector is Annaly Capital Management, Inc. (NYSE:NLY), a real estate investment trust which engages in the ownership, management, and financing of a portfolio of investment securities. Annaly invests primarily in mortgage pass-through certificates, collateralized mortgage obligations, agency callable debentures, and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans. Annaly Capital also invests in Federal Home Loan Bank, Federal Home Loan Mortgage Corporation, and Federal National Mortgage Association debentures.

The company has elected to be taxed as a real estate investment trust (REIT). As a REIT, the company would not be subject to federal corporate income tax, provided it distributes at least 90% of its taxable income to its stockholders. Today (Wednesday), after one analyst downgraded NLY from outperform to market perform with a $16 price target, the stock price plunged over 3.3% on almost 5 times (that's nearly 600%) increase in its daily-average-volume.

What did the analyst base his downgrade on? Let me quote the Forbes version,

"...as the companies business model is leveraged to a flatter yield curve."

That and about $16.55 will buy you one share of NLY, which pays a sensational 13% dividend yield and is selling at a mouth-watering forward price-to-earnings ratio of slightly above 7. Now I'm aware that Annaly recently reported 4th quarter 2011 earnings that missed by about 3 pennies. But this is a hugely successful, best-in-breed sector leader that knows how to capitalize on the Federal Reserve's very magnanimous monetary policies and how they positively impact the mortgage-backed and collateralized-debt securities sector.

As Shakespeare wrote in Hamlet, "Something is rotten in Denmark", but in this case, the "Denmark" is code for "Wall Street". Why, oh why would this happen the day before the Fed's treasury bond auction, and on the same day that Fed Governor Williams held out more hope for some more helpings of "Quantitative Easing"? Yes, the answer might be, "the big market mavens don't buy into the hope that the Fed will keep this 'party' going". Or, it may be a preparatory set-up for a huge redistribution of shares of companies like Annaly at very attractive prices. I'm voting on the latter.

If I'm correct, that would greatly help other similar companies like Hatteras Financial Corp (NYSE:HTS) and American Capital Agency Corp (NASDAQ:AGNC), whose yield has now popped to 19% and the P/E ratio appears to be a ridiculous 5, meaning its shares are selling at less than 5 times earnings.

By way of knowing, Hatteras Financial Corp. operates as an externally-managed mortgage real estate investment trust (REIT). The company invests in adjustable-rate and hybrid adjustable-rate single-family residential mortgage pass-through securities guaranteed or issued by the United States Government agency, or by the United States Government-sponsored entity.

What could be more secure than investing in debt obligations "guaranteed or issued by the U.S. Government", especially in this environment and considering its current 12.9% yield? It has elected to be taxed as a REIT under the Internal Revenue Code of 1986, and would not be subject to Federal income tax to the extent that it distributes 100% of its taxable income. That's what it's doing. The markets are pricing in a dividend-reduction and a drop in yield, and that seems to be the most obvious explanation for the current share pricing of NLY, HTS, and AGNC.

Oh yes, and then there is Chimera Investment Corporation (NYSE:CIM), which operates as a real estate investment trust (REIT) as well. The company, through its subsidiaries, invests in residential mortgage-backed securities (NASDAQ:RMBS), residential mortgage loans, commercial mortgage loans, real estate-related securities, and other asset classes. This is a riskier set of debt instruments, but it includes the kind of mortgage loans and commercial paper that the "Central Bank of the U.S."-- the very independent Federal Reserve-- want to keep supporting and funding.

In a recent article written by Dr. Steve Sjuggerud titled "How to Collect 14%-plus dividends in a Zero-Percent World", he pointed out that CIM fills a void in the investment world that banks and even the government seem to want to avoid.

"You see, since the real estate market fell off a cliff, banks have been desperately trying to get rid of many of their real estate loans... at ANY price. And that's where Chimera comes in...

"Chimera is willing to buy loans that banks want to get rid of - as long as it can buy those loans at a huge discount.The company collects double-digit interest rates on those loans, and then pays that interest out to shareholders at an outstanding 14.5%", Dr. Sjuggerud explained.

CIM targeted asset classes include agency or non-agency RMBS; prime, jumbo prime, and Alt-A mortgage loans; first or second lien loans secured by multifamily properties, mixed residential or other commercial properties, retail properties, office properties, or industrial properties; and asset-based securities (ABS), including commercial mortgage-backed securities, debt and equity tranches of collateralized debt obligations, and consumer and non-consumer ABS.

The company also has elected to be treated as a REIT for federal income tax purposes, and would not be subject to income tax if it distributes at least 90% of its REIT taxable income to its shareholders.

Investors seem to be ignoring this sector and downplaying its potential. Even if these companies cut their dividends a little, when the dust settles and it becomes more obvious that QE3 has descended from on-high, the share prices will bounce higher. Combined with a 10%-14% yield, a total return over the next year or two of more than 50% is quite feasible.

Here's the Strategy, and it's a Relatively Conservative One

Buy shares of some or all of the above mortgage REITs now, BEFORE the "all-clear-signal" is sounded, but buy half of what you'd usually invest in each one. This way, if there's a big disappointment ahead and QE3 doesn't materialize, you can buy the second half at a deeper discount. If QE3 does happen, you'll be nicely rewarded when the share prices pop and in the meantime you'll be earning a sweet dividend for your patience and risk tolerance.

You might want to buy more of NLY and HTS since they appear to be more risk-averse and well-managed, and buy somewhat less of AGNC, because its parent company is the still-wounded American Capital Ltd (NASDAQ:ACAS). Again, the best time to invest in a sector or a solvent, cash-rich company is when it is deeply out-of-favor, and that surely seems the case with NLY and HTS...as well as AGNC and CIM.

Undervalued Sector Runner-Up

I'd be remiss in not mentioning the close runner-up sector, and that's the precious metal sub-sector of the basic materials sector. I'm aware of the minor pull-back we've just witnessed in gold and silver pricing. But gold is still above $1,732 and silver is pennies below $34.

The mid-tier producers include Eldorado Gold (NYSE:EGO), Yamana Gold (NYSE:AUY) and Seabridge Gold (NYSEMKT:SA), which is an $923 million market cap gold explorer with two world-class precious metals deposits in British Columbia Canada. I'd encourage you to read and carefully study Seabridge's website to see for yourself the potential billions of dollars of gold, copper and silver that it has in the ground. The two projects that SA is working are massive "trophy assets", and analyst-geologists like Matt Badiali (the editor of the S&A Resource Report) feel strongly that the Chinese are itching to buy into or buy-out Seabridge to pull all the proven precious metals reserves out of the ground and into the markets.

At some time in the near future the Market Mavens will begin buying shares of companies like Seabridge, EGO, AUY, IAMGold (NYSE:IAG) and Kinross Gold (NYSE:KGC), which still looks ludicrously cheap (below book value) with a PEG ratio (5-year expected) of only 1.10. It's undoubtedly a takeover target at these prices.

So there you have them. Two sectors and 9 companies that are "under-the-radar" of the investment community at the present time despite excellent fundamentals and a very supportive economic environment. Look at each carefully and see if the results of what you see are telling you to "...hear a different drummer" than the herd is hearing now.

Disclosure: I am long IAG, SA, KGC.