An 18% Dividend Yield I Don't Want to Earn

Last week, the Financial Times reported that some of the world's largest hedge fund managers have experienced painful losses over the past month, prompting many funds to reduce their risk by selling down some of their positions. Which stocks look vulnerable to that process? I name five below and take a deeper look at one -- a stock with a deceptively attractive dividend yield of 18.5%.

5 stocks hedge funds are selling
This table contains five among the top 20 stocks in the Russell 1000 that have suffered the largest absolute declines in hedge fund ownership since the end of March:

Company

Hedge Fund Ownership: Latest vs. March 31

Forward Price-to-Earnings Multiple*

Alpha Natural Resources (NYSE: ANR  ) 9.6% / 18.0% 9.0
American Capital Agency (Nasdaq: AGNC  ) 6.8% / 9.4% 1.2
[Price-to-book value]
CIENA (Nasdaq: CIEN  ) 13.8% / 17.8% 50.2
Novellus Systems (Nasdaq: NVLS  ) 3.8% / 7.3% 10.8
Family Dollar 15.9% / 24.6% 15.8

Source: Capital IQ a division of Standard & Poor's.*As of July 7, based on next 12 months' forward earnings estimates.

An old classic: Borrow short, lend long
The stock I want to focus on today is American Capital Agency, a mortgage real estate investment trust (I'll refer to the company and its stock by its ticker from now on). American Capital borrows money on a short-term basis and invests in mortgage-backed securities that are guaranteed by the U.S. government or nationalized housing agencies Fannie Mae and Freddie Mac. American Capital faces no credit risk (in theory) and collects the difference between its borrowing cost and the interest it receives on the securities in its portfolio.

(Annaly Capital Management (NYSE: NLY  ) , which is both an 11 O'Clock Stock and a Rising Star pick, is a mortgage REIT with a similar model.)

Lever up!
Sounds like a good business, and American Capital's 18.5% dividend yield must look absolutely irresistible to yield-starved investors right now. Those dividends are supported by high returns on equity (18.4% and 19.6% for the fiscal years 2010 and 2009, respectively.) However, those returns are mainly the product of leverage (currently: 7.4 : 1); unleveraged returns are much less impressive, at 2.3% and 2.9%, respectively.

Not only does American Capital's dividend depend heavily on leverage, but its obligations are for the short term and need to be rolled over continually: Repurchase agreements (or "repos," a form of short-term financing) represent three-quarters of AGNC's balance sheet. Compare that with the way Warren Buffett conducts his affairs at the head of his financial-industrial conglomerate, Berkshire Hathaway (NYSE: BRK-B  ) . In his 2009 chairman's letter, he wrote:

We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses.

Financially dependent
Contrary to Berkshire's modus operandi, American Capital depends very much on "the kindness of strangers," and it's impossible for the company to strengthen its capital position by retaining earnings. As a REIT, it is required by law to distribute 90% of its taxable net income annually.

Despite this, two exceptional hedge fund managers, Balestra Capital and Whitebox Advisors, were among the top hedge fund owners of American Capital shares as of the end of the first quarter (Balestra was also Annaly's largest hedge fund investor). Unless you follow the hedge fund industry relatively closely, you won't have heard of them; however, I can assure you they are the real deal (both anticipated the subprime crisis, for example). It will be interesting to see whether they were among the funds that reduced their exposure to American Capital during the second quarter.

The dividends aren't free money
Barring a substantial mispricing, the market is not gifting investors a better-than-15% equity premium over the 10-year Treasury yield without risk, and there is no reason whatsoever to believe American Capital's shares are substantially undervalued. They may have been in March 2009 but have doubled since then.

Investors should be aware that American Capital (and Annaly) are exactly the sort of stocks that could inflict maximum pain on shareholders if the U.S. fails to extend its debt ceiling in time and enters into technical default -- or if the credit markets were seize up for any reason. To get an idea of the kind of losses I'm talking about, one needs to only look at shares of American Capital's external manager, American Capital Strategies (NYSE: ACAS  ) , which lost 99% of their value between January 2007 and March 2009 (today, that loss is only three-quarters).

Crisis -- what crisis?
Not to worry, though, "in the absence of another crisis, you'll do well," as PIMCO's Bill Gross assured investors in recommending Annaly in Barron's January Roundtable. Another crisis? It hardly bears mentioning, surely.

If you're looking for low-risk dividend stocks, The Motley Fool has identified 13 high-yielding stocks to buy today.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Berkshire Hathaway and Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (22) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 11, 2011, at 2:02 PM, rlp2451 wrote:

    If there is a debt crisis, REITs won't be the only stock to lose value.

    The key as always is diversification - hold no more than 10% of your portfolio in such assets. Also useful are stop losses.

  • Report this Comment On July 11, 2011, at 2:36 PM, 1020chicago wrote:

    I see you are value investor and understand your reasoning. The risk for Agency backed mREITS is yield spread and more importantly in the short term, has you point out, the debt ceiling. Do you really think that congress will allow the debt ceiling increase not to pass? The problems we will see in worldwide financial markets will be widespread. AGENCY backed mREITs i contend may be hard hit, but in the end the govt. will be forced to step in. Essentially mREITs like AGNC and NLY will be on sale for some time. It is also worthwhile to note the amount of paper AGNC and others hold in fixed versus variable instruments.

  • Report this Comment On July 11, 2011, at 3:51 PM, definer wrote:

    The issue here is that REITs are not a sure money bet but in fact are a "get it while you can" opportunity.

    Additionally you hear a lot of badmouthing about high paying dividend companies (REITs or otherwise) from the "analysts" who worry about dividend reductions. Any dividend is better than NO dividend all other things being equal.

  • Report this Comment On July 11, 2011, at 4:16 PM, mystro125 wrote:

    Wow!! A foolish article, from a surprising source. How can you use the debt ceiling as an arguement for that not owning a nortagage REIT. If the debt celing is not passed, everyone loses. What would happent to treasury obligagtions, not just FNMA and Freddie and all debt holders of the US??

    Think before writing something like this.

  • Report this Comment On July 11, 2011, at 4:50 PM, dsandman999 wrote:

    How long do you think there will be an impass on the debt ceiling? a Day, A week, a month? And what of thier hedge positions?

    The hit is unlikely to hit the long term part of thier portfollio other than some price to market crap. The underlying securities are sound. And they could suspend a payment for a quarter and still be paying 14+% for the year with recovery likely.

    I do not plan ob selling and I might actually take any major drop as a buying opertunity because if it reprices at 14% and then next quarte is back on the 18+%, it will be a good investment.

  • Report this Comment On July 11, 2011, at 5:26 PM, TMFAleph1 wrote:

    Some readers are missing the forest for the trees. I'm only pointing out that a failed debt ceiling negotiation and technical default are only one potential catalyst for a correction in these shares. I'm by no means asserting that this is the only scenario in which AGNC investors can get burned.

    Alex Dumortier

  • Report this Comment On July 11, 2011, at 5:28 PM, TMFAleph1 wrote:

    In addition, it's clear from the comments that some people think these dividends are free money. As I point out in the article, they aren't.

    Alex Dumortier

  • Report this Comment On July 11, 2011, at 5:41 PM, NovaB wrote:

    One item The Fool failed to mention in the 11 O'Clock stocks is dividends and reinvestment. 50 shares of NLY over the last year or so would be worth significantly more than what that page lists it at. I am guessing there are other stocks in that list as well, raising the current portfolio gain a great deal higher than the $8,000 listed.

    I have owned NLY for 10 years. Bought $3,000 of it, reinvested and now own over 434 shares.

  • Report this Comment On July 11, 2011, at 5:50 PM, rsd57 wrote:

    The commentary above is a bit of fighting the last war. Financing agency mortgage backed bonds at 7:1 leverage sounds very ominous in fact it isn't that risky in the market. I know I worked at an mbs hedge fund previously. Unlike most other bond strategies during the crisis, agencies, especially at large reits were almost always able to be financed. The real issue for investors in this sector besides an accident by a manager is the shape of the yield curve and the spread between agency bonds and the hedging instrument (us treasury bonds, swaps, etc.), as well as the skill of the manager in hedging the moving target of bond convexity in his longs. The best bet for investing in them is to make them a relatively small part of an income strategy and to buy different mReits that use different amounts of leverage, have different business strategies/investment plans and hedge differently. Comparing an MReit to Berkshire Hathaway is actually a little foolish frankly. Berkshire should never rely much on Repo markets - it owns companies and illiquid investments. An Agency MREIT owns mostly liquid assets that can be sold and that run off continuously from default settlements and prepayments. I think the commentators knowledge of this sector is enough to make sound good but not enough to give a true picture of the risks (they are there but not what the author is pointing out.)

  • Report this Comment On July 11, 2011, at 6:44 PM, revealedin71 wrote:

    I have been hearing this same siren song about AGNC for the past 2 years. The firm has good, proven management and has a easy to understand business model of why that yield is what it is. Their is a valid argument that rates may not rise,nor rise very much, if growth stays stagnant. And AGNC and its bretheren may continue to prosper accordingly. I concur this is a measured risk,but the opportunity has been there and continues to be there.

  • Report this Comment On July 11, 2011, at 7:36 PM, 11x wrote:

    How did I know this was going to be about AGNC or CIM? I've been hearing that argument for years. "That dividend will be cut at some point!!!" So if their dividend gets cut in half, is it not worth owning?

  • Report this Comment On July 11, 2011, at 8:30 PM, Mohawk1510 wrote:

    I think the author has an axe to grind here. Certainly there is leverage in any MREIT, but it does not appear that interest rates will rise significantly in the near future - 12 to 18 months. All of the analysts tht cover the stock recommend buying or holding it. None recommend selling it. I have been in AGNC since soon after it began and have been very happy, not only with the yield from the distribution, but also the share appreciation in spite of numerous secondary offerings. Just another Foolish article in my opinion.

  • Report this Comment On July 12, 2011, at 12:23 AM, maiday2000 wrote:

    I bought AGNC right after the debt crisis in 2008 and it has rewarded me handsomely. Yet, as someone else mentioned, MF has been bashing it constantly this entire time, although I know it has outperformed every portfolio they have. Not a fair comparison? Neither is comparing it to Berkshire!

  • Report this Comment On July 12, 2011, at 11:49 AM, pondee619 wrote:

    "(I'll refer to the company and its stock by its ticker from now on). American Capital borrows... American Capital's 18.5% dividend yield.. American Capital's dividend depend.. American Capital depends... hedge fund owners of American Capital shares...their exposure to American Capital during the second quarter...American Capital's shares are substantially undervalued...aware that American Capital (and Annaly...American Capital's external manager.."

    "(I'll refer to the company and its stock by its ticker from now)"? You used the ticker ONCE. Why add the paranthetic phrase and then ignore it?

  • Report this Comment On July 12, 2011, at 2:06 PM, pastreet wrote:

    I'd say this follows the old adage of, if you can't understand the company, you have no business owning the stock...

  • Report this Comment On July 12, 2011, at 2:07 PM, pastreet wrote:

    This company's business model sounds just rife with risk, and it's no surprise they experienced losses.

    Pat

    www.compoundingreturns.com

  • Report this Comment On July 12, 2011, at 6:19 PM, TT4N wrote:

    The sky is falling the sky is falling...

  • Report this Comment On July 15, 2011, at 12:13 PM, cdvision wrote:

    There's no immediate need for worry. The debt ceiling will be raised in some form or another, and it's going to be a good amount of time before the Fed tightens rates.

    I have no problem buying leveraged M-REITs here and keeping the dividends from being un-reinvested. I'll take that cash and buy large caps to hedge. I especially like Wells Fargo as a hedge here, since they earn better returns as interest rates rise.

  • Report this Comment On July 16, 2011, at 8:03 PM, Sturmudgeon wrote:

    can someone explain why the CIM stock price has decreased so steadily during the past month or so?

    thanks.

  • Report this Comment On July 20, 2011, at 9:08 PM, 1caflash wrote:

    I'll try to explain CIM's share price decline. Many traders do not like dilution; Jim Cramer likes Annaly, and Chimera had some dividend cuts. You also have folks constantly claiming that interest rates will rise while the United States is experiencing a weak economy. That kind of thinking seems dumb. CIM and AGNC are in my DRIP, as is ARES Capital (ARCC).

  • Report this Comment On July 29, 2011, at 5:48 PM, TMFAleph1 wrote:

    @dsandman999, you wrote:

    "How long do you think there will be an impass on the debt ceiling? a Day, A week, a month? And what of thier hedge positions?

    The hit is unlikely to hit the long term part of thier portfollio other than some price to market crap. The underlying securities are sound."

    In that scenario, the problem would not emerge from the firm's securities portfolio (assets) -- although it would likely suffer in a second stage -- it is with the repo borrowing (liabilities) that finances the portfolio. That borrowing needs to be rolled over continually.

    What do you think happens to AGNC and many other investors who are heavily dependent on repo financing if that market seizes up? Unless they can find an alternative source of finance, they will be forced to sell down the portfolio, etc

    Repo markets are a critical piece of the plumbing of the financial system, something that became spectacularly clear during the Bear and Lehman crises. That critical piece of plumbing could be highly vulnerable in a default scenario.

    Alex Dumortier

  • Report this Comment On June 22, 2012, at 5:38 PM, TMFAleph1 wrote:

    “It’s a double whammy and a little unsettling for the repo market to no longer have SOMA lending as a backstop,” said Michael Cloherty, head of US interest rate strategy at RBC Capital Markets.

    'Operation Twist' threat to bond trading, Financial Times, Jun. 21, 2012

    http://www.ft.com/intl/cms/s/0/a8e4fc4c-bba8-11e1-90e4-00144...

    "As a reminder, there has been abnormally low liquidity, reflected in offer-to-cover ratios, in the recent auctions for some of the Treasuries that the Fed purchases as part of the program. Other strategists have also pointed out that the Fed has a dwindling supply of sub-three-year Treasuries to sell, which among other things might exacerbate future strains in repo markets."

    RBC: Problems with extending Twist... not fixed by extending Twist, FT Alphaville, Jun. 22, 2012

    http://ftalphaville.ft.com/blog/2012/06/22/1056421/rbc-probl...

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