The 7 Highest Potential Returns in Mortgage REITs

In a private speech to the Financial Planning Association, legendary Vanguard founder and former CEO John Bogle made an observation that’s absolutely critical to understanding where the best stock returns come from -- and how to find the next great stock to buy.

He told the assembled guests that only three things drive investor returns:

  • Dividends
  • Earnings growth
  • Changes in valuation

Historically, stocks have returned 9.6% per year on average -- 5%, 4.5%, and 0.1% from dividends, earnings growth, and valuation changes, respectively. Naturally, the best stocks to buy are the ones that will produce the highest combined returns.

So which mortgage REITs will earn investors the best returns today? Obviously, no one knows for sure. You should always take future estimates with a grain of salt, particularly when analyst forecasts are involved. In fact, studies show that analysts' long-term earnings-per-share estimates tend to be over-optimistic by roughly 40%, so I've reduced their estimates accordingly.

But by running the numbers, we can compile a list of which stocks are the implied best buys today. Here are our assumptions:

Company

Dividend Yield (current)

5-Year Growth Rate (reduced by 40%)

Price-to-Earnings Ratio (in 2016)

Chimera Investment (NYSE: CIM  ) 17.4% 3% 12
American Capital Agency (Nasdaq: AGNC  ) 20% 1% 10
Dynex Capital (NYSE: DX  ) 12.1% 5% 13
Hatteras Financial (NYSE: HTS  ) 14.8% 3% 11
Two Harbors Investment (NYSE: TWO  ) 17.4% 3% 12
Anworth Mortgage (NYSE: ANH  ) 14.4% 3% 12
Annaly Capital (NYSE: NLY  ) 14.8% 1% 10

Data from Capital IQ, a division of Standard & Poor's. Includes stocks on major U.S. exchanges capitalized over $200 million, with positive earnings and at least one analyst issuing long-term earnings estimates.

And here are their implied five-year annualized returns for shareholders. I've ordered the three return components by their reliability -- first dividends, then earnings growth, then valuation.

Company

Dividend Return*

Earnings Growth Return

Valuation Return

Implied Cumulative Annual Return

Chimera Investment 14% 3% 17% 34%
American Capital Agency 15% 1% 18% 34%
Dynex Capital 11% 5% 15% 30%
Hatteras Financial 12% 3% 11% 26%
Two Harbors Investment 14% 3% 6% 23%
Anworth Mortgage 12% 3% 8% 23%
Annaly Capital 12% 1% 8% 21%

Source: Author's calculations. *Assumes dividend growth at rate of earnings growth.

The raw numbers tell us that these are the seven most promising names in mortgage REITs. Of course, analyst growth assumptions for any individual company could prove overly optimistic or pessimistic. Given that interest spreads are at historical highs, I'd be somewhat skeptical of positive long-term earnings-per-share growth estimates for this industry. That said, the high potential returns on fairly low growth estimates indicate that there is a decent margin attached to these stocks, making this list an excellent starting point for further research. (You can read more about my two favorites here.)

So don't stop here. If any of these stocks interest you, add them to your personalized stock Watchlist. If you haven't started one yet, click here to begin.

Ilan Moscovitz doesn’t own shares of any company mentioned. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management. 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 (3) | Recommend This Article (9)

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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 August 30, 2011, at 7:45 PM, jimvargas wrote:

    I'm new to investing, so bear with me if this is a dumb question. :)

    I'm wondering why -- when the fed has declared rates will stay low, low for at least 2 years -- CIM and others still maintain such high dividends?

  • Report this Comment On August 30, 2011, at 9:57 PM, neamakri wrote:

    to louisianne; here are some things to help you.

    1. REIT's borrow money at a low rate, and purchase Mortgage-Backed-Securities that yield a higher rate. (lookup MBS in wikipedia)

    2. Since they borrow money, they are using leverage. Leverage multiplies your profits.

    3. REIT's are registered in a special IRS tax bracket. They must return 90% of their profits as dividends to shareholders.

    4. Not all the seven are equal. You need to research their EARNINGS. You will discover that one or more pay dividends higher than their earnings, so skip those. Also, see what "Analysts Estimates" are for the next two years. Some of the seven are expected to EARN LESS in the coming years, so keep that in mind.

    5. Of the seven, only DX is worthy of my money...good luck!

  • Report this Comment On September 03, 2011, at 4:09 PM, TMFDiogenes wrote:

    @ louisianne,

    Two things: 1) You can't expect a lot of capital gains out of them, because they don't retain much of their earnings. To grow assets, they have to issue new shares. 2) At some point, interest rates will rise, which is enough to keep some investors out since the dividend (and stock) could fall significantly at or sometime anticipating that point.

    Hope that helps,

    Ilan

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