Has KKR Financial Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if KKR Financial (NYSE: KFN  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at KKR Financial.

Factor

What We Want to See

Actual

Pass or Fail?

Growth

5-Year Annual Revenue Growth > 15%

11.4%

Fail

 

1-Year Revenue Growth > 12%

(15.4%)

Fail

Margins

Gross Margin > 35%

100%

Pass

 

Net Margin > 15%

69%

Pass

Balance Sheet

Debt to Equity < 50%

373.8%

Fail

 

Current Ratio > 1.3

16.92

Pass

Opportunities

Return on Equity > 15%

15.7%

Pass

Valuation

Normalized P/E < 20

10.69

Pass

Dividends

Current Yield > 2%

8.2%

Pass

 

5-Year Dividend Growth > 10%

(19.2%)

Fail

       
 

Total Score

 

6 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at KKR Financial last year, the company has given back not only the point it earned from 2010 to 2011, but another point on top of that, as revenue has fallen over the past year. Yet shares of the high-yielding company have managed to pick up about 25% over the past year.

KKR Financial is a specialty finance company that acts as a holding company for subsidiaries that are real estate investment trusts. Because of KKR Financial's structure as a partnership, its distributions are governed by partnership tax law, which can lead to favorable treatment of some of the money shareholders receive as nontaxable return of capital rather than dividend or ordinary income.

The company's primary business is to buy collateralized loan obligations. Using a leveraged model that's similar to what mortgage REITs Annaly Capital (NYSE: NLY  ) , American Capital Agency (Nasdaq: AGNC  ) , and Chimera Investment (NYSE: CIM  ) use to invest in mortgage-backed securities, KKR Financial profits from spreads between the income it receives from its investments and the interest expense it pays to borrow money.

Because the Fed plans to keep interest rates low at least until 2015, KKR Financial has plenty of time to keep benefiting from current favorable conditions. Yet it has also taken steps to lock in longer-term financing, having issued exchange-traded bonds under a separate KKR Financial (NYSE: KFI  ) ticker symbol.

For KKR Financial to improve, it needs to try to keep interest spreads up while also minimizing loan losses. Over time, though, gains on investment sales, which also fall into revenue, will have to peter out, representing a continuing headwind for the company and potentially keeping it from perfection in the future.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Both KKR Financial and mortgage REIT Annaly Capital have a history of paying huge dividends to shareholders. But with Annaly, there are some crucial issues investors have to understand about its business model before buying the stock. In our new premium research report on the company, our analyst assesses whether Annaly is a buy by running through these absolute must-know topics, as well as the future opportunities and pitfalls of the mortgage REIT's strategy. Click here now to claim your copy.

Click here to add KKR Financial to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Dan Caplinger has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital. 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.


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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 October 19, 2012, at 10:56 AM, Trumpace wrote:

    I do not think the author did enough research into the KFN business as lumping it with Annaly shows. KFN has other interests than just Mortgage REITS. It has diversified more in recent years and for awhile did not pay a distribution during the last five year period this example shows. From what I can tell, KFN is a MLP and is not for all investors. For the past three years now KFN has increased its distribution which is different to a dividend. KFN is subject to a K-1 for tax purposes. Some of its business are commody related to Nat Gas and Oil and take positions in actual companies. As for their strength, they have been improving the balance sheet much since the low point in March 2009. In closing KFN is a complex investment but IMHO management has done good job turning around this company since it was trading below a buck and a half in 2009 and has continued to grow the book value since. Although there is a lot of uncertainty about the economy because of the political atmosphere currently I do think once that is understood in Nov then the markets will beable to move and KFN will too.

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