American Capital Agency's Smart Moves Could Produce A Dividend Hike

American Capital Agency did a great job of capitalizing on the bad times in the mREIT sector...and it's paying off.

May 8, 2014 at 8:00AM

American Capital Agency (NASDAQ:AGNC) is one of the most popular high-dividend stocks on the market, and like most mortgage REITs, it has struggled over the past couple of years.

However, shareholders may have a reason to breathe a sigh of relief after the company's most recent quarterly results. It looks like the company's strategies during the rough times are paying off, and the good times could be just beginning.

Two smart moves during rough times
During the first quarter of 2014; American Capital Agency reported its best quarter in over a year. For the first time since 2012, the company's book value per share gained, and the dividend didn't get cut. The company's management attempted to take advantage of the tough times for mREITs, and they appear to have succeeded, so far.

AGNC Book Value (Per Share) Chart

Virtually all mortgage REITs have been trading for significant discounts to book value due to interest rate spread uncertainty, and American Capital Agency capitalized on this in two ways. First, they began to aggressively buy their own shares back. During 2013, the company bought back 40.3 million shares, which represents more than 10% of the total.

Essentially, they were buying back control of their own assets for about 80 cents on the dollar, which seemed like a better investment to management than increasing leverage by buying more assets.

Also, in order to diversify their holdings a little further, the company also spent $400 million to buy equity in its peers, which included a large stake in Hatteras Financial Corp. During the first quarter, these investments produced almost $50 million in dividends and capital appreciation, which represents a 12% gain in just one quarter.

The gamble paid off
The $400 million investment in other mREITs accounted for $0.14 of the company's $1.18 in total income per share for the quarter, and along with the buybacks, played a huge role in allowing American Capital Agency to maintain their $0.65 per share dividend. The company produced a 5.1% return on equity for the quarter, including both the dividend income and rise in book value.

The only negative was the slightly lower spread income, which dropped by about 6% on both narrowing spreads and a decrease in leverage in the portfolio.

However, I see this as an opportunity, as the decreased leverage will allow the company the flexibility to take advantage of further opportunities as they present themselves.

Is the market expecting the dividend to rise?
Mortgage REITs tend to gravitate toward certain dividend yields, which depend on several factors such as the leverage ratio employed by the trust and the quality of assets held. American Capital Agency's share price tends to correspond to a 14-15% payout.

AGNC Chart

To illustrate this, consider that when the dividend was $0.80 in September, shares traded for around $23.00, which would correspond with a 14% annualized payout. When the quarterly payout was cut to $0.65 per share in the fourth quarter, the share price dropped to around $19, again corresponding to the same payout. Since then, shares have risen to the $23 range on the positive quarter and the increased book value, perhaps indicating an anticipated dividend hike.

More risk, more reward
American Capital Agency and other mREITs do carry a great deal of risk, which is to be expected with any highly leveraged investment paying such high dividends. The share buybacks and investments in peers could have been devastating for the company if interest rates had continued to spike and spreads continued to erode.

However, at the current price levels, the risk definitely justifies the reward, especially in American Capital Agency's case. Management has shown its willingness to take advantage of adverse environments, and the company is in a great position to capitalize as opportunities present themselves.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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