One of the most popular real estate investment trusts that focus on mortgages, American Capital Agency (AGNC 1.85%), is an interesting high-dividend stock. Currently yielding about 11.6%, the company has had a rocky couple years that have seen some dividend cuts and some interesting strategies to boost returns.
Is American Capital Agency a good choice for your portfolio? Specifically, is the dividend sustainable at the current level, and what might the future have in store?
What the company does
American Capital Agency is a real estate investment trust, or REIT, that invests in mortgages and mortgage-backed securities.
These types of REITs make money by purchasing mortgages that pay higher rates than they can borrow money for. As a simplified example, if a company borrows money at 2% interest and uses it to purchase mortgages that pay 4%, the 2% "spread" is the profit.
To deliver attractive returns, these companies use high leverage ratios. American Capital Agency uses a leverage ratio of about five to one, according to its most recent quarterly report. Because of the high use of leverage, these companies are sensitive to rapid changes in interest rates, which can erode the spreads and profits.
Why it's been a rocky few years
There has been tremendous uncertainty regarding interest rates over the past couple years. As the market awaited the Federal Reserve's "taper" of its economic stimulus, interest rates shot up and American Capital Agency and most other mortgage REITs saw their profit margins narrow.
This forced the company to cut its dividend several times and to lower leverage in anticipation of interest rate volatility. As a result of these moves, American Capital Agency will have a significant amount of buying power to capitalize on future opportunities as they come up, and is also less susceptible to interest rate-related headwinds as the market awaits a rate hike.
Management handled the tough times brilliantly
When times got tough for mortgage REITs, American Capital Agency's management made two very savvy moves.
First, since its stock was trading at a substantial discount to book value, the company felt the best use of its capital was to buy back its own shares for less than they're worth, essentially making an immediate profit. As a matter of fact, in late 2013, shares were trading for as little as 75% of the value of the company's assets. Buying shares for 25% less than their worth, then simply absorbing that value back into the remaining shares, seems like a big no-brainer, and a much better investment than increasing leverage to buy more mortgage-backed securities.
In 2013, the company bought back more than 40 million shares, or more than 10% of the total share count.
In a particularly successful move, American Capital Agency spent about $400 million to buy shares of competitors whose stock prices were even more beaten down than its own. During the first quarter of 2014 alone, these investments produced about $50 million in dividends and gains, a 12% gain in just three months.
These moves, along with the stabilization of interest rates, have pushed American Capital Agency's book value per share up by nearly 10% since the end of 2013, even though the company owns fewer assets, as evidenced by the lower use of leverage.
American Capital Agency Book Value and Leverage Ratio | Create Infographics.
While these moves are in the past, these are shining examples of why I trust American Capital Agency's management to make prudent moves going forward, no matter what the rest of the stock market or interest rates are doing.
And it's still cheap
After a big rise in valuation earlier this year; American Capital Agency is once again trading at a nice discount.
The company's assets are worth $26.26 on a per-share basis, and the stock trades for about $22.25, meaning $1 worth of American Capital Agency's assets is currently trading for roughly $0.85.
While there is admittedly a high level of risk when buying mortgage REITs, the nice discount to asset value definitely helps to swing the odds in the investor's favor. In fact, I wouldn't be surprised to learn the company has repurchased another large chunk of its own stock to take advantage of the discount. It does seem like a good time to do so.
