Will American Capital Agency Help You Retire Rich?

Now more than ever, a comfortable retirement depends on secure, stable investments. Unfortunately, the right stocks for retirement won't just fall into your lap. In this series, I look at 10 measures to show what makes a great retirement-oriented stock.

For cash-strapped investors, dividend income is more important than ever. That's the main reason for the massive spike in popularity for American Capital Agency (AGNC 0.11%) and its peer real-estate investment trusts that invest in mortgage-backed securities. With the Federal Reserve having pledged low interest rates for the foreseeable future, is it a no-brainer to invest in a business tailor-made to benefit from low rates? Below, we'll take a look at how American Capital Agency does on our 10-point scale.

The right stocks for retirees
With decades to go before you need to tap your investments, you can take greater risks, weighing the chance of big losses against the potential for mind-blowing returns. But as retirement approaches, you no longer have the luxury of waiting out a downturn.

Sure, you still want good returns, but you also need to manage your risk and protect yourself against bear markets, which can maul your finances at the worst possible time. The right stocks combine both of these elements in a single investment.

When scrutinizing a stock, retirees should look for:

• Size. Most retirees would rather not take a flyer on unproven businesses. Bigger companies may lack their smaller counterparts' growth potential, but they do offer greater security.
• Consistency. While many investors look for fast-growing companies, conservative investors want to see steady, consistent gains in revenue, free cash flow, and other key metrics. Slow growth won't make headlines, but it will help prevent the kind of ugly surprises that suddenly torpedo a stock's share price.
• Stock stability. Conservative retirement investors prefer investments that move less dramatically than typical stocks, and they particularly want to avoid big losses. These investments will give up some gains during bull markets, but they won't fall as far or as fast during bear markets. Beta measures volatility, but we also want a track record of solid performance.
• Valuation. No one can afford to pay too much for a stock, even if its prospects are good. Using normalized earnings multiples helps smooth out one-time effects, giving you a longer-term context.
• Dividends. Most of all, retirees look for stocks that can provide income through dividends. Retirees want healthy payouts now and consistent dividend growth over time -- so long as it doesn't jeopardize the company's financial health.

With those factors in mind, let's take a closer look at American Capital Agency.

Source: S&P Capital IQ. Total score = number of passes. *This is a gain; American Capital Agency hasn't suffered a dividend-adjusted loss in any calendar year since its 2008 IPO.

With six points, American Capital Agency has a lot of what conservative investors prefer to see in a stock. The big question, though, is what the future holds for the mortgage REIT and its peers.

As a mortgage REIT, American Capital Agency uses extreme leverage to generate profits from the spread between its low short-term borrowing rates and its somewhat higher income from investing in mortgage-backed securities. Like better-known mortgage REIT Annaly Capital (NLY 0.76%), American Capital Agency focuses on mortgage investments backed by agencies like Fannie Mae and Freddie Mac, leaving riskier non-agency mortgage-backed securities to Chimera Investment (CIM 1.82%) and other mortgage REITs in the sector.

The Fed's decision to implement new quantitative easing, however, puts American Capital Agency in a bind. As the company said at a conference last week, Fed buying of mortgage-backed securities will hurt yields and bring spreads down. Already, those narrowing spreads have forced American Capital Agency, Annaly, and Invesco Mortgage Capital (IVR 1.58%) to reduce their dividends from their peak levels. Moreover, the risk that mortgage borrowers will prepay their home loans could cause even more challenges for mortgage REITs.

Perhaps most importantly, though, competition among the many popular mortgage REITs is driving demand for mortgage securities through the roof. Cypress Sharpridge (NYSE: CYS) recently explained how these dynamics hurt investors, and with the Federal Reserve now stepping in with more force, the pressures are just going to get worse.

For retirees and other conservative investors, double-digit dividend yields are hard to pass up. With the shares continuing to soar higher, investors don't have much margin of safety in the case something more serious should happen to the dividend in the future. With the amount of leverage it has, American Capital Agency has little room for error, and prudent retirement investors should weigh their appetite for risk with the lucrative payouts.

Keep searching
Finding exactly the right stock to retire with is a tough task, but it's not impossible. Searching for the best candidates will help improve your investing skills and teach you how to separate the right stocks from the risky ones.

Mortgage REITs are a tough nut to crack. Get all the information you need from our premium report on Annaly Capital, which also includes details on how competitors like American Capital Agency threaten its long-term success. Click here to get your copy instantaneously.

Add American Capital Agency to My Watchlist, which will aggregate our Foolish analysis on it and all your other stocks.