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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.