Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.
Let's examine how American Capital Agency
First and foremost, dividend investors like a large forward yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.
American Capital Agency yields a whopping 16.5%, considerably higher than the S&P 500's 2%.
2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company paid out in dividends last year to the earnings it generated. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford, even when its dividend yield doesn't seem particularly high.
As a real estate investment trust, however, American Capital Agency is required by law to pay out more than 90% of its earnings in the form of dividends in return for not having to pay corporate income taxes.
3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The debt-to-equity ratio is generally a good measure of a company's total debt burden, but remember that for mortgage REITs like American Capital Agency, debt is a big part of their business model. It's also important for mortgage REIT investors to consider portfolio makeup, since leverage isn't the only kind of risk. The proportion of mortgage-backed securities not guaranteed by Fannie and Freddie is a good first glance at portfolio risk.
Let's see how American Capital Agency stacks up next to some other agency-focused REITs:
Non-Agency Securities as % of Total Mortgage-Backed Securities
|American Capital Agency||797%||100%|
Source: S&P Capital IQ, company filings.
As far as mortgage REITs go, American Capital Agency tends to use moderately high leverage to finance a relatively low-risk, low-yield portfolio. To put it another way, American Capital Agency's investments yield an average of 3.1%, in line with Annaly Capital's 3.2% and ARMOUR Residential's 3.1%, but above Hatteras' 2.8%. For the residential mortgage REIT industry, these figures are quite common and are near the lower end of the spectrum. Consider that high-risk portfolios, such as Chimera's, can be composed of half non-agency securities and yield as much as 7.2%.
A large dividend is nice. A large, growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
REITs have been enjoying a boom in recent years, as low interest rates have driven their cost of funding down much faster than the yield on their investments. That equation can't last forever, but it's unclear when it will change. Last month the Fed announced it expects interest rates to remain near zero through 2014.
But that good news for REIT investors doesn't prevent long-term rates from falling further should the Fed become more concerned about the pace of economic recovery. All four of the REITs above have seen their interest rate spreads fall considerably in just the past year.
The Foolish bottom line
With a large yield, moderately large leverage as far as its industry is concerned, a default-guaranteed portfolio, and economic conditions working in its favor for the time being, American Capital Agency looks like a dividend dynamo for the time being, though these high dividend payouts are almost certain to come down eventually. If you're looking for some other great dividend stocks, I suggest you check out "Secure Your Future With 11 Rock-Solid Dividend Stocks," a special report from the Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these 11 generous dividend payers -- simply click here.
Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. 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.