Has American Capital Agency Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if American Capital Agency (AGNC 0.99%) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

• Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
• Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
• Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
• Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
• Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
• Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, and with the understanding that not all of these factors fit perfectly with traditional measures of mortgage REITs, let's take a closer look at American Capital Agency.

Source: S&P Capital IQ. Total score = number of passes. *4-year growth rate.

Since we looked at American Capital Agency last year, the company has dropped a point for the second year in a row, as return on equity fell. But investors have to be reasonably pleased with the mortgage REIT's performance, as its share price has risen by 5% on top of its hefty dividend payouts over the past year.

Mortgage REITs have given income-hungry investors huge dividend yields for years. But last year, the Federal Reserve's implementation of its quantitative easing program using mortgage-backed securities has reduced the supply of available MBSes, leading to lower yields. As a result, industry giant Annaly Capital (NLY 1.33%) saw its spreads fall below the 1% mark in its most recent quarter, even though its earnings jumped more than 50% from the year-ago quarter.

Yet American Capital Agency has used an innovative strategy to keep its spreads up. Rather than trading mortgage securities directly, the mortgage REIT is using a separate market for mortgage trading to cash in on what's called the dollar roll market, whereby American Capital Agency agrees to defer taking delivery of mortgages until a future date in exchange for collecting a financing charge. Because the Fed has boosted immediate demand, counterparties are willing to pay American Capital Agency significant amounts in this alternative market, and that's helping the mortgage REIT keep its spreads up.

One threat to American Capital Agency is the non-agency market, which it won't participate in. With Annaly looking to buy commercial-paper investment vehicle CreXus (NYSE: CXS), and with ARMOUR Residential (ARR 2.60%) having changed its charter to allow investment in non-agency securities, American Capital Agency could be left out if that market takes off.

For American Capital Agency to improve, it needs to get its returns on equity back up. Until the Fed exits the market, however, improvements in dividend yield aren't terribly likely.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest. 

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