Charlie Munger once said that to find great stocks you have to "look at the cannibals," companies that eat themselves over time by buying back their own shares.
Great companies that make great buybacks can compound investors' capital quicker, juicing total returns.
This quarter, American Capital Agency (AGNC -0.37%) went full-blown cannibal, repurchasing 7% of its shares in just one quarter.
How this pays off
American Capital Agency is aggressively buying back its own stock. In the last quarter, it reported that it repurchased 28.2 million shares at an average cost of $20.82. All in all, the company spent more than $587 million on repurchases.
However, after the dust settled, the company reported a book value of $23.93 per common share as of Dec. 31, 2013.
In short, American Capital Agency spent $587 million on its shares, but it received $674.83 million in value from those repurchases. In effect, American Capital Agency traded $20.82 for $23.93 over and over again -- 28.2 million times in the quarter, to be exact.
American Capital Agency created nearly $88 million in value just by buying back its own stock.
Something for nothing
Mortgages amortize over time. When a borrower makes a payment, they pay part of the principal and interest owed on the outstanding balance. So, in the ordinary course of business, mREITs have to buy new mortgages to replenish the declining balance of mortgages on their balance sheet.
Thanks to depressed stock prices, mortgage REITs aren't paying full price to reinvest. American Capital Agency could have spent the $587 million it spent on share repurchases to buy mortgages on the open market. Instead, it bought its shares at a discount, and effectively bought more of the portfolio it already owns for 13% less than the prevailing price.
It gets better. Quarterly earnings numbers are a snapshot in time. When American Capital Agency reported its book value as of December 31, the 10-year U.S. Treasury yielded 3.04%. Today, it yields a little more than 2.6%. American Capital Agency's portfolio is worth more today than it was on December 31. Book value is higher. Therefore, repurchases actually created more value than calculated above, although we can't know for certain, because the portfolio can change from day to day.
I know repurchases can be controversial. However, investors should embrace mREIT buybacks. For mortgage REITs, a buyback is the most efficient way to make new mortgage investments.