Mortgage REITs have had a good run so far in 2014; they have benefited from a return of investor confidence. Exemplifying this difference from last year, shares of American Capital Agency Corporation (NASDAQ:AGNC) are up 18% this year, and shares of its largest competitor, Annaly Capital Management (NYSE:NLY), increased 14%.
Furthermore, with strong book value growth year to date, a less uncertain monetary policy from the Federal Reserve, a history of outperformance, and capital gains potential, investors in American Capital Agency could see an even better 2015.
1. Strong year-to-date book value growth
American Capital Agency's third-quarter earnings were at first glance a bit disappointing on the earnings and book value fronts: The mortgage REIT reported a total loss of $0.07 per share and a 2.7% sequential decline in its book value to $25.54 per share.
While those results may appear weak, especially the decline in book value, they certainly need to be put into context. Since the beginning of the year (that is, since the mortgage REIT reported 2013 fiscal year results), its book value has nonetheless increased a total of 6.7%, driven by strong book value growth of more than 7% in the second quarter.
American Capital Agency's slight sequential decrease in its book value is forgiven, for two reasons: First, the mortgage REIT already presented investors with a strong year-to-date performance in terms of book value growth.
Second, American Capital Agency's earnings are and will remain volatile. Mortgage REITs, which take out short-term funding to finance the purchase of long-term securities, are inherently risky investments.
Evidence of this risk can be seen in American Capital Agency's earnings per share, which have historically fluctuated wildly. With earnings being volatile, investors need to be prepared for a weak quarter at any time, but that doesn't necessarily affect American Capital Agency's long-term value proposition negatively.
2. History of outperformance
One of the best indicators of future performance is a REIT's past performance. Though a convincing past performance record is no guarantee of future outperformance, it does make a strong case for or against an income investment.
And American Capital Agency doesn't have to shy away from scrutiny: American Capital Agency has outperformed other mortgage REITs over time, both before and after the initiation of the Federal Reserve's latest round of quantitative easing.
American Capital Agency has also returned a massive $29.56 in dividends since the mortgage REIT went public in 2008.
3. Capital gains potential
The uncertainty about the Federal Reserve's future monetary policy led to a broad-based sell-off in shares of mortgage REITs in 2013 as extraordinary pressure on mortgage security portfolios built up.
The return to book value growth in 2014, on the other hand, has again led to a change in investor sentiment, and investors started to come back to American Capital Agency and the sector in hopes that the storm had passed.
Investors always tend to overreact, and share prices of mortgage REITs appear to have fallen way too low, way too quickly in 2013. Though they have somewhat recovered, as evidenced by double-digit year-to-date returns, they are still relatively cheap.
Since both American Capital Agency and Annaly trade at meaningful discounts of 11% and 14% to their respective net asset values, investors can now expect capital gains to contribute to their total return performances going forward.
4. Dividend yields
American Capital Agency currently offers investors a dividend yield of 11.61% (according to S&P Capital IQ), whereas Annaly's is 10.52%.
Capital appreciation potential, in addition to a high dividend yield, only makes a stronger case for income and growth-focused investors to add a mortgage REIT like American Capital Agency to their investment portfolios.
The Foolish bottom line
While American Capital Agency's third-quarter results were a bit disappointing, investors need to look at the bigger picture here. The mortgage REIT operates in a business that regularly sees wildly fluctuating earnings. But American Capital Agency's book value grew a total of 6.7% in 2014, despite the reported book value decline of 2.7% in the third quarter.
Over time, however, American Capital Agency has handsomely outperformed its peers and presented investors with good returns. Given that American Capital Agency still trades at an 11% discount to its accounting book value, and also offers investors a nearly 12% dividend yield, it is an interesting investment for investors who want to accentuate both recurring dividend income and capital growth.
Kingkarn Amjaroen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.