Has American Capital Agency Become the Perfect Stock?

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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 (NAS: AGNC) 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, let's take a closer look at American Capital Agency.

Factor

What We Want to See

Actual

Pass or Fail?

Growth5-Year Annual Revenue Growth > 15%129.4%*Pass
 1-Year Revenue Growth > 12%176.7%Pass
MarginsGross Margin > 35%100%Pass
 Net Margin > 15%90.6%Pass
Balance SheetDebt to Equity < 50%796.7%Fail
 Current Ratio > 1.30.06Fail
OpportunitiesReturn on Equity > 15%19.8%Pass
ValuationNormalized P/E < 209.66Pass
DividendsCurrent Yield > 2%16.4%Pass
 5-Year Dividend Growth > 10%9.2%*Fail
    
 Total Score 7 out of 10

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

Since we looked at American Capital Agency last year, the mortgage REIT has dropped a point. Dividend growth has slowed and recently even reversed course, which could be a sign of things to come for the company.

Investors have gravitated to mortgage REITs for their outsized dividends. With bonds yielding next to nothing, the double-digit yields that American Capital Agency and its peers offer look exceptionally attractive.

But recently, changing trends are threatening those dividends. In its most recent quarter, American Capital Agency reported lower earnings per share due to a big jump in outstanding shares, and more importantly cut its dividend from $1.40 per share to $1.25 for the first quarter of 2012. The company's interest rate spread fell below 2%, prompting further concerns.

The challenges aren't unique to American Capital Agency. Annaly Capital (NYS: NLY) saw similar drops in interest rate spreads, prompting its own dividend cut. Moreover, Annaly and Chimera Investment (NYS: CIM) have started to clamp down on their leverage ratios, which helps make them less sensitive to adverse conditions going forward (but comes at the expense of some profits). Additionally, with new initiatives to help underwater homeowners refinance, prepayment rates could also hurt.

Given its leverage, American Capital Agency is as close to perfection as it's likely going to get. If conditions continue to worsen, though, the company could deteriorate further in the years ahead.

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.

American Capital Agency has plenty of promise, but we've got some ideas you may like even better. Let me invite you to learn about three smart long-term stock plays in the Fool's latest special report. It's yours for the taking and is absolutely free, but don't miss out -- click here and read it today.

Click hereto add American Capital Agency to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

At the time this article was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. The Motley Fool owns shares of Chimera Investment and Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. 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 Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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