In a private speech to the Financial Planning Association, legendary Vanguard founder and former CEO John Bogle made an observation that's absolutely critical to understanding where the best stock returns come from -- and how to find the next great stock to buy.
He told the assembled guests that only three things drive investor returns:
Changes in valuation
Historically, stocks have returned 9.6% per year on average -- 5%, 4.5%, and 0.1% from dividends, earnings growth, and valuation changes, respectively. Naturally, the best stocks to buy are the ones that will produce the highest combined return.
So which mortgage REITs will earn investors the best returns today? Obviously, no one knows for sure. You should always take future estimates with a grain of salt, particularly when analyst forecasts are involved. In fact, studies show that analysts' long-term earnings-per-share estimates tend to be over-optimistic by roughly 40%, so I've reduced their estimates accordingly.
But by running the numbers, we can compile a list of which stocks are the implied best buys today. Here are our assumptions:
Dividend Yield (current)
5-Year Growth Rate (reduced by 40%)
Price-to-Earnings Ratio (in 2016)
Chimera Investment (NYS: CIM)
American Capital Agency (NAS: AGNC)
Dynex Capital (NYS: DX)
Hatteras Financial (NYS: HTS)
Two Harbors Investment (NYS: TWO)
Anworth Mortgage (NYS: ANH)
Annaly Capital (NYS: NLY)
Data from Capital IQ, a division of Standard & Poor's. Includes stocks on major U.S. exchanges capitalized over $200 million, with positive earnings and at least one analyst issuing long-term earnings estimates.
And here are their implied five-year annualized returns for shareholders. I've ordered the three return components by their reliability -- first dividends, then earnings growth, then valuation.
Earnings Growth Return
Implied Cumulative Annual Return
American Capital Agency
Two Harbors Investment
Source: Author's calculations. * Assumes dividend growth at rate of earnings growth.
The raw numbers tell us that these are the seven most promising names in mortgage REITs. Of course, analyst growth assumptions for any individual company could prove overly optimistic or pessimistic. Given that interest spreads are at historical highs, I'd be somewhat skeptical of positive long-term earnings-per-share growth estimates for this industry. That said, the high potential returns on fairly low growth estimates indicate that there is a decent margin attached to these stocks, making this list an excellent starting point for further research. (You can read more about my two favorites here.)
At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned. The Motley Fool owns shares of Chimera Investment and Annaly Capital Management. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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