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 Capstead Mortgage (NYS: CMO) 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 Capstead Mortgage.
What We Want to See
Pass or Fail?
5-year annual revenue growth > 15%
1-year revenue growth > 12%
Gross margin > 35%
Net margin > 15%
Debt to equity < 50%
Current ratio > 1.3
Return on equity > 15%
Normalized P/E < 20
Current yield > 2%
5-year dividend growth > 10%
7 out of 10
Source: Capital IQ, a division of Standard & Poor's. Total score = number of passes.
With seven points, Capstead Mortgage looks like it's giving investors the REIT stuff. The real estate investment trust has tapped into the hottest trend in the dividend world, but investors need to understand what they're getting into.
Capstead is a mortgage REIT, which means that it invests in mortgage-backed securities. In order to maximize their profits, most mortgage REITs take on a substantial amount of leverage to make the most of the thin spreads between what their investments earn and their borrowing costs. Even given all that, Capstead has one of the highest leverage ratios among mREITs, with debt-to-equity that exceeds those of Annaly Capital (NYS: NLY) , American Capital Agency (NAS: AGNC) , and Chimera Investment (NYS: CIM) .
The Federal Reserve's announcement that it would keep interest rates low until 2013 was good news for Capstead. But lately, Capstead and other mortgage REITs have faced some threats. A government proposal to give homeowners cheap refinancing for their homes could pose a big problem for mREITs in getting new mortgage securities. More importantly, the SEC is taking comments on whether it should regulate mREITs like mutual funds, which would potentially hurt their ability to use the immense leverage they employ.
As a long-term investment, Capstead could see its fast dividend growth reverse course if rates ever start heading higher. For now, though, shareholders are having a perfectly good time reeling in double-digit dividend yields.
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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At the time thisarticle was published Fool contributor Dan Caplinger owns shares of Chimera Investment. The Motley Fool owns shares of Annaly Capital Management and Chimera Investment. 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.
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