Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.
Let's examine how ARMOUR Residential (NYS: ARR) stacks up. In this series, we consider four critical factors investors should examine in every dividend stock. We'll then tie it all together to look at whether ARMOUR Residential is a dividend dynamo or a disaster in the making.
First and foremost, dividend investors like a large forward yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.
ARMOUR Residential yields a whopping 17.5%, considerably higher than the S&P 500's 1.9%, though in the same neighborhood as many of its peers.
2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company paid out in dividends last year to the earnings it generated. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford, even when its dividend yield doesn't seem particularly high.
As a real estate investment trust, however, ARMOUR Residential is required by law to pay out more than 90% of its earnings in the form of dividends in return for not having to pay corporate income taxes.
3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The debt-to-equity ratio is generally a good measure of a company's total debt burden, but remember that for mortgage REITs like ARMOUR Residential, debt is a big part of their business model. It's also important for mortgage REIT investors to consider portfolio makeup, since leverage isn't the only kind of risk. The proportion of mortgage-backed securities not guaranteed by Fannie and Freddie is a good first glance at portfolio risk.
Let's see how ARMOUR Residential stacks up next to its peers:
American Capital Agency
Source: S&P Capital IQ, company filings.
As far as mortgage REITs go, ARMOUR Residential uses considerable leverage to finance a relatively safe, lower-yielding portfolio. To put it another way, ARMOUR Residential's investments yield on average 3%, lower than American Capital Agency's (NAS: AGNC) 3.2%, Annaly Capital's (NYS: NLY) 3.7%, or Invesco's (NYS: IVR) 4.1%. These safer assets mean lower income that ARMOUR Residential juices with higher leverage.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
REITs have been enjoying a boom in recent years, as low interest rates have driven their cost of funding down much faster than the yield on their investments. That equation can't last forever, but it's unclear when it will change. Earlier this year the Federal Reserve announced it expects interest rates to remain near zero through 2014.
But that good news for REIT investors doesn't preclude long-term rates from falling further should the Fed become more concerned over the pace of economic recovery. Just one year ago, ARMOUR Residential's portfolio yielded 3.3%. Invesco, American Capital Agency, and Annaly have seen their portfolio yields decline as well.
The Foolish bottom line
With a large yield, a relatively safe portfolio leverage as far as its industry is concerned, and economic conditions working in its favor for the time being, ARMOUR Residential looks like it should be able to ride the REIT dividend wave for the near to medium term, though these high dividend payouts are almost certain to come down eventually. If you're looking for some great dividend stocks, I also suggest you check out "Secure Your Future With 9 Rock-Solid Dividend Stocks," a special report from The Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these nine generous dividend payers -- simply click here.
At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital Management. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.