How High Can American Capital Agency Fly?

Shares of American Capital Agency (NAS: AGNC) hit a 52-week high on Friday. Let's take a look at how the company got there and whether clear skies remain in the forecast.

How it got here
American Capital Agency -- and the entire mortgage real estate investment trust sector, for that matter -- has benefited in recent years from record-low interest rates, which have allowed them to reap better-than-average margins. Mortgage REITs profit from the difference between the interest rate at which they borrow (record-low rates) and the interest rate at which they lend, and although many of these REITs aren't making a killing per se and this gap has been closing for some, most are still pocketing a healthy 1.5%-3% margin.

American Capital Agency and Annaly Capital Management (NYS: NLY) are most notable for using large amounts of leverage to achieve these strong operating results. With razor-thin margins, some REITs have taken to levering themselves sometimes in excess of seven to 10 times their equity to take advantage of the Federal Reserve's promise to keep rates at record low levels through most of 2014. While leverage for many mortgage REITs has dropped recently, many -- including several of us at the Fool -- feel that an eventual rise in interest rates could cripple these highly levered companies.

The allure of American Capital Agency then becomes its more-than-15% dividend yield, and the danger is whether it can safely continue to lever its purchase of mortgage-backed securities much beyond 2014.

How it stacks up
Let's see how American Capital Agency stacks up next to its peers.

Source: Morningstar. Yields are projected.

Here we can see both the joys of a high-yielding dividend and the danger of buying into a stock solely because of its yield.

Last week, the Fool's Dan Caplinger took a closer look at mortgage REITs and discovered that many have pumped up their assets to Hulk-like proportions in just a short timeframe. American Capital Agency may only be trading at 4.8 times cash flow, but that's only because its current $88.4 billion in assets have increase by a factor of 19 since December 2009. Annaly Capital has seen its assets under management rise six-fold.

ARMOUR Residential (NYS: ARR) had about $25 million in assets in December 2008 and now boasts a portfolio of MBS' of $12.8 billion. Similarly, Two Harbors Investment has seen its assets under management rise 43-fold since December 2008. With quite a few companies still relatively new to the game, Wall Street has every reason to be concerned.

Even Chimera Investments, which is one of the lesser-levered mortgage REITs, had its fair share of profitability issues during the recession and has yet to recover much of its pre-recession losses.

What's next
Now for the real question: What's next for American Capital Agency? That question is going to depend on whether the company can successfully manage its leverage and continue to keep investors interested with its market-trouncing dividend.

Our very own CAPS community gives the company a four-star rating (out of five), with a whopping 95.6% of members expecting it to outperform. Although I have yet to have enough conviction to make a CAPScall in either direction on American Capital, I am erring more toward making an outperform call than an underperform call.

Weighing the arguments that are out there and taking into account the current pace of the global recovery, I just don't see much in the way of significant margin pressure for mortgage REITs anytime in the next three to four years at minimum. That timeframe gives these companies more than ample time to wind down their least profitable MBS positions and prepare them for tighter margins and higher borrowing rates. I'm well aware that American Capital Agency's highly levered portfolio has a lot to do with its cheap metrics (specifically price-to-cash-flow), but it still appears to offer investors the potential for more upside. If it pulls back below $28, I would probably pull the trigger in my CAPS account.

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At the time thisarticle was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. 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.

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