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 Armour Residential (NYS: ARR) 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 Armour Residential.
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%
5 out of 9
Source: S&P Capital IQ. NM = not meaningful; Armour Residential paid its first dividend in March 2010. Total score = number of passes.
Since we looked at Armour Residential last year, the company has dropped a point. A rising valuation is responsible for the score loss, although a nicely positive total return partially makes up for it.
For years, real estate investment trusts that invest primarily in mortgages have done exceedingly well. By combining long-term mortgage investments with borrowing financed by highly leveraged short-term loans, Annaly Capital (NYS: NLY) , American Capital Agency (NAS: AGNC) , and Armour have all managed to produce amazing dividend yields for their shareholders. Moreover, with interest rates likely to remain low for the foreseeable future, mortgage REITs like Armour could continue to benefit for some time.
But even with continuing low rates, interest rate spreads at many mortgage REITs have started to narrow, forcing Armour and some of its peers to cut back on dividend payments. One culprit is the Federal Reserve's Operation Twist program, which is aimed at bringing long-term rates down and in turn decreases the amount of profit Armour can earn. The company hasn't seen anything close to the magnitude of cuts that Chimera Investment (NYS: CIM) has suffered, but Armour's agency focus has sheltered it from the worst of the volatility in the area.
One thing that makes Armour stand out from most of its mortgage REIT brethren is that Armour pays a monthly dividend. For income investors, monthly payouts align better with living expenses, and as with retail REIT Realty Income (NYS: O) , it also matches up with the rent and mortgage payment frequency that their securities produce.
For Armour to improve, it needs to work on boosting earnings while making the most of its leverage. If higher interest rates come, though, Armour may now be as close to perfection as it's likely to get for the foreseeable future.
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 doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of 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.
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