News Analysis date published New: 
Friday, July 27, 2012 - 11:30
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Friday, July 27, 2012 - 11:30
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Friday, July 27, 2012 - 11:30

Is This Dividend-Paying Monster Worth the Risk?

Friday, July 27, 2012 11:30 AM

One way to build a large stock portfolio is by taking advantage of dividend reinvestment plans, also known as DRIPs. Just like the name states, DRIPs reinvest dividend payments, so the investor is purchasing additional shares of the stock when a dividend is paid, rather than getting a check in the mail or a direct deposit into a brokerage account.

There are several reasons DRIPs make good investment sense. First, the process is automatic. Once you sign up, there is nothing else you need to do. Shares are purchased automatically on your behalf. Second, fractional shares can be purchased in DRIPs. That may not sound like much, but in the long term, fractional shares can really add up.

Finally, and perhaps most important, there are generally little to no commissions involved when purchasing shares via DRIPs. This is critical because it allows the purchase of a few shares -- or even a fraction of a share -- without the typical costs that would eat up any immediate benefits.

Over time, DRIPs can really help build up your long-term wealth. Many average investors have acquired huge nest eggs by participating in dividend reinvestment plans.

One of the keys to success with DRIPs is locating high-dividend-yielding stocks in which to invest. Obviously, the higher the yield, the greater the number of shares that can be purchased by the plan when a dividend is paid out.

I recently ran several screens hunting for high-yielding, solid stocks with professional ownership that participated in DRIPs. What I found nearly blew my socks off...

Imagine a company with profit margins above 90%, a price-to-earnings (P/E) ratio of 5.2 (which is well below that of others in its space), and one that is held in the portfolio of at least 24 hedge funds. Not only that, but this firm is a dividend-paying monster, yielding an astounding 14% at the current stock price.

The company went public in 2008 and has provided investors with 300% returns since then. As you can imagine, this firm has posted impressive revenue growth and has an attractive valuation. It boasts a market cap of $10.45 billion, and shares are up 23.5% this year, as of the close of trade July 25.

This dividend investor's dream is American Capital Agency Corp. (Nasdaq: AGNC). As a real estate investment trust (REIT), it holds residential mortgage pass-through securities and collateralized mortgage obligations guaranteed by the U.S. government. Therefore, the fledging upswing in the real estate market should help this REIT.

Now for the risks. REITs like American Capital Agency Corp. are highly dependent on the spread between long-term and short-term interest rates. Basically, mortgage REITs borrow short-term to buy long-term mortgages. In other words, American Capital Agency's success is highly dependent on the actions of the Federal Reserve.

Since the company's IPO in 2008, the economy has not experienced an inverted yield curve or collapsing spreads in interest rates. Should this happen in the future, it has the potential to adversely affect AGNC.

Rising interest rates cause something academics call "negative convexity," resulting in mortgage REITs suffering as mortgage-backed security prices decline. In addition to being affected by economic forces, preliminary second-quarter 2012 results are indicating a nearly 30% decline in interest income. This is a severe drop, and right now, it is still uncertain why. Hopefully, this is just a short-term situation and things will recover in the third quarter.

Risks to Consider: As stated above, mortgage REITs are highly dependent on interest rates, and therefore, on the actions of the Federal Reserve, for their success. In addition, some analysts have pointed out that American Capital Agency has questionable debt management practices, adding another layer of risk on this dividend-paying monster.

Action to Take --> I believe mortgage REITs should make up a portion of everyone's dividend reinvestment portfolio. American Capital Agency Corp. has been in a strong uptrend since February. However, it experienced a sharp pullback last week, which I think provides investors with a great buying opportunity. A breakout above $35.50 or a breakdown to the 50-day simple moving average at $34.91 will make ideal technical entry points. Pending no adverse changes in Fed policy, I see American Capital Agency breaking $40 by the end of this year.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.