Why I Bought Invesco Mortgage Capital

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I recently made some major moves in my personal portfolio and sold non-dividend paying stocks in order to purchase income producing securities. Part of the reason is, I believe these dividend payments will give me a better long-term return than taking the higher risk on non-dividend paying companies. Since I plan on reinvesting the dividends, this income will in turn buy more shares, which then will produce more income. Over time it's been shown that dividend paying stocks routinely outperform non-dividend paying stocks, and usually with less volatility. With this in mind, I took a calculated risk in purchasing shares in Invesco Mortgage Capital (NYSE: IVR). With all the other dividend paying stocks available, let me explain why I chose this particular company.

Let me be blunt, and say the first thing that attracted me to the company was its expected dividend yield. With a REIT like Invesco, investors need to understand that their dividends will neither be constant nor predictable. However, during low interest rate times such as these, REIT investments can make predictable bets on higher-yielding long-term mortgages versus lower-cost short-term borrowings. Most people are familiar with companies such as Annaly Capital (NYSE: NLY), American Capital Agency (NASDAQ: AGNC), and maybe even Capstead Mortgage (NYSE: CMO). In fact, I would bet that if you did a search for the highest yielding stocks in the market, some of these names will show up in the top 10. However, many investors in REITs make the mistake of looking at the current yield instead of what the company's expected yield should be. Since this type of company is required to pay out 90% of its earnings to maintain its tax advantaged status, predicting the company's future dividend is based on the company's future earnings. In part, the future earnings growth at Invesco was a deciding factor between this company and others.

One factor that led me to choose Invesco was the company's portfolio. Looking at the company's last earnings release, we get a breakdown of what types of loans Invesco has selected. Management has shown that it's willing to take on a bit more risk, to try and increase returns to investors. While companies such as Annaly and American Capital choose to invest in primarily agency securities, Invesco is willing to put a portion of its portfolio in non-agency loans which pay a better weighted yield. Roughly half of Invesco's portfolio is in 30 year fixed-rate agency securities. With an average weighted yield of 3.63%, and a cost of funds of 1.7%, the company makes a spread of just less than 2% on half of its portfolio. Invesco has placed just over 16% of its funds in 15 year fixed-rate agency securities. While these have a lower weighted yield at 2.8%, they also represent a slightly lower risk to the company. The two product choices that I like the most are, the company's almost 10% in Hybrid ARM loans and non-agency securities. While both of these choices mean greater risk, they also give the company some protection against future interest rates and a better current return. As you can see, the company has not placed too much emphasis on one type of security, and I believe in the future this will serve them well. Another factor in Invesco's favor is the company's ability to grow its book value.

In the company's last earnings report, Invesco noted that its book value had increased to $18.42 up from $16.41 three months prior. This gain was from multiple areas, including borrowed funds up 7% and average equity up 8.37%, which led to average earning assets up 9.14%. With the company growing its book value through both borrowed funds and higher equity, Invesco is making sure not to take on too much debt without raising equity levels as well. This balanced approach was another factor that led me to Invesco. However, without question the primary reason to purchase any REIT is dividend yield.

Next year's earnings should give us a guide as to what the company's dividend payout will be. It makes sense to compare each REIT's expected earnings, and try to determine what pay out investors should expect. Let's take a look at Invesco compared to three of its competitors, and see what investors should expect from each:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>EPS expected</strong></p> </td> <td> <p><strong>90% = Dividend</strong></p> </td> <td> <p><strong>Expected yield</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> </tr> <tr> <td> <p>Invesco</p> </td> <td> <p>$2.80</p> </td> <td> <p>$2.52</p> </td> <td> <p>13.04%</p> </td> <td> <p>4.50%</p> </td> </tr> <tr> <td> <p>Annaly</p> </td> <td> <p>$1.97</p> </td> <td> <p>$1.77</p> </td> <td> <p>10.29%</p> </td> <td> <p>3.00%</p> </td> </tr> <tr> <td> <p>American Capital</p> </td> <td> <p>$5.91</p> </td> <td> <p>$5.32</p> </td> <td> <p>14.45%</p> </td> <td> <p>2.00%</p> </td> </tr> <tr> <td> <p>Capstead</p> </td> <td> <p>$1.71</p> </td> <td> <p>$1.54</p> </td> <td> <p>10.92%</p> </td> <td> <p>3.00% </p> </td> </tr> </tbody> </table>

You can see that of the four different companies, Invesco has the highest expected growth rate and the second highest expected yield. Though American Capital does have a higher expected yield, the company also has the lowest expected growth rate. When choosing between dividend paying companies, many times the company with the best expected growth is, also the one that can afford its dividend even if this growth doesn't materialize perfectly. As an example, if Invesco ran into problems that would cut their growth rate by 3%, the company would still increase its earnings; where American Capital is concerned, if the company's growth rate were cut by 3%, overall earnings would decline. While clearly none of these companies' yields will stay this way forever, the fact that the Fed has committed to low interest rates into 2014 is reassuring. In addition, the economy seems to slowly be recovering, and a slow recovery would not cause a large jump in short-term rates. In the meantime, investors have the option of multiple companies paying a greater than 10% expected yield. For me, the best choice was Invesco because of their growth rate and expected yield. In terms of full disclosure, I also purchased Annaly because of their relatively longer track record, and excellent management team.

MHenage owns shares of Invesco Mortgage Capital and Annaly Capital Management. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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