4 Highly Rated Stocks with High Yields

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

When it comes to mortgage REITs I've found there are basically two types of investors. In one camp are the investors who believe that these are solid investments offering extremely high yields. While they realize that these yields won't be around forever, the current low interest rate environment is expected to last a while and they are willing to ride the wave. The second set of investors believes that mortgage REITs are a huge value trap and that when interest rates rise investors will get crushed.

I've been on both sides of this argument in the past. What I find comforting is the fact that the Motley Fool CAPS community believes in several of these companies enough to give them either 4 or 5 star ratings. With the two highest ratings possible, these investments could be the best of the bunch. Let's take a look at the four companies and see if we can determine which one might be the best buy today.

The four stocks we will look at are American Capital Agency (NASDAQ: AGNC), Annaly Capital Management (NYSE: NLY), Chimera Investment Corp. (NYSE: CIM), and Hatteras Financial (NYSE: HTS). While there are other REITs that also earned a 4 or 5 star rating, this gives us a good cross section of the industry and the different investment styles. American Capital and Annaly tend to invest in more fixed-rate government-secured debt. This means they are more exposed to interest rate fluctuations and must use their hedging strategy to avoid a big drop when rates do eventually rise.

Chimera tends to invest in non-government guaranteed debt, which typically carries a higher yield and more risk than guaranteed debt. Hatteras, on the other hand, invests in mostly variable rate debt. In theory this protects the company against rising interest rates, but it has to accept lower yields up front because of the variable nature of its assets. Now that you know what each one does, let's look at the relative valuations of the four companies. 

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>American Capital Agency</p> </td> <td> <p>9.18</p> </td> <td> <p>2.00%</p> </td> <td> <p>4.59</p> </td> </tr> <tr> <td> <p>Annaly Capital Management</p> </td> <td> <p>9.35</p> </td> <td> <p>-7.50%</p> </td> <td> <p>negative</p> </td> </tr> <tr> <td> <p>Chimera Investment</p> </td> <td> <p>5.77</p> </td> <td> <p>-5.00%</p> </td> <td> <p>negative</p> </td> </tr> <tr> <td> <p>Hatteras Financial</p> </td> <td> <p>8.32</p> </td> <td> <p>1.00%</p> </td> <td> <p>8.32 </p> </td> </tr> </tbody> </table>

It's rare where you can find investors excited about an industry that is set up for a decline in earnings and/or anemic growth. So why are investors even considering these stocks? The simple answer is yield. Each company pays a significant dividend, and investors are betting that even with lower earnings these yields will still be far higher than those of most stocks. On a valuation basis, rating the companies is easy. The one with the highest growth is first, the one with the lowest (or negative) growth is last. (American – 4, Hatteras – 3, Chimera – 2, Annaly – 1)

Trying to predict cash flows from any of these companies is basically a fool’s errand. The amount of pre-payments, direction of interest rates, and other factors heavily determine the company's earnings power. What is more quantifiable is their relative risk when it comes to their balance sheets. The first measure I use to compare the companies is their debt-to-equity ratio. Since these companies use leverage to increase investors returns it's not unusual for this ratio to be high. The most highly leveraged company of the four is American, with a ratio of 7.85. Hatteras and Annaly come in second and third at 7.49 and 5.94 respectively. Chimera is the least leveraged (primarily because of its riskier loan portfolio) and shows a debt-to-equity ratio of 0.59. Even though Chimera invests in riskier debt, this is more than offset by their tremendously less leveraged balance sheet. (Chimera – 4, Annaly – 3, Hatteras – 2, American – 1)

A second way to measure risk is by comparing the company's investments to liabilities on their balance sheets. Each of these companies investments are mortgage securities, and their liabilities are traditionally short-term loans. Needless to say, the higher their investments and the lower their loans the less risk. I use a ratio to compare the two, and the higher the number the more well covered the company's debt.

Annaly leads the way with a ratio of investments to liabilities of 1.27. Hatteras comes in second at 1.17 and American is third at 1.07. Chimera is last, with much more debt relative to its investments at 0.64. In theory, Annaly could increase its debt the most and still cover this debt with its investments because of their highest ratio. Conversely Chimera needs to be careful not to let its liabilities get away from it. (Annaly – 4, Hatteras – 3, American – 2, Chimera – 1,)

No matter how you cut it, the main reason most people buy these stocks is for their dividend. Many people make the mistake of looking at dividend history when comparing REITs. This is foolish (with a small f) because each company pays a percentage of its earnings. If its earnings increase or decrease its dividend will rise or fall in tandem. Using 2013 projected earnings for each company and then the standard 90% payout ratio, we find that Chimera has the highest projected yield at 13.28%. Hatteras and Annaly come in at 10.82% and 10.10% respectively. American comes in last at 9.80%. Since we are using projected earnings and not historical data, this gives investors an idea of what each company's yield might be next year. (Chimera – 4, Hatteras – 3, Annaly – 2, American – 1)

The totals are Chimera – 11, and Hatteras – 11, Annaly – 10, American – 8, which means it’s a tie between Chimera and Hatteras for the lead. If there is a tie breaker it's that Chimera is still in the middle of attempting to restate earnings for multiple periods. While the company says this won't affect future cash flows, it adds a level of uncertainty to the stock that some investors might not be comfortable with. That being said, Chimera is managed by Annaly and the latter has a good reputation in the industry. Hatteras seems to offer the best combination of traits without this uncertainty. Use this information as a starting point for your own research. I would suggest adding all of these companies to your customized Watchlist today to keep up with these highly rated and high yielding stocks.

MHenage owns shares of Chimera Investment, Hatteras Financial, 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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