A Jack of All Trades With an 11% Yield

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

In certain businesses, it's better to have flexibility. I'll never forget Peter Lynch saying that this was one of the keys to his investing success was that his fund wasn't tied to one type of investment class. He could take good ideas from growth or value funds and invest where the best opportunity was at the time. This is the way I think of Invesco Mortgage (NYSE: IVR) in the field of real estate investment trusts. Invesco isn't afraid to buy 30 year agency securities right along with adjustable rate securities. I believe this is a competitive advantage and a great reason to consider this stock.

With high yields offered by multiple mREITs, you may wonder what made me pick out Invesco? To be fair, I own a cross-section of the mREIT field with shares in Annaly Capital (NYSE: NLY), Chimera (NYSE: CIM), and Hatteras Financial (NYSE: HTS). To be blunt, I feel like these four companies offer investors diversification in this industry. Since the Federal Reserve has all but guaranteed that short-term rates will stay low for a while, these companies are poised to continue delivering on their high-yields for the next several years. Each company takes on a different investment tactic, and this is part of what sets Invesco apart.

Annaly is well known in the mREIT field, and for good reason. The management team is experienced in more than just the current market, and they also manage Crexus and Chimera's portfolios as well. The difference between Annaly and Chimera, though, is Annaly buys mainly 30 year agency securities, while Chimera buys non-agency investments. Most companies in this industry use hedging techniques to try to mitigate their interest rate risk, but there is no question that 30 year investments are higher risk than shorter term mortgage securities. The shorter term market is where Hatteras Financial plays. The company has about 83% of its portfolio in adjustable rate loans and the rest in 15 year deals. This gives Hatteras some potential, as they have also locked in low fixed rate debt to finance these investments over the next several years. However, while I like each of these companies on its own, Invesco's willingness to buy where there is opportunity gives investors a unique opportunity.

Just as an example of how diverse Invesco's portfolio is, consider that about 56% is in 30 year securites, 12.4% is in 15 year deals, about 4% is in ARMs, and nearly 24% is in non-agency paper. As you can see, the company is diversified across multiple types of investments, and this partially accounts for their 3.31% weighted average yield. Since Invesco can buy wherever they see opportunity, over the long-term they should be able to give investors better results. Investors seem to like what they see, as the company's book value is up nearly 14% in the last three months, and part of this is due to a nearly 12% increase in diluted shares. The company's ability to raise capital allows Invesco to find new investment opportunities going forward. Another positive of the company's ability to raise capital through share sales is they can grow the size of their portfolio while keeping their balance sheet strong.

Looking at the few companies I've mentioned, Invesco currently has one of the strongest balance sheets in the industry. Peter Lynch also used to say that he used the equity-to-assets ratio to gauge the strength of a financial company. Using this measure, Invesco has a 0.14 ratio, whereas both Annaly and Hatteras have a ratio of 0.12 or less. While it's true that Chimera's ratio is a good bit higher at 0.34, this higher equity cushion is needed as the company's non-agency concentration is a higher risk portfolio. With Invesco's stronger balance sheet comes opportunity for earnings outperformance, as the company can take advantage of situations where others might not have the same capacity.

It's rare when you can say a company could outperform its peers by showing negative 2.5% EPS growth, but that is the situation at Invesco. Analysts expect earnings to decline, but I think some of this earnings projection is based on assumptions that may need to be changed. In theory, earnings would decline based on continued compression of the yield the company can earn. However, we are already to the point that offering mortgages for many banks doesn't make a lot of sense. If you are a bank and 30 year mortgage loans are being offered at less than 4%, how well do you think you'll do when short-term rates eventually rise? Considering that it wasn't that many years ago that short-term rates exceeded 4%, offering a lot of 4% mortgages could be trouble later on.

Low fixed mortgage rates are less likely to affect Invesco, Hatteras, and Chimera compared to Annaly. Since the first three companies have either adjustable rate securities, or higher yield securities in the form of non-agency paper, their average yield should already be higher. Annaly purchases a lot of 30 year securities, and while I believe management will navigate the next few years well for investors, it will be difficult for them to outperform a company like Invesco. In fact, analysts are calling for negative EPS growth of at least 7% from both Annaly and Hatteras in the next few years. While Chimera is expected to post 5% EPS growth, the company's non-agency investments pose more risk. In the end, each company's yield is what investors should look at. However, investors need to calculate forward yield rather than looking at what the company pays today.

Invesco's forward yield based on next years' earnings should be about 11%. This tops Hatteras at about 10.4%, and Annaly at roughly 9.13%. Chimera comes out on top with a projected 14% yield, but again this is due to the portfolio being higher-yield from non-agency purchases. In the end, investors looking for a jack of all trades with a 11% forward yield should put Invesco on their Watchlist.

MHenage owns shares of Chimera Investment, Invesco Mortgage Capital, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus