Editor's Choice

These 3 Numbers Make This High-Yield Stock A Buy

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

High yielding stocks get a lot of attention these days, because of the low interest rate environment. The challenge for investors is, discovering which high yield will hold up. The REIT business holds many high yield candidates, but from what I can see, there are three numbers that make Hatteras Financial (NYSE: HTS) a buy at these levels.

An Idea As Old As The Market Itself
It's ironic that the idea of investing in dividend paying stocks is being talked about as a fad. I've read multiple articles about a “dividend bubble” and whether the days of “buy and hold are over.” However, what most of these articles miss completely is a dividend payment is something as old as the stock market itself. Investors who give their money to own a piece of a company expect a return. What better way to get your return than in a quarterly dividend check?

What's almost comical is how different analysts discuss the risks of high-yield stocks. In reality, a stock with a 2% yield might hold just as much risk of a dividend cut as a stock with a 7% yield. The yield is a function of the dividend versus the price, and shouldn't be taken as a sign of weakness or trouble.

This Market Was Made For These Companies
In the mortgage REIT industry, you couldn't really ask for a better environment. While it's true that compression in their interest rate spread has cut into profits, most companies are still expected to pay impressive dividends. Since mREITs are required to pay 90% of their profits in distributions to maintain their tax status, a large distribution is the norm.

Hatteras and Capstead Mortgage (NYSE: CMO) are somewhat unique, in the sense that they both focus on adjustable rate securities. Other competitors like Invesco Mortgage (NYSE: IVR) and Annaly Capital (NYSE: NLY) focus on more fixed rate instruments. With the Federal Reserve expected to keep rates low for an extended amount of time, investors should have at least the next few years to capitalize on this environment.

Earnings Growth Is Important Even For High Yield Companies
Some investors make the mistake of thinking that a nice yield will save them from a company's declining earnings. The problem with this strategy is, a company with less earnings in the future can't protect its dividend the same as a company with earnings growth. Less earnings in the future means less distributable income and lower dividends in the mREIT space.

Of the four companies we've looked at, Hatteras is expected to grow earnings by 4.47% over the next year or so, which is second best. The only company expected to grow faster is Capstead Mortgage at 4.61%. By comparison, Invesco is expected to grow earnings by 4.02%, and Annaly Capital is projected to grow EPS by 3.47%. With the second best growth rate of their peers, Hatteras seems to do okay by this measure.

A Discount And Their Future Yields
Another way to measure mREITs is by their current price relative to their book value. Of the group, Capstead Mortgage sells at the greatest discount to book value at 8.98%, with Hatteras coming in second at 4.47%. Annaly once again loses out to these two at a 3.47% discount, and Invesco is actually selling for a slight premium to book.

While it's nice to know that Hatteras is selling for below book value, and they are expected to grow, the real reason most investors buy mREITs is for their yield. However, many investors make the mistake of comparing their trailing yields. Since mREITs pay a yield based on 90% of earnings, it makes much more sense to look at their expected earnings for 2013 and then calculate 90% of that figure. After all, it doesn't matter what the company paid in the last twelve months if they can't pay the same in the future.

The leader of the pack when it comes to future yield should be Invesco. The company's 2013 EPS is expected to be about $2.59, and at 90% of this figure would indicate a forward yield of 10.89% based on a 90% payout. Using the same calculations, Hatteras would have the second highest yield at 9.1%, followed by Capstead at 9.07%, and Annaly at 8.1%.

While all of these yields are impressive in a low interest rate environment, Hatteras is the most consistent of the group. The company has the second highest expected growth rate, the second best discount to book value, and the second highest forward yield. They may not be the best at everything, but those are three solid reasons this high-yield stock looks like a buy at current prices.

Chad Henage owns shares of Invesco Mortgage Capital, Annaly Capital Management, and Hatteras Financial. 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!

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