Housing Recovery: Buy These 2 Stocks

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New home construction starts are at their 4 year highs, and with the Fed pumping liquidity in the market, housing recovery is becoming imminent. Also boosting the recovery is the dipping unemployment rates, low interest rates, and rising credit in the market. These facts make REITs lucrative investment options, but one needs to be cautious while making investment decisions. Due to lower interest rates, more consumers may be willing to buy mortgages, but the interest income of REITs has declined. Also, due to increasing prepayments, REITs are not able to fully reap their rewards.

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>Conditional Prepayment Rate(CPR)</strong></p> </td> </tr> <tr> <td> <p><strong>American Capital Agency</strong> <span class="ticker" data-id="210594">(NASDAQ: <a href="http://caps.fool.com/Ticker/AGNC.aspx">AGNC</a>)</span></p> </td> <td> <p>15.86%</p> </td> <td> <p>9%</p> </td> </tr> <tr> <td> <p><strong>Annaly  Capital Management</strong> <span class="ticker" data-id="204722">(NYSE: <a href="http://caps.fool.com/Ticker/NLY.aspx">NLY</a>)</span></p> </td> <td> <p>13.62%</p> </td> <td> <p>20%</p> </td> </tr> <tr> <td> <p><strong>CYS Investments</strong> <span class="ticker" data-id="222603">(NYSE: <a href="http://caps.fool.com/Ticker/CYS.aspx">CYS</a>)</span></p> </td> <td> <p>13.78%</p> </td> <td> <p>17.3%</p> </td> </tr> <tr> <td> <p><strong>Apollo Residential Mortgage</strong> <span class="ticker" data-id="249988">(NYSE: <a href="http://caps.fool.com/Ticker/AMTG.aspx">AMTG</a>)</span></p> </td> <td> <p>15.37%</p> </td> <td> <p>3.7%</p> </td> </tr> </tbody> </table>

From the above table, it’s not hard to conclude that American Capital and American Residential Mortgage carry the highest yields with the lowest prepayment rates. Since both the companies have a greater exposure to HARP and low balance mortgages, the lower CPRs become justified.

American Capital

With the increasing liquidity in the market, mortgage rates have gone down, hurting the bottom-line of most REITs. However, American Capital has over $89.6 billion in mortgage backed securities, out of which 98% are fixed rate securities.  American Capital’s exposure to fixed MBS' is significantly higher than the industry average, giving it a chance to outperform the industry in 2013.

Upon digging deeper, its operating cash flow/dividend and cash/dividend are well within acceptable limits, which ensure a stable 16.39% yield. YTD its shares are up by 8.9%, and analysts expect the EPS growth over 2013 to be around 44%. Going by these numbers, American Capital Agency could be one of the fastest growing and highest dividend paying companies in 2013.

Shares of American Capital appear undervalued, with a forward P/E of 10.44x and a P/B of 0.96x. P/FCF equates to a hefty 13.66x and the company enjoys a gross profit margin of 75.93x. The company reported an EPS of $3.98, crushing the Street’s estimates by 268%. Since the Fed recently increased its monthly bond buying budget, we could expect mortgage rates to further decline. I strongly believe that since AGNC has a greater exposure to fixed MBS' with low prepayment risks, the company could have a blockbuster year in 2013.

Apollo Residential Mortgage

Besides having the lowest prepayment rate in the industry, Apollo Residential is one of the most undervalued REITs. Shares of Apollo Residential yield a hefty 15.9% with a massive gross profit margin of 86.4%.

Talking about portfolio distribution, the company holds 66% Agency RMBS with only 22% non-agency RMBS. The remaining 14% is held in cash, which equates to around $630 million.

So what?

With a higher exposure to agency-backed RMBS and 14% portfolio liquid, the company can leverage itself to higher debt/equity levels. Also, agency-backed RMBS have lower prepayment risks, lower default rates, and relatively higher fixed rate mortgages. The housing sector is only expected to boom, and with the Fed’s increased spending, REITs could have a huge rally.

The company has performed exceedingly well and recently boosted its dividend. With a massive chunk of cash reserves, its dividend payout seems sustainable. Shares of Apollo Residential are up by 35.4% YTD. I strongly believe that the company will continue to deliver spectacular returns in 2013 on the back of its well positioned portfolio.


PiyushArora has no positions in the stocks mentioned above. 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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