Stocks to Sell

Written By Briton Ryle

Posted April 3, 2013

I’m a pretty level-headed guy. The list of things that can send me into a panic is pretty short.

But right at the top sits walking into a spider web.

As a kid, my brother and I would cross the creek and cut through the woods to get to the bus stop for school. Many a morning, a web transformed me into a kung fu master with wild leg kicks and karate chop arms. So I took to waving a spider-stick out in front of me to take down any heart attack-inducing webs.

To this day, I’ll still grab a spider-stick at the first sign of spider country… and on the rare occasion that my spider-stick fails me and I display my kung fu skills, my kids will run in the other direction (if they can stop laughing long enough).

As co-editor of The Wealth Advisory, I am an income investment specialist. When you’re building a a top-notch portfolio of long-term income investments, panic is the enemy.

Did we panic-sell Boeing when its entire fleet of Dreamliners was grounded for mysterious on-board fires that forced at least one emergency landing?

No way. In fact, we called the dip in the stock price to $74 a buying opportunity. Shares now trade at $85 and change, good for a 15% return.

Overall, our readers are up 42% on Boeing — including dividends.

Did we freak out when health care REIT Medical Properties Trust (NYSE: MPW) dipped below $9 a share last summer?

Not a chance…

Our analysis showed the stock was undervalued, and our research on aging trends in the U.S. continued to support the health care REIT investment thesis. We reiterated our “buy” recommendation for MPW in the July issue of The Wealth Advisory.

Shares have risen from $9.90 to $16.25. Our loyal readers who took that advice are up 68%, including dividends.

We took advantage of every buying opportunity in 2012.

Now The Wealth Advisory portfolio is absolutely trouncing the S&P 500: The S&P 500 is up 10.3% so far in 2013, whereas The Wealth Advisory portfolio has more than doubled that performance — we’re up 24.94% this year.

But just because we are enjoying this success doesn’t mean we’re not still carrying our proverbial spider-sticks…

Today I want to tell you about one group of stocks that has the potential to send investors into a panic.

Will These Stocks Ruin Your Portfolio?

Sixteen months ago, Angel Publishing President Brian Hicks and I took over The Wealth Advisory.

The first order of business was to clean up the portfolio as we transitioned to the newsletter to focus on income investing.

One of the first stocks I reviewed was Annaly Capital Management (NASDAQ: NLY). Annaly is a mortgage REIT (or mREIT, as the cool kids call them).

Basically, the company owns paper: a variety of mortgage-related securities, much of them backed by Fannie Mae and Freddie Mac. Because the investments are focused on real estate, the mREITs get tax exempt status, so long as they distribute +90% of income to shareholders.

It’s a pretty simple idea: Borrow money at low rates and buy mortgage securities that pay higher rates.

After the worst mortgage securities blew up in the financial crisis and the Fed started attacking interest rates, the mREITs have done pretty darn good. Annaly pays an 11% dividend. American Capital Agency(NASDAQ: AGNC) pays 15%.

But it won’t last…

When interest rates rise — and they will eventually — the mREIT business model will get tuned on its head.

You see, mREITs often use short-term borrowing to buy long-term securities. That means the loans have to get rolled over at some point. I find it easy to imagine interest rates on loans will rise above the interest rates that current mortgage securities pay.

If mREITs end up paying more for loans than they get in mortgage security payments, well, let’s just say that’s not a sustainable business model. mREITs also raise capital by selling stock. It’s cheap, for sure. It also dilutes shareholder value.

I was reading through a 4Q 2012 presentation from American Capital, and the company was pointing out that it bought back $2.7 million worth of shares in the fourth quarter 2012. Good for them — stock repurchases are a decent way to enhance shareholder value.

Then there was the press release from February 28 announcing the company was selling 50 million shares for $1.5 billion in a secondary offering…

Ummm, so, why did the company buy back shares in the first place?

Diluting Your Gains

As a recent Bloomberg article points out, American Capital is run by a former Freddie Mac executive, Gary Kain.

Kain was with Freddie Mac for 20 years, managing $800 million in mortgage debt. He joined American Capital after Freddie Mac went bust and was seized by the government. I’m not sure how good that looks on a resume, but at the helm of American Capital, Kain has rapidly expanded the balance by selling stock — and has leveraged the company by around 8 to 1.

In 2009, when Kain took over, American Capital had 24 million shares outstanding and just under $5 billion in mortgage assets. Today it has 338 million shares outstanding and assets around $100 billion. Yes, assets have surged… but so have the shares outstanding. And you can see the effect on the share price.

American Capital bottomed at $14.73 in March 2009. Today it’s around $32.50. And it’s paid out $22.60 in dividends since January 1, 2009.

Perfectly timed, you could have made around 274% on American Capital. That’s on par with a stock like Bank of America (NYSE: BAC), which bottomed at $3.14. (Apple Computers (NASDAQ: AAPL) bottomed at $85.30. Gulfport Energy (NASDAQ: GPOR) bottomed at $1.56. It’s $45 now.)

However, I see much more risk for mREITs like American Capital than a stock like Bank of America…

And the situation is no better at Annaly Capital. At the March 2009 bottom, Annaly was an $11.85 stock. Today it’s just under $16. Annaly Capital has paid out $8.36 in dividends since the start of 2009. At the end of 2009, Annaly Capital had 541 million shares outstanding; today it has 947 million.

The share count has nearly doubled, so shareholder value has been greatly diminished.

We advised Wealth Advisory readers to sell Annaly Capital at $16.60 in February 2012.

In fact, we believe all the mREIT stocks have taken advantage of a unique situation where interest rates are kept artificially low.

How much longer will that window stay open? Hard to say…

But when it closes, it will slam shut — and mREITs could suffer the most when it does.

Until next time,

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Briton Ryle for Wealth Daily

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