How High Could This Real Estate Investment Fund (REIT) Stock Go?

This week I have another one of my favorite stock picks for you.  I added this company to my portfolio a while back and it’s treated me well.  Best of all, this stock has lots of room to run.

I’ll give you the company name in a moment… but first a little background on why I like this stock so much.

We all know how aggressive the Federal Reserve has been when it comes to flooding the economy with cheap and easy money.  How can you argue the point with $600 billion in stimulus entering the market, and interest rates at 0.25%.You simply can’t!

Now I’ve been watching for companies performing well in cheap money environments… and today’s company is one I really like.

Now keep in mind, this isn’t another tirade on the falling value of the US Dollar or how inflation is going to spin out of control (though it eventually will).

The key to this company’s success is low borrowing costs.

My pick this week is a company who borrows money very cheaply and then invests for a higher return.  It’s a strategy called capturing the spread… and the profits can be fat and easy in today’s market place.

So what company am I talking about?  None other than MFA Financial (MFA).

Now I’m sure you’re wondering who MFA is and how they make their money.  And I’m glad you asked.

Think of MFA like a bank… they borrow money very cheaply and then invest the money in higher yielding investments.  Their investment of choice is mortgage backed securities.

Wait a minute, aren’t mortgage backed securities as good as MUD after the financial meltdown?  Well, yes and no.

You see, the MFA management team is smart.  They only invest in quality mortgage backed securities.  That means while other “risky” funds put their money in high risk, high yield mortgage pools, MFA stuck with the most stable and secure.

It cost them a little in earnings… but when the crisis hit they were looking good!

Now, here’s where I need to let you in on a little secret that most people don’t know.  These mortgage backed securities are special.  MFA is able to borrow against their own investments!

Banks will loan MFA money… as long as the mortgage backed securities back up the loan.

This means MFA can leverage up their investment.  Consider this… for every one dollar the company has to invest, they can borrow another 5 to 10 dollars… which they use to buy… you guessed it… more mortgage backed securities.

MFA owns almost $8 billion of the mortgage backed securities.

So by borrowing and investing, MFA is capturing even more of the spread.  So how profitable is investing for the “Spread”?  In the third quarter of 2010 the company captured a spread of 2.56%.  It doesn’t sound like much.  However, during that time, MFA was able to generate a net income of over $75 million!

Not bad…

But I haven’t even told you the best part about this investment.  MFA is set up as a REIT. So by law, they have to send shareholders their cut of the profits.  In the third quarter it worked out to a dividend of over $0.22 per share.

Now 22 cents won’t get you very far in life… but consider on an annualized basis (and with the stock around $8), MFA yields more than 11%!

Let’s see you get that kind of a return in a savings account… it’s just not going to happen.

Now, before you rush out and load the boat on this one… there are some risks.  Obviously, if the banks stop lending to MFA, or their loans get called the company could be in a pickle.

They are also at risk once interest rates start moving.  This risk doesn’t really concern me… remember good old Ben Bernanke at the Federal Reserve is working hard to keep rates low and the easy money flowing.

Besides, the MFA management team has been around for a while.  And they’ve all worked in environments where interest rates have been much, much higher.

 

So how high can MFA’s stock go?

 

That’s a million dollar question.  Just remember, a few short years ago the stock was trading for over $10 a share.  That’s a 20% return from here.

Don’t forget too, the yield at 11% is an attractive one.  Bigger companies often have dividend yields of around 2% or 3%.

Assuming the dividend payout of $0.88 per year stays the same… MFA would need to see the stock climb to $17.50 a share (more than double current levels) to see the yield fall to a more reasonable 5%

Chart courtesy of StockCharts.com

 

Despite the recent run-up from $7.50 to $8, I still think this is a good area to establish a position in MFA.

 

ACTION TO TAKE

If you like what you read, remember to do your own diligence.  Buy shares of MFA Financial (MFA) up to $8.75 a share.

 

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