Today's Buy Opportunity: Annaly Capital

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We're living and investing in a tough economy, to say the least: high unemployment, possible deflation, and slow-to-moderate economic growth are the order of the day. It's not exactly the environment that many investors relish, but it's a beautiful one for Annaly Capital (NYSE: NLY  ) .

Fast facts on Annaly Capital

Market Capitalization

$10.6 billion

Industry

real estate investment trusts

Revenue (TTM)

$1.3 billion

Earnings (TTM)

$1.1 billion

Debt/Equity Ratio

6:1

Price/Book Value

1.01

Dividend Yield

15.6%

Source: Capital IQ, a division of Standard & Poor's. TTM is trailing 12 months.

Annaly uses short-term financing to buy longer-term mortgage-backed securities and other debt, largely issued by Fannie Mae and Freddie Mac. Annaly's profit is the difference between the two, which is known as its interest rate spread. As a real estate investment trust, Annaly gains favorable tax treatment, but must distribute at least 90% of its earnings to shareholders in the form of dividends.

Annaly and its huge yield could make a great investment or a useful hedge for this economy.

Why Annaly makes sense today
When unemployment is high and inflation low, the Federal Reserve lowers interest rates to stimulate the economy. The Fed is currently targeting short-term rates of 0%-0.25% -- pretty much the lowest possible.

But with the economy in such awful shape, even that may not be enough to substantially reduce unemployment or boost inflation on its own. Though there have been some stirrings, the Fed hasn't announced yet other initiatives, and "deficit hawks" in Congress succeeded in scaling back or delaying stimulus measures.

What this means is that the same economic conditions that led to the Fed keeping rates this low are likely to persist. Federal Reserve estimates, which show unemployment remaining above 7% and inflation only rising to some 1.25% by 2012, led the board to commit once again to keeping interest rates low for "an extended period."

Why is this great for Annaly? When the Fed lowers the overnight interest rate at which banks lend to each other, the interest rates for other overnight and short-term loans also decline -- usually much more so than long-term interest rates. This means higher profits for Annaly, because it uses short-term financing to buy longer-term mortgage-backed securities.

Take a look at how declining Fed rates (green) drag down Annaly's borrowing costs (red) much more than they reduce Annaly's interest yield (blue). The expanded area between the red and blue lines represents Annaly's profit:

Source: Company filings and the Federal Reserve Bank of New York.

Source: Company filings and the Federal Reserve Bank of New York.

This is essentially the same phenomenon that's responsible for the recent explosive profits at bond trading desks for Goldman Sachs (NYSE: GS  ) , JPMorgan (NYSE: JPM  ) , Bank of America (NYSE: BAC  ) , and Morgan Stanley (NYSE: MS  ) .

While traders at these companies enjoy significant advantages, we're talking about black boxes that could carry enormous risk, the rewards of which go largely to star traders -- traditionally about 50%. Annaly, on the other hand, spends just 12% of its revenue on all administrative and salary expenses combined, leaving a greater portion of the spoils for shareholders.

What else there is to like
In such an economy, it's easy to see how homeowners might default on the mortgages backing most of Annaly's assets. Mortgage-backed securities were responsible for the blowups at a number of companies at the heart of the financial crisis. However, Annaly's portfolio is reasonably conservative and high quality -- at least 75% must be short term, be of top ratings quality, or be guaranteed by Fannie or Freddie, and therefore implicitly, by the U.S. government. Annaly's creditors know this, which is partly how it's able to keep financing costs low. (American Capital (Nasdaq: ACAS  ) -managed American Capital Agency (Nasdaq: AGNC  ) follows a similar model, but its history is shorter.)

There are few competitive advantages in Annaly's industry, so a management team with the ability to navigate changing interest rates and allocate capital effectively is critical. Michael Farrell, Annaly's CEO and chairman, has been with the company since he founded it in 1997. Through the years, the company has held up well through different interest rate environments.

Because Annaly is required to pay most of its earnings as a dividend, growth is often funded with new share issuances. You want to see more shares issued when the stock is expensive relative to book value, something Annaly's management has also done very well over the past decade.

What could go wrong?
Well, for starters:

1. Interest rates. A Fed short-term rate hike would crimp Annaly's profitability and could reduce its book value, but that's unlikely to happen for some time, and Annaly is partially hedged.

Perhaps the more likely risk is falling long-term rates. The Fed could get creative and begin buying up long-term debt again. Deflation fears or a flight to quality could prompt investors to buy up long-term Treasury notes. Both would probably hurt Annaly's profitability.

2. An end to the Fannie/Freddie gravy train. The House Financial Services Committee has already begun hearings on how to reform Fannie Mae and Freddie Mac. If Annaly isn't able to count on an implicit government guarantee for future mortgage-backed securities, its lenders could get cold feet and demand much higher rates. Annaly's costs would go up, and it could even be forced to find a new business model.

But as my Foolish colleague Matt Koppenheffer so aptly described it, reforming Fannie and Freddie is like defusing a massive nuclear weapon. It's a complicated, dangerous, and time-consuming process. We don't know if and how badly reform will hurt Annaly's future profitability, but the stock is trading for no more than book value today. And in the meantime, we can enjoy that fat dividend.

Foolish takeaway
It's not always easy to find good stocks for a lousy economy. But this interest rate environment does wonders for Annaly's profitability and dividend, and the stock is pretty cheap. Annaly could yield some nice returns or make a good hedge in a tough economy.

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At the time of publication, Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (77)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 10, 2010, at 11:09 AM, wolfhounds wrote:

    Reread the section about risks. In the universe of stocks that pay good, dependable dividends, is this really the right stock to buy now based on your own assessment.

  • Report this Comment On August 10, 2010, at 11:32 AM, Nrgyindependance wrote:

    At last an intelligent article about Analy from TMF! It seems that many of your authors have stretched their resoning to find reasons to bash the stock lately due to concern for future unknown events. All stocks ahve pros and cons when considering the unknown future. This is the first article I have seen that simply explains how profits are made and the potential risks and rewards.

    To wolfhounds above: All the "risks" stated for annaly also apply to the whole universe of stocks including those that pay "dependable dividends" plus a few more risks not associated with NLY.

  • Report this Comment On August 10, 2010, at 11:59 AM, mikecart1 wrote:

    This is a stock I can support! Love the dividend stocks like BP, MO, WIN, and NLY.

  • Report this Comment On August 10, 2010, at 1:25 PM, torpex77 wrote:

    Annaly or Chimera (CIM)?

    Chimera was a spin-off of Analy and has a similar dividend.

    Anybody have any insight on to the pros and cons between the two?

  • Report this Comment On August 10, 2010, at 2:18 PM, TMFDiogenes wrote:

    Hey everyone,

    I'm Ilan, the article's author. I'd be happy to answer your questions.

    Fool On!

    Ilan

  • Report this Comment On August 10, 2010, at 2:25 PM, ContraryDude wrote:

    Excellent article, Ilan! Have you looked at MFA? I would love to see a similar write-up on it.

  • Report this Comment On August 10, 2010, at 4:07 PM, plange01 wrote:

    nly and cim are both great stocks i own both.50k in annaly gives you over $1,800 every quarter in dividends about $2,000 for cim

  • Report this Comment On August 10, 2010, at 6:00 PM, saoco wrote:

    Any suggestions on NLY's buy price? Seems to be flirting with its all-time high.

  • Report this Comment On August 10, 2010, at 7:35 PM, Pat4Ra wrote:

    Ilan,

    A large number of mortgages are under water at present. There is rumor that Obama administration could allow Freddie and Fannie to adjust loan values downward this August (Aug 17 may be) thereby adjusting LTVs, so that mortgagees can refinance at a lower rates. Would this not have -ve impact on NLY? BTW, how much credence can be given to the rumor? Will certainly help Dems in the coming election.

  • Report this Comment On August 10, 2010, at 8:22 PM, Pat4Ra wrote:

    Ilan,

    There is rumor that Obama admin will attempt to do something in Aug (17th?) about underwater mortgages by working thru Fraddie and Fannie to adjust home mortgage principal downward. This will allow mortgagees to refinance easily again. If this is true surely this could impact NLY.

  • Report this Comment On August 11, 2010, at 7:55 AM, JustMee01 wrote:

    hiddenlevers wrote:

    "I charted NLY against interest rates (1y treasuries) and it is very telling:"

    Go back further, and you'll see how well the inverse correlation holds up (very well). Chart the Fedfundsrate against its divi and it will be even clearer. The problme that NLY may face is rising rates, digging into their profit. Their divi really trims as rates rise. The perfect time to buy NLY is when rates are high and their spread is trimmed. Then NLY pays out a lower divi and the street pulls the stock down.

    I like NLY, and hold some. But, it's not the best time to initiate a large position. Better to keep this well-managed company in mind and remember that it will be a great buy a few years from now, when everyone else is uninterested and chasing the Google's of the world again.

  • Report this Comment On August 11, 2010, at 12:35 PM, TMFDiogenes wrote:

    Hey Dude,

    I glanced at the other players in the industry when doing my writeup. From their 10-k, MFA seems to have more latitude with the types of risky assets they buy -- I think only 50% has to be of those really high grade securities (NLY's minimum is 75%), and they hold more non-agency (read: non-guaranteed) and adjustable (perhaps more default-prone) assets. The upside, of course, is that they could potentially get higher returns on those riskier securities. They say this allows them to use less leverage.

    So in short, MFA appears to buy riskier assets than NLY, which should allow them to use less leverage or higher profits, depending on how they use that strategy.

  • Report this Comment On August 11, 2010, at 12:42 PM, TMFDiogenes wrote:

    NLY's price is sortof in the upper-mid range of its price history.

    http://www.google.com/finance?chdnp=0&chdd=1&chds=1&...

    To the extent that it's high, it may reflect the fact that book value/share has grown and that this is a good environment for them. But when you look at their price-to-book ratio, it's only around 1, which is near the bottom of their historical range of around 1 to 1.5. That could reflect uncertainty about FNM/FRE and perhaps interest rate uncertainty, if some investors are still worried about near-term inflation even after what we're seeing.

  • Report this Comment On August 11, 2010, at 1:01 PM, TMFDiogenes wrote:

    Pat,

    I thought I saw something on tv a couple of days ago with the wh denying that rumor, but it might have been something else because I'm having trouble finding a response online.

    They did say they'll have their proposal for FNM/FRE reform ready by January:

    http://www.treas.gov/press/releases/tg791.htm

  • Report this Comment On August 11, 2010, at 2:43 PM, TMFDiogenes wrote:

    Regarding the question about whether a policy of forgiving mortgages would be bad for NLY, my understanding is that FNM (Treasury Dept.) would have taken those losses, not NLY. And it looks like that's not what's happening -- the wh announced it will spend $3b of the TARP money on aid to states to help out homeowners, which seems to be an alternative move.

    http://www.cnbc.com/id/38658978

  • Report this Comment On August 16, 2010, at 3:43 PM, ikkyu2 wrote:

    No article intended for laypersons about Annaly Capital is complete, in my opinion, without the following components:

    1) The tax treatment of Annaly's "dividend," which is not eligible to be taxed under the "capital gains and dividends" rate, but instead is taxed as ordinary income.

    2) The percentage of assets under management that would have to default in order to zero Annaly's earnings. If you don't actually know, Ilan, I encourage you to do the math and post the findings. I could tell you - but I suspect you'd find it unbelievable.

    3) A clear, understandable analysis of the downfall of Novastar Financial (NFI) and New Century Financial (NEWC), and why Annaly is not (or is) in danger of replicating it. New Century in particular went from an apparently-healthy company with a 35 % dividend yield, to a bankrupt company in receivership with a stock value of 0.0, in less than 6 weeks.

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