Rising Star Buy: Annaly Capital

This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

Unemployment is obstinate, companies are operating below capacity, and inflation is low.

Are there any companies that can actually benefit from the slump?

Why, yes there are
The name that's caught my interest is Annaly Capital (NYSE: NLY  ) , one of the largest publicly traded residential real estate investment trusts (REITs).

Annaly's business model seems complicated, but it's actually pretty straightforward: Imagine if you could borrow $10,000 at 2%, lend it at 4% to a guaranteed borrower, and keep the $200 difference.

That's Annaly's business in a nutshell. The company issues shares to raise capital, which it levers up with short-term financing. It uses this capital to buy longer-term mortgage-backed securities (MBS's), collects the interest on these securities or sells them, and then repays its lenders.

Virtually all the leftover profit is returned to shareholders via dividends. This currently works out to a 15% yield. (As a REIT, Annaly is required to distribute least 90% of its earnings as a dividend in exchange for not having to pay corporate income taxes. However, this dividend can be taxed differently than normal dividends.)

The diagram below shows how it all comes together, with arrows representing money flows:

Shareholders and lenders provide Annaly with capital which the company uses to buy mortgage-backed securities.

The bulk of Annaly's profit is the difference between the short term rates at which it borrows, and the long term rates at which it lends, multiplied by the amount of leverage it employs – currently 6.4 times.

This is similar to the profit model employed by many proprietary traders at banks likeGoldman Sachs (NYSE: GS  ) , JPMorgan, Bank of America (NYSE: BAC  ) , and Citigroup (NYSE: C  ) . The difference is that Annaly's investments are probably safer (all of them are issued and guaranteed by U.S. government agencies), a greater portion of the rewards are distributed to shareholders rather than as bonuses to traders, and proprietary trading will theoretically become illegal for the aforementioned banks should regulators actually enforce financial reform legislation.

There are other companies similar to Annaly, such as American Capital Agency (Nasdaq: AGNC  ) , Hatteras Financial (NYSE: HTS  ) , and Annaly-managed Chimera (NYSE: CIM  ) . But Annaly's bigger, has an ultra-safe portfolio, a long track record, and a strong management team headed up by Michael Farrell.

Here's where things get good
When inflation is too low and unemployment too high -- as is the case today -- the Federal Reserve lowers short term interest rates to stimulate the economy. The Fed is currently targeting 0%-0.25%, pretty much as low as you can go.

Since short-term rates are more responsive to the Fed's low interest rate targeting and Annaly borrows at short-term rates to purchase longer-term securities, its costs have fallen significantly faster than the interest it collects.

Check out how the declining Fed funds rate (green) drags down Annaly's borrowing costs (red) much faster than its investments yield (blue). The area between red and blue is Annaly's interest spread (profit):

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

This is an awesome environment for Annaly. The current spread of 2.11% (the area between the blue and red lines and the key determinant of the company's profitability) -- is nearly double its historical average of approximately 1.20%.

And it's one that's likely to persist for some time. As it's exceedingly unlikely we're going to see any meaningful economic stimulus to address unemployment emerge from the soon-to-be Republican-controlled House of Representatives and dysfunctional Senate, we can expect the slump – and low interest rates – to continue for some time. Traditional monetary rules prescribe as many as four years (!) of near-zero percent interest rates to cope even with mainstream economic forecasts.

Scenarios galore
Here are a few possible scenarios and their outcomes for our investment in Annaly, ranked from most to least likely.

  • The slump goes on: We continue to collect dividends on a massive interest spread – approximately 10%-15% annually.
  • Fed gets more aggressive: Intensified policies like quantitative easing that seek to lower long-term interest rates could put the squeeze on Annaly's interest spread. Annaly sells its investments at a profit and pays a dividend.
  • Employment recovers or inflation rises: Fed raises interest rates, Annaly's profits decline and investments fall in value. While Annaly is partially hedged and I don't expect this to happen for at least a couple of years, this would be a bad situation for our investment in Annaly.
  • Radical GSE reform: Legislation pulls the rug out from under the mortgage market by removing federal guarantees for Fannie- and Freddie-issued securities. In this unlikely scenario, Annaly could have to switch business models, but our downside is protected somewhat by the stock's modest (1.2 times book value) valuation.

We're buying
We're buying $500 of Annaly shares. The most likely outcome is that the economy will remain sluggish, interest rates stay more-or-less favorable, and the Dada Portfolio collects a large yield for at least a year or two.

We're not expecting much share appreciation from Annaly, as the company, by law, retains very little of its earnings. Growth is often financed with share offerings, though the company has historically done of good job of selling when its valuation is high.

Instead, we're buying the stock for its tasty 15% yield that should remain high so long as the economy lumbers along and the Fed holds interest rates down.

The Dada Portfolio is a part of the Rising Star series of real money portfolios. It is co-managed by Sean Sun and Ilan Moscovitz. If you're interested in learning more about Annaly Capital or the portfolio, click here to join us on our discussion board or follow us on Twitter @TMFDada.

At the time of publication, Ilan Moscovitz didn't own shares of any company mentioned. The Fool owns shares of Annaly Capital, Bank of America and JPMorgan Chase. 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.


Read/Post Comments (23) | Recommend This Article (117)

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 November 15, 2010, at 6:54 PM, langco1 wrote:

    nly a great stock to own along with its partner company cim

  • Report this Comment On November 15, 2010, at 7:00 PM, FlyingRiki wrote:

    Seems like a lot of good research for a $500 investment! Is that a typo? How big is the portfolio? Would be interesting to see how strongly the author feels about his conclusions.....

  • Report this Comment On November 15, 2010, at 7:10 PM, jm7700229 wrote:

    I have about $75k of Hatteras split between my IRA and my taxable account. The only thing I don't understand is why dividend investors don't bid the price up. With a 17% dividend and years of low interest rates in prospect, it seems to me that the price should be higher (pushing the return lower) -- unless investors know something that I've been unable to discover. Any thoughts?

  • Report this Comment On November 15, 2010, at 8:06 PM, tomd728 wrote:

    jm........It must be unwarranted fear that keeps NLY nearly range-bound.In fact,I have recommended NLY to friends of mine who seek yield and many of them have come back with the old "too good to be true" response...... albeit quietly.

    I certainly hope that cooler heads prevail when a rise in rates appears imminent.

    This piece by Mr.Moscovitz is as good as any I have read as it outlines precisely how the leverage works within NLY and out to the share holders.Aside from the explanation offered here a review of the NLY financials should suffice unless one is yelling......"The sky is falling" !

    Not mentioned as a source of Funds are the Preferred shares.

    Tom

  • Report this Comment On November 15, 2010, at 8:34 PM, TMFBane wrote:

    Great article, Ilan! I'm very intrigued by this one.

  • Report this Comment On November 16, 2010, at 7:54 AM, afamiii wrote:

    Surely it is folly to value a business by its dividend yield.

    Its PE of 13 and price to book of 1.2 show it to be fairly valued for a business with no competitive advantage and little prospect of growth without raising fresh equity.

    'The most likely outcome is that the economy will remain sluggish, interest rates stay more-or-less favorable, . . .' i.e. you mean to say that the spread between long rates and short rates (currently the highest in over 30 years) is going to remain there for the next two years.

    Your wish may well come true (I'm the last person who will try to predict the economy or stock prices.) And I do subscribe to the view that there is certainly something wrong with every great investment (which is the reason everyone else is running away.)

    But in uncertain times, most experienced investors will look at the worst possible outcome as well as the best. Hence the reason for the 17% yield.

    The other possible outcomes are that QE succeeds and long term rates drop, resulting in a squeeze on NLY.

    Or QE succeeds and after six months inflation picks up resulting in short term rates starting to go up and another squeese on NLY.

    NLY is fairly valued, buying based primarily on dividend yield is a poor strategy. Be guided first by intrinsic value and only then look at the dividend.

  • Report this Comment On November 16, 2010, at 8:28 AM, rtekosky wrote:

    guaranteed, mortgage backed securities, hmmmm, where have we heard these terms before? Sounds just too good Can't miss. I'll bet all those securities have great ratings as well.

  • Report this Comment On November 16, 2010, at 1:23 PM, Jbay76 wrote:

    I agree with RayTekos 100%. I would rather put my money in EXG or ETY and get 10% yields than follow what seems like a repeat of the recent past

  • Report this Comment On November 16, 2010, at 3:32 PM, TMFDiogenes wrote:

    RayTekos -- yep, no one should buy a stock they don't feel comfortable with. That said, I chose NLY rather than another REIT largely because their MBS's are guaranteed against default by FNM and FRE. (To answer the question about ratings, they're AAA-rated, but that's of little comfort to me -- it's the gov't backstop that's nice.)

  • Report this Comment On November 16, 2010, at 3:33 PM, TMFDiogenes wrote:

    afamiii does an awesome job laying out the bear case.

    I posted his comment and my response on the Dada portfolio discussion board, along with a few words about QE2:

    http://boards.fool.com/nly-bear-case-28896385.aspx

  • Report this Comment On November 16, 2010, at 7:51 PM, neamakri wrote:

    okay, this is the third or fourth time in the last two weeks that someone has hawked Annaly (NLY). I looked up data on Bigcharts and they pay $2.72 annual dividend.

    They earned $1.36 last year, projected $2.40 this year, and $2.58 next year. It appears that somebody is lying because you cannot continue to pay more than you earn year after year after year.

    Please either explain how this is possible year after year after year, or else stop trying to sell NLY!

  • Report this Comment On November 17, 2010, at 5:46 PM, LQM2 wrote:

    Wow. Have we forgotten 2008 so quickly? When something is too good to be true it probably is?

    The scenario everybody seems most worried about is inflation with short rates popping. Flat yield curve. It could happen fast and NLY will be hurting.

    And who is lending these guys money? In an inverted yield curve scenario, their credit could dry up. Then what?

    If this was such a great business anybody could do it.

    More risk than meets the eye.

  • Report this Comment On November 18, 2010, at 10:14 AM, tom2727 wrote:

    Yup. The reason this guy yields 17% now is because there's a real chance of it dropping to zero if inflation rears it's ugly head and interest rates rise rapidly. Then NLY is stuck with it's long term portfolio yielding 4% with short term rates at 6%.

    Then it's not a question of how low the div will drop, but how long until they go broke. They got a great 15 year track record, but they weren't around last time rates rose significantly.

  • Report this Comment On November 18, 2010, at 2:06 PM, TMFDiogenes wrote:

    Great discussion. Yup, inflation and rising short term rates would be really bad for them.

    That said, I think the *near-to-mid-term* risk of inflation and rising rates are way, way, way overstated (for many pundits and newspapers, that's due to ideology and politiking). Consider: we have 9% unemployment and 16% underemployment. Yesterday, it was reported that core inflation is at its lowest level since they began recording it in 1957. As I noted in the article, even mainstream CBO forecasts suggest a bad enough downturn to require near-0% rates for some time.

    Also, Annaly is partially (though not entirely) hedged against this possibility, and they've dealt with varying conditions in the past.

    But yeah, it is a real risk. The dividend and stock price would probably both fall.

    Ilan

  • Report this Comment On November 18, 2010, at 2:25 PM, TMFBane wrote:

    Great discussion! For the record, it was the rise in core inflation that was the lowest since 1957. Here's the report from the NYT:

    When excluding food and energy, the rise in core consumer prices in October was flat for the third consecutive month, and on an annual basis, core prices were up 0.6 percent, the smallest rise since the government started keeping the records in 1957.

    Anyway, I agree with Ilan that the inflation scare is way overstated.

  • Report this Comment On November 18, 2010, at 8:45 PM, ikkyu2 wrote:

    I always like to drop in and remind people to take a look at Annaly's competitors, companies like New Century Financial and NovaStar.

  • Report this Comment On November 19, 2010, at 3:26 AM, depsee wrote:

    I don't see massive inflation or interest rate hikes anytime soon. I base this on personal observations. While not my main line of work I have done quiet a bit welding and fabricating in my time. Lots of times when I have seen something I like I will build it. But several years ago I saw that I was a dieing breed with a visit to a Harbor Freight store, suppliers of tools, most made in China. I looked at a hand truck. If you don't know what that is, its the thing with 2 wheels a delivery driver rolls cases of beer into a 7-11 with. Anyway, they were selling them for $30.00. I can't buy the steal to build it for that, much less the wheels and paint. Forget the labor. I bought the Chinese hand truck.

    My point to all this is the fact that companies have opened factories overseas to take advantage of cheap labor. Now unemployment is high in the U.S. They won't change that until labor hear is cheap compared to China or India. But more than likely a new frontier such as Africa would be the next manufacturing hot spot.

    In the end I would say U.S. unemployment remains high, thus the Fed will try to keep interest rates low. Inflation could possibly raise its head from demand from developing countries.

    All that aside, I've looked into these stocks in the past. Seams like everybody is always pushing Annaly. The numbers looked better with American Capital and that's where I parked some money a while back, with no complaints yet.

  • Report this Comment On November 19, 2010, at 12:59 PM, TMFDiogenes wrote:

    American Capital currently uses slightly higher leverage (they've ramped up to 8x as NLY has lowered to 6x if I remember correctly.) Could still be a great stock, just one difference to consider.

    Ilan

  • Report this Comment On November 19, 2010, at 4:20 PM, Nrgyindependance wrote:

    Everybody is fretting about when rates go higher and resulting squeeze on NLY's net profit. I wonder what people in Japan thought over 2 decades ago as their rates were going down and stayed down. Had they been able to buy NLY ...... it would have been profitable for 20+ years. Could we be in the start of a Japan-like low interest rate period? Low cost of money for NLY may be here for a long time....

  • Report this Comment On November 20, 2010, at 4:56 PM, Anysimplefool wrote:

    One of the realities of comments on TMF is the lack of knowledge and experience of many posters. I've owned NLY for many years. Does it have risk? Of course, do you think you get a 15%+ yield for free? Will it go BK if rates move up? NO. Silly (aka ignorant) bloggers have been predicting the demise of NLY for the last 3 years. NLY management is one of the best in the business. The worst situation for NLY is an inverted yield curve. I've held through one cycle, it wasn't fun. There is no credit risk with NLY, but there is interest rate risk. If you don't know what that means, this is not a stock for you.

    Simple

  • Report this Comment On November 20, 2010, at 8:26 PM, polenium wrote:

    Sounds too much like the make Ponzi schemes that brought Wall Street crashing down. A touch of larceny and Bob's your Uncle.

  • Report this Comment On November 29, 2010, at 1:49 PM, tom2727 wrote:

    @Anysimplefool

    The bloggers who have been predicting the death of NLY for the last 3 years have also been predicting wild, out of control inflation due to out of control government spending. Check out gold prices to see that these guys are not alone in their belief.

    They were wrong about inflation, and wrong about rising rates, and hence wrong about NLY going belly up. That does not mean that they their thesis about NLY's exposure to rising rates is invalid.

    FWIW, I don't see rates rising or inflation anytime soon. But then I didn't see the 2008 crash either. Wouldn't bet the farm on NLY, though maybe a few percent of the portfolio could go there.

    Just remember that if you hold similar companies (AGNC, CIM, IVR, etc), they carry the same risk, so beware of how much you put in the sector overall. Also might be good to have a few companies that will do well if rates rise as a hedge.

  • Report this Comment On January 07, 2011, at 11:09 PM, jdfarm wrote:

    I don't see how some of you have ever bought any stocks. First thing you should know is that stocks go up and stocks go down. Any stock. You just can't be too alert.

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