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:

Nly

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):

G


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.