I Hate This Stock

Annaly Capital Management (NYSE: NLY) has become a favorite of many dividend investors. That's not all that surprising, since the stock sports an eye-popping 15.8% yield. Yes, you read that correctly.

What many investors are likely seeing is the opportunity to buy a stock that will kick out a very attractive double-digit return whether the market goes up, down, sideways, slantways, longways, or backways (like Willy Wonka's Wonkavator).

Not so fast
As many of my colleagues have pointed out, Annaly has been doing as well as it has because interest rates have been low, allowing the company to gorge itself on healthy spreads between its borrowing costs and what it can earn on the agency-backed paper that it invests in.

But that low-rate environment won't last forever, and when rates rise, Annaly will end up with a nasty hangover from this party.

That's what happened after the last party. During the last recession, Annaly saw a similar spike in profits as the Fed slashed its rate target. But rates didn't stay low forever, and Annaly's stock took a nasty spill as rising rates caught up with profits.

What's worse is that the company's dividend payout in 2006 was nearly 80% lower than it was in 2002. That hurts.

It gets worse
But there's an even bigger reason that I'm well outside of the Annaly fan club: There's no moat here.

Outsized profits for a company and outsized returns for investors can only continue when a business has a defendable competitive advantage. As far as I can tell, there's really none present for Annaly.

The company borrows on the cheap, buys Fannie Mae- and Freddie Mac-backed paper, and reaps the spread between the borrowings and its investments. Few barriers to entry; simple business; no special sauce.

If you ask me, that likely means that investors expecting spectacular returns are going to end up disappointed.

However ...
As much as I dislike Annaly and its assailable business model, I would never short its stock.

For one thing, I am absolutely, 100% uncomfortable with trying to predict anything the Federal Reserve is going to do. Rates will have to come up at some point, but I have no idea when that point will be. And the longer the Fed keeps rates low, the longer Annaly prospers and the longer my short would suffer.

In addition, that 15%-plus dividend cuts both ways. When you short a stock, you're borrowing it from someone, and when the ex-dividend date hits, you're responsible for paying the dividend to the investor you borrowed the shares from.

Combine the timing issue with the dividend payout issue and you're left with a pretty lousy short.

Better ideas
In a recent article, my fellow Fool Tim Hanson mused on some shorting experiences he's had as the advisor for Motley Fool Global Gains. In that article, he hit on one of the key points to finding a good short opportunity: a company "whose financials reveal emerging operational red flags that will act as a near-term catalyst for the stock's decline."

That's not Annaly, but below are four companies that may be more interesting short possibilities. Why? Because all of these companies are walking a very dangerous tightrope when it comes to their financial health.

As I illustrate in the table below, they're all seriously indebted (first red flag). More than that, however, they all have a very low Altman Z-score, which is used as a predictor of bankruptcy. (Scores of 3.0 and above are generally considered safe, while scores between 1.8 and 2.99 are worrisome, and scores below 1.8 are downright scary.)

Source: Capital IQ, a Standard & Poor's Company.
EBITDA = earnings before interest, taxes, depreciation, and amortization.
NM = Not meaningful. SandRidge Energy does not have positive shareholder equity.

Of course, even though these companies are in financial distress, that doesn't mean they're going to be guaranteed victories for short-sellers. Melco Crown competitors Las Vegas Sands (NYSE: LVS) and MGM Mirage (NYSE: MGM) have had similarly dubious financial health, but both have managed to skirt worst-case scenarios, and their stocks have soared since bottoming out in early 2009.

Other companies are waiting for turnarounds in their respective industries -- natural gas for SandRidge, steel for U.S. Steel, and oil and gas drilling for Hercules Offshore. The less-than-thrilling balance sheets for each of these companies mean that they're in a particularly precarious position if their respective industries don't shore up, but they could find some much-needed breathing room if there is an industrywide turnaround.

Even so, I believe these are all much better short candidates than Annaly Capital. Each appears to be in a precarious financial situation and is currently facing very difficult headwinds. And maybe most importantly, none of the four pays a significant dividend.

Hold that trigger finger
While shorting isn't for everyone, using a portion of a portfolio for selective shorting can serve many investors well. My fellow Fool John Del Vecchio -- a CFA and leading forensic accountant -- has put together a special report, "5 Red Flags -- How to Find the Big Short," that looks at some of the top ways to find short-worthy companies. Enter your email in the box below and I'll send you John's report for free.