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.)

Company

Altman Z-score

Debt-to-Equity Ratio

EBITDA-to-Interest Expense

SandRidge Energy (NYSE: SD  )

(1.2)

NM

1.5

Melco Crown Entertainment (Nasdaq: MPEL  )

0.8

79%

2.3

U.S. Steel (NYSE: X  )

1.8

82%

0.4

Hercules Offshore (Nasdaq: HERO  )

(0.2)

94%

1.1

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.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. Melco Crown Entertainment is a Motley Fool Global Gains pick. The Fool owns shares of Annaly Capital Management. The Fool's disclosure policy takes no stance on Annaly Capital, but assures you that it's OK to think Matt's crazy.


Read/Post Comments (14) | Recommend This Article (51)

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 31, 2010, at 6:03 PM, golfwineski wrote:

    More appropriate title: "Stocks that kick my @ss"

    Whaaaaaaaa......their business model sucks.....whaaaaaa... interest rates MUST go up AT SOME POINT.....but whaaaaaaa.....Ben won't raise them.

    Anyone who owns NLY SHOULD understand the risks but until the housing market and rates go up, which isn't going to be any time soon, NLY prints money.

    Get over it.

  • Report this Comment On August 31, 2010, at 6:18 PM, 1batitude wrote:

    As you state, there are not huge barriers to entry, but there are not very many players big enough to invest in. What you are getting with NLY is experienced management, impressive history, and a large enough company to handle changing financial conditions.

    All the points you made are valid, and NLY is always hedging for the future - they have done interest swaps so that WHEN interest rates go up, they will maintain their spread longer. WHEN interest rates go up, so does the coupon rate of any new mortgages NLY invests in. So, although I am in agreement that they are/have been in a sweet spot, and that with rising interest rates the spread will be smaller, and the dividend will be reduced, I also expect that it will be a wave, and any market over-reaction will be an opportune time to buy. The dividend is a distribution of profit in a REIT, and anyone buying NLY needs to understand that - but you are buying several things with NLY - proven profitability and management, current returns, and the probability that the only market losses are just that - "market", and not the underlying value of the business.

  • Report this Comment On August 31, 2010, at 6:38 PM, TMFKopp wrote:

    @golfwineski

    Thanks for the enlightening comment! :)

    @1batitude

    "WHEN interest rates go up, so does the coupon rate of any new mortgages NLY invests in. "

    Yes, but it's not quite that simple. New investments will have those new yields, but the company borrows short-term and invests long (or at least long-er) term, so you'll see borrowing costs shoot up much faster than investment yields.

    At the end of 2009, the company had roughly $55 billion in repo agreements, $38 billion of which matured within 30 days. Meanwhile, $55 billion of the company's investments have a duration between one and five years. That makes for a pretty painful squeeze in the middle as rates rise.

    As I was very clear in the article, NLY has proven me wrong over the years -- it has been a very successful investment to date, even with the drop a few years back.

    But it's a *cute* financial business model based solely on collecting spreads. We saw a lot of cute financial business models go down in the crisis, models that investors had previously defended by saying, "But it just works." Not saying that's necessarily NLY's fate, but it's just not my kind of investment and not one that I see continuing to produce outsized returns for years to come.

    Of course, still not a stock that I have ANY appetite to short!

    Matt

  • Report this Comment On August 31, 2010, at 6:42 PM, richie54 wrote:

    Let me expand on one point Matt makes. You can't predict 100% of anything that the entire U.S. government is going to do.

  • Report this Comment On August 31, 2010, at 6:45 PM, Freshmaninvest12 wrote:

    Hey im really interested in what you think of MSB. Im not sure whether you have ever wrote and article on it but it would be really great to here your viewpoint. Thank you

  • Report this Comment On August 31, 2010, at 7:15 PM, TMFKopp wrote:

    @Freshmaninvest12

    MSB would fit well with another article I recently wrote -- http://www.fool.com/investing/dividends-income/2010/08/31/ca...

    I can't claim to be terribly familiar with it, but it wouldn't be my first stop for a solid dividend stock because it's payouts vary wildly. I tend to have a preference for companies that are able to reliably pay out a dividend and consistently grow it over years (preferably decades).

    Matt

  • Report this Comment On September 01, 2010, at 10:34 AM, clintspicks wrote:

    "As I was very clear in the article, NLY has proven me wrong over the years -- it has been a very successful investment to date, even with the drop a few years back."

    That statement should tell you quite a bit. NLY isn't the the kind of investment you buy and take your eye off of (no investment should be). But it has been a long-term winner. In a hostile environment, when rates are up and dividends are down, and the price is down I'll probably buy more.

  • Report this Comment On September 01, 2010, at 11:01 AM, Tomdunno wrote:

    Always appreciate varying opinions, thanks for taking the time.

    I am not in agreement the the potential hitches in Anally's future profits are worth giving up that 15+% dividend. Take me for instance (not literally) I was lucky to get in in March of 2008 at was has turned out to be a great price. I have collected the divi for that perion of time and kick myself daily for not buying a little bit more. If interest rates rise it means the economy is heating up. That will be good for the rest of the equities I own. It may cause Annaly PPS to fall. If emotion investing continues as it has for 2 years, it will fall quite a bit. That being said, Annaly is not a driverless moving vehicle. Management is preparing every day for similar problems and have done quite well thru tougher conditions than an improving ecconmy will present. Also, I beleive we are stuck in this range for at least a year. By that time Annaly can go to zero (not very likely) and I will have still made more from it than I put into it. Yep, it's a gamble... but I am almost to the pint of playing with the houses money. Can't ask much more than that. Wisdom requires that you always look for the preverbial "fly in the ointment and perhaps a stop loss may make some sleep better at night. And as a contrarian, I have no trouble seeing or hearing the fly coming. Till then, they keep showing me the money.

    Again, thanks for the food for thought.

  • Report this Comment On September 01, 2010, at 1:03 PM, pewillard wrote:

    For a different perspective on NLY check out

    http://seekingalpha.com/article/194043-high-conviction-an-at...

  • Report this Comment On September 01, 2010, at 1:56 PM, madmilker wrote:

    I love this one.....TCCO

  • Report this Comment On September 01, 2010, at 2:07 PM, Nrgyindependance wrote:

    Another Anally bashing article from TMF. They must be printing at least one per week lately! If one takes a contrarian viewpoint ..... then NLY is a serious buy!

    NLY is not a short term investment, yes it can fluctuate (what stock doesn't?), but a holding period several years long has proven quite profitable. I have probably owned the stock 8-10 years and yields have varied from approx 6 to 20 % (not sure of exact amounts) as the values and interest rates fluctuate. Having said that, there is no doubt which way interest rates are headed in the future and it should impact NLY negatrively for a period of time. But that looks to be a long way off with this economy!

  • Report this Comment On September 01, 2010, at 3:24 PM, Nrgyindependance wrote:

    @ pewillard

    Thanks for the excellent link! I have just spent the last 30+ minutes reading. Everyone interested in learning more about NLY should read it and especially all the comments. It can get very technical and it is amazing all the smart people with such opposed opinions. I guess that makes the worrld go 'round.

    In that article, someone suggest going to buyupside.com for more detailed info. Amazing website with much valuable info. Check out all the charts and graphs to see how the stock value and dividends have varied over the last 10 years.

  • Report this Comment On September 01, 2010, at 9:08 PM, KZMike wrote:

    Seems like I have read several MF articles telling the virtues of NLY. . .??? I own it in part because of those articles and expect to hold it for the foreseeable future of this current economic conditions we have.

  • Report this Comment On September 02, 2010, at 4:24 PM, TMFKopp wrote:

    Thanks for the comments all. As there's always a buyer for every seller in the stock market, there's bound to be differing opinions.

    One other thing I might throw out there -- and this is more of a longer term consideration -- is the future of Fannie Mae and Freddie Mac. These are unsustainable "companies" and it's on the back of their tax-payer-backed guarantees that Annaly has built its business. Should the government start winding these behemoths down or do something crazy like expect them to act like private companies and support themselves with profits, that would have serious implications for Annaly.

    Also @Nrgyindependance

    "Another Anally bashing article from TMF. They must be printing at least one per week lately! If one takes a contrarian viewpoint ..... then NLY is a serious buy!"

    I'm curious which Fool articles you've been reading. There are actually a lot of folks at the Fool that are very positive on NLY.

    This one is neutral / somewhat positive --

    http://www.fool.com/investing/dividends-income/2010/08/13/th...

    This one is pretty positive --

    http://www.fool.com/investing/dividends-income/2010/08/03/th...

    And then of course, there's this one, which is very positive --

    http://www.fool.com/investing/dividends-income/2010/08/10/to...

    And it was on the back of that last article that the Fool (the company) actually bought shares of NLY (see the disclosure above).

    We don't always agree at the Fool and that's encouraged. But I'd be curious to see what you've been reading that's been so negative on NLY (maybe I just missed it).

    Matt

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