Rising Star Buy: Annaly Capital

This article is part of our Rising Star Portfolios series.

High unemployment, a dour housing market, overleveraged consumers, and dallying legislators -- what's a Fool have to do to earn a return in this market? I see the answer in Annaly Capital (NYSE: NLY  ) , which my Special Situations portfolio is buying tomorrow. Annaly can still benefit from this set of ugly circumstances, as the economy returns to normalcy only in fits and starts. And we get to cash the company's 13.8% dividend.

The business
Annaly's business model is focused around the interest rate spread it earns between borrowing short-term money and buying long-term mortgage-backed securities that are guaranteed by the government and collecting the interest on them. Since Annaly is a mortgage REIT, it pays out nearly all of its earnings, and so it has that gaudy dividend you see.

The more Annaly can leverage up its balance sheet, the more it can earn and the greater its dividend. The company has a leverage ratio of about 6.3 -- or $6.30 of debt for every dollar of equity. But debt can cut both ways, and the company has been prudent about how much leverage it's taken on. The company continues to monitor its leverage closely, since a decrease in its rate spread can quickly curtail profit. During 2010, the spread consistently narrowed sequentially, down to 1.85%, but in the latest quarter it jumped to 2.17%. That will be a key metric to watch.

Because Annaly pays out virtually all its cash, the company relies on secondary offerings to raise capital for expansion.

Why I'm buying
With unemployment stalling, the Federal Reserve promising that it won't engage in Quantitative Easing 3.0, and the legislature refusing to provide any more economic stimulus, I see little impetus to the broader economy. This situation is not helped by the blockade in Congress over a balanced budget. Any attempt at fiscal austerity, as we've seen in Ireland and the U.K., will simply put the economy on a rockier road and cause unemployment to rise.

I also see Fed Chairman Ben Bernanke continuing his low interest rate policies for quite a while yet. With unemployment still close to its highs, a too-quick move to raise rates would also throw the economy back into harder times. As a student of the Depression, Bernanke realizes this, of course, but he may well be swayed to bump rates by pressures from various corners. While a rate increase would hurt Annaly initially, it would prove to be bad for the economy, ultimately improving the overall conditions for the company.

In short, I see officials as likely to make moves that ultimately benefit Annaly. Even if cooler heads prevail, it will still be years before unemployment reaches levels that cause inflation. In addition, Annaly makes a good hedge against some of my other positions, such as Red Robin Gourmet Burgers, which is at least partly a play on the return of the consumer. So tomorrow I'm adding a 6% position in the company, or $1,000, to my Special Situations portfolio. I already own shares of Annaly in my own account and have owned them for a few years.

While this is not a typical transaction-related special situation, the potential return here for idle cash is high. I don't expect this to be a long-term hold and will watch rates closely.

Risks
I see the primary risk to this company as economic improvement. But I expect that to come slowly enough, given the lack of stimulus to improve the situation, as I've described above. As with any investment, a number of things could harm results: increasing interest rates, too much leverage or a miscalculation about future rates, or a change in the government sponsorship of mortgages. But Annaly's management is sharp and has a strong track record of providing returns to investors.

Summary
Annaly offers us a good hedge against ongoing economic malaise, while providing a fat dividend for the piles of cash we have sitting yet in our account. With the economy only slowly improving, this stock should offer solid returns for the next couple of years.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios) here.

Jim Royal, Ph.D., owns shares of Annaly and Red Robin. The Motley Fool owns shares of Annaly. 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 (5) | Recommend This Article (31)

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 May 31, 2011, at 11:00 PM, jdobbins828 wrote:

    I bought NLY a couple of years ago. Not that much but enough to actually see where it could go. in those couple of years, it has held at a 14-18% gain a year. Not to shabby for a few bucks on the side. Dividend is always consistent. No serious bumps from NLY that made me want to dump. Jim, I feel you made a good choice in this one

  • Report this Comment On June 01, 2011, at 10:09 AM, TMFHelical wrote:

    I'm inclined to see the last listed risk, that of the fate of government agency backing of MBS, to be the primary one.

    TMFHelical

    Home Coverage Fool

  • Report this Comment On June 04, 2011, at 3:52 PM, nitedawg wrote:

    Hmmmm....I thought the end of QE2 on 6/30/2011 almost guaranteed that interest rates would rise. That would not bode well for the REITs the likes of Annaly. I think they are a very good company, but I don't trust that after 6/30, the interest spread will narrow and may drive the price of the stock down as people get out of it.

    I sold my Annaly at a profit, while I could after a few quarters of very nice interest. I'm ahead; I'm happy.

  • Report this Comment On August 11, 2011, at 11:31 AM, dave22q wrote:

    if you think Bernake lies or that rates will rise as frightened investors race to dump US bonds to invest in Switzerland, then sell NLY.

    you will miss a chance to cash in on the passing of the generalized market panic that has depressed the stock while pocketing a very nice yield.

  • Report this Comment On September 16, 2011, at 6:31 PM, harry2311 wrote:

    At the present time, the mREITS are under some pressure with the Fed hinting at either changing their status as a REIT or possibly limiting their hedging ability. Could be more of a threat than rising interest rates which Bernanke has said will remain as is for the next couple of years.

    Still a good investment for the time being but in the near term, keep your eye on possible changes in mREIT status.

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