Has Annaly Capital Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Annaly Capital Management (NYSE: NLY  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Annaly Capital.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15% 86.6% Pass
  1-Year Revenue Growth > 12% 79.1% Pass
Margins Gross Margin > 35% 100% Pass
  Net Margin > 15% 89.3% Pass
Balance Sheet Debt to Equity < 50% 576.5% Fail
  Current Ratio > 1.3 0.02 Fail
Opportunities Return on Equity > 15% 17.1% Pass
Valuation Normalized P/E < 20 9.42 Pass
Dividends Current Yield > 2% 15.1% Pass
  5-Year Dividend Growth > 10% 40.7% Pass
       
  Total Score   8 out of 10

Source: S&P Capital IQ. Total score = number of passes.

When we looked at Annaly Capital last year, it weighed in with only six points. A boost in returns on equity as well as easier comparisons on long-term dividend growth gave the mortgage REIT an extra couple of points.

Over the past year, mortgage REITs have retained their appeal as dividend kings. With American Capital Agency (Nasdaq: AGNC  ) and Invesco Mortgage Capital (NYSE: IVR  ) among REITs yielding more than 20%, currently low interest rates have supported the entire industry.

But despite its move toward perfection, Annaly has seen concerns rock its stock in recent months. The Federal Reserve quashed fears of rising interest rates by pledging an accommodative rate policy through mid-2013, but its Operation Twist could cut the spread between short- and long-term rates, damaging Annaly's profit potential.

Of greater concern is the SEC's look at limiting the use of leverage within mortgage REITs. Such a move would hurt the business models of most mortgage REITs, especially American Capital Agency and Cypress Sharpridge (NYSE: CYS  ) , which have particularly high leverage levels.

Finally, because they have to pay out all their earnings in dividends, REITs constantly need new capital. In July, Annaly did a massive $2.1 billion offering of shares, representing a seventh of its market cap. Smaller REITs like Armour Residential (NYSE: ARR  ) and Two Harbors (NYSE: TWO  ) boosted their capital even more on a percentage basis. For now, that capital is available, but if it dries up, growth could get choked off.

With its leveraged model, Annaly will never be a perfect 10 on our scale. But as long as the good times last for interest rates, it should stay close to perfection.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate the best investments from the rest.

Click here to add Annaly Capital to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our "13 Steps to Investing Foolishly."

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. The Motley Fool owns shares of Annaly Capital. 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 Fool has a disclosure policy.


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  • Report this Comment On October 19, 2011, at 1:16 PM, dsandman999 wrote:

    I think this article, like so many like it, greatly exagerate the effects of Operation Twist on NLY and AGNC. Both of them have recently brought huge secondary offerings and already invested them in LONG term instuments. Twist is only going to affect the long term rates for a short while (probably measured in months at best).

    Only the roll over of previously long term intruments would be at these reduced rates and they could probably just pay off short term debt until rates go back up. Short term rates are also not going to stay up long and even doubling would hardly change the spread that much. Also some of the short term instruments will last at least as long or longer than Twist will be operating. The roll over here would be more significant, but not 100%.

    You folks need to do an analysis on the portfolios of both short and long term and then plug in the Twist esitmated drops and duration. That would be a useful article.

    SEC regulation has 3 possible outcomes:

    1) Rules that are already there for other securities would be in place. Most of the REITs like NLY and AGNC already conform. Compliance costs would go up, but not that much.

    2) Leverage rates would be imposed. These would be based on the riskiness of the assets used. Low risk assets like Treasury bonds allow a 90% borrowing for an effective 9:1. A good stock is allowed a 50% or 2:1. Both NLY and AGNC are using low risk Agency instruments. NLY is 5.x:1 and AGNC is 7.5:1 It would make sense, and prevent massive lawsuits, if the SEC followed that line, and probably would not make much of a difference to these folks. The ones leveraging higher risk assets would be constrained. And the higher risk ones are the group that the SEC is primarily worried about.

    3) SEC finds some way to redefine them such that they can not use thier current models at all. That would end up at the Supreme court assuming some lower court or congress did not kill it before it could go into effect. The IRS, not the SEC also determines tax related issues, so there might even be an IRS change to allow these groups to continue with REIT type rules for tax purposes.

    The biggest threat to these groups is that someone will actually come up with a plan to get rid of the Agencies behind the paper. That would be a long term issue that might cause NLY and AGNC to have to change thier model and assets.

    These folks have to pay out 90% of thier profits to remain classed as REITs, not all of it. The book value of AGNC has continued to go up year after year.

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