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.
What We Want to See
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.
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.
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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."