There's no denying the fact that Annaly Capital Management (NYSE:NLY) has had an impressive run in the years since the financial crisis. Spurred by ultralow short-term interest rates, which boost profits at leveraged funds like Annaly, the company's five-year shareholder return was more than double that of the S&P 500 just six months ago.
But then, everything changed. In May, the Federal Reserve hinted that it could soon begin to taper its monthly purchases of agency mortgage-backed securities -- that is, the very securities that Annaly holds in its portfolio. Because such a move would drive down the value of existing securities, the announcement ignited a slow but steady plunge in Annaly's share price, as investors began to worry about a decline in the mortgage REIT's book value.
If you're a current shareholder of Annaly -- and particularly if you bought in earlier this year -- you'd be excused for being concerned. Regardless of how you look at the situation, it's simply going to take time for the company's dividends to make up for the roughly 25% fall in its share price. On top of this, there's little reason to believe that we've seen the worst of it, as an additional drop in book value seems inevitable once the central bank does indeed begin its long-anticipated taper.
With these concerns in mind, I've drawn up a list of three things investors in Annaly need to know in order to gauge whether it's time to hold your cards or fold them.
1. Annaly's stock is trading at a 10% discount to book value
Thanks to the precipitous drop in Annaly's share price, its stock now trades at the lowest multiple to book value in more than a decade. One way to look at this is to consider it a true discount. This is the reason, for instance, I encouraged prospective investors over the weekend to consider establishing a new position in the company -- the operative term here being "consider."
Another way to look at this is to assume the valuation is merely anticipating the additional drop in book value that seems likely to occur, as I've said, once the Fed starts to reduce its third round of quantitative easing. If this is the case, then new investors would be wise to wait before buying Annaly's stock, and prospective investors may even want to consider unloading their positions -- the operative term being, again, "consider."
2. It's diversifying into nonagency securities
For better or for worse, Annaly isn't sitting back and helplessly surrendering to these headwinds. Earlier this year, it acquired CreXus, a commercial real estate investment trust that was once one of Annaly's publicly traded portfolio companies.
The good news is, CreXus earns a considerably higher yield on earning assets than Annaly and it's almost entirely unleveraged -- though, to be clear, CreXus is a fraction of the size of its now-parent company. The bad news is, its portfolio exposes shareholders to credit risk, as the commercial securities it holds aren't backed by Fannie Mae or Freddie Mac like Annaly's holdings of agency mortgage-backed securities are.
Additionally, the CreXus acquisition has led some (including me) to speculate that Annaly may acquire its other publicly traded portfolio company, Chimera Investment (NYSE:CIM), too. Some will understand why this wouldn't bode well for Annaly, as Chimera has run into a series of accounting issues that have caused it to be delinquent on securities filings with the SEC for well over a year now.
3. Its management leaves a lot to be desired
The final thing current and prospective shareholders should consider is that Annaly's management team recently took a giant step to reduce transparency. Earlier this year, it adopted a management structure under which executives no longer work for Annaly per se, but rather for a privately owned management company that, in turn, runs the mortgage REIT.
The net result is that Annaly no longer has to disclose information related to executive compensation, as well as certain conflicts of interest like the hiring of relatives for executive-level positions -- the former CFO at Chimera, for example, is the sister of Annaly's now-CEO.
John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.