Investors in Annaly Capital (NYSE:NLY) like its robust dividend yield -- now at 12.1% -- but they have to endure the likely decline of the stock as all of its cash flow goes out the door and is not reinvested in the business. Still, investors can time their buys to minimize their downside, enjoy the dividend, and maybe even catch an upswing in the stock price.

However, when is the right time to buy? The good news is that Annaly follows a relatively predictable pattern.

Dividends written on a chalkboard


Follow Annaly's pattern

One of the most predictable cycles for Annaly and other mortgage REITs such as Two Harbors (NYSE:TWO) and AGNC Investment (NASDAQ:AGNC) is that their valuation circles around 100% of tangible book value. It's a valuation they come back to time and again, swinging above and below it, because of how their business models work. Because they pay out virtually all of their cash flow as dividends, these mortgage REITs retain only their book value. They don't actually grow their equity organically, so all of the stock's return is in the dividend, not the capital gain. (Here's a primer on how Annaly makes money.)

That's problematic for investors who buy and hold mortgage REITs, because over a bull market, their payouts tend to shrink, and the stock prices decline as a result. So yes, investors get a dividend, but their total capital declines, too, muting or maybe even completely offsetting the dividend.

However, because the stock price returns again and again to around tangible book value, investors have a good yardstick for gauging when the stock is cheap and worth another look. The chart below tracks Annaly's stock against its price-to-tangible-book-value (P/TBV, based on the trailing quarter) over the past year. See the pattern?

A graphic showing Annaly's stock price against its tangible book value


Over the past year, Annaly's valuation has stayed relatively range-bound, never dipping below about 90% of tangible book value, and never climbing above about 110% of tangible book. So, dips of between 5% and 10% below tangible book value have been attractive spots to enter or add to a position. Meanwhile, at valuations above 105% of tangible book, it's been a good time to exit or avoid the stock.

Annaly's valuation today

Today, the stock sits at a valuation of 96%, so it looks cheap enough to start a position, if not add to it. Don't be surprised if the stock continues to move lower, though it probably doesn't have much downside in the near term, based on historical trends. However, there's reason to be suspicious of these trends.

First, the past is not always predictive of the future, even if they are similar.

Second, like other mortgage REITs, Annaly operates with a lot of leverage -- debt to equity is 603% in the latest quarter -- and it's very sensitive to interest rates. Thus far, the Federal Reserve has moved rates up at a slow and steady pace, allowing mortgage REITs to gradually adjust their portfolios to the rising rates. Such accommodative policy may not always occur, though, so debt is always a risk, here. Rates that rise too quickly may wipe out a huge chunk of equity.

Third, when Annaly reports the results of its latest quarter in the next couple of weeks, tangible book value may well move lower, so today's valuation may in fact be more expensive than it now appears.

For this latter reason, today's price might be good to open a position, but it's not "mortgage the house" cheap. A valuation closer to 90% of tangible book would likely be a lot closer to the bottom.

Another alternative to Annaly

Annaly's common stock has that meaty yield, but it's not the only way to invest in the company. The REIT has a number of preferred stocks that dividend investors might find interesting as well. These preferred stocks offer significant yields -- as high as 8.125% -- without the same kind of downside risk (though usually with no or limited upside). Effectively, the dividend on the common stock would have to be wiped out before the preferred payout could be touched. In this regard, preferred stocks operate like bonds.

Preferred stocks aren't perfectly safe, either, but they do offer benefits to the right kind of investor -- one who's looking for lower risk.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.