Is Annaly Capital a Buffett Stock?

Warren Buffett attracts a lot of attention. As the world's third-richest person and most celebrated investor, thousands try to glean what they can from his thinking processes and track his investments.

While we can't know for sure whether Buffett is about to buy Annaly Capital (NYSE: NLY) -- he hasn't specifically mentioned anything about it to me -- we can discover whether it's the sort of stock that might interest him. Answering that question could also inform whether it's a stock that should interest us.

In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size and a reasonable valuation, he demands:

1. Consistent earnings power.
2. Good returns on equity with limited or no debt.
3. Management in place.
4. Simple, non-techno mumbo jumbo businesses.

Does Annaly meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine Annaly's earnings and free cash flow history:

Source: Capital IQ, a division of Standard & Poor's. Free cash flow is adjusted based on author's calculations.

Annaly's earnings fluctuate fairly dramatically with interest rates.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it actually is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.

Source: Capital IQ, a division of Standard & Poor's.

Annaly doesn't seem to be generating the highest return on equity of its peers, though this may be partly because it appears to use leverage more sparingly.

3. Management
Annaly's Chairman and CEO, Michael Farrell, has been at the job since he founded Annaly in 1997.

 4. Business
This is a tricky one: Annaly's business doesn't involve technological uncertainty, though there is political risk should Fannie and Freddie be drastically reformed, and there is interest rate risk should the Fed decide to raise rates.

The Foolish conclusion
Regardless of whether Buffett ever buys Annaly, we've learned that the company exhibits several characteristics of a quintessential Buffett investment: tenured management and a business that doesn't rely too heavily on technology innovation. Buffett would probably prefer to see a business with a stronger competitive advantage whose earnings are much less beholden to interest rates.