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 and then decide whether Annaly Capital (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.
• Moneymaking 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.

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

Since we looked at Annaly Capital last year, the company has lost all the ground it gained from 2010 to 2011 and then some. The share price isn't much changed from its levels a year ago, but its double-digit percentage dividend has given shareholders a reasonable if not spectacular return.

Annaly Capital is a leader among mortgage REITs, which use high levels of leverage to profit from spreads between mortgage-backed securities and short-term interest rates for its borrowings. For years, Annaly, American Capital Agency (AGNC -0.16%), ARMOUR Residential (ARR -0.50%), and numerous other mortgage REITs have been able to sustain double-digit dividend yields from their common business models, using higher-quality agency mortgage-backed securities as their primary portfolio investments. That distinguishes Annaly from its sister REIT, Chimera Investment (CIM 0.76%), which along with Invesco Mortgage Capital (IVR 0.59%) goes beyond agency securities to find other opportunities.

Recently, though, Annaly has lowered its dividends. That comes on the back of higher interest expense, which has squeezed total revenue and largely resulted from substantial losses on interest rate swap arrangements designed to try to hedge the company against rising interest rates. That strategy may help Annaly avoid the huge dividend plunge it suffered in the mid-2000s, but it's also holding the company back right now.

Potential Annaly investors now find themselves in a tough spot. One analyst thinks the shares now look cheap, as they trade below book value. But others note that greater refinancing activity and higher prepayment rates could force Annaly to scurry for replacement securities.

For Annaly to improve, it needs its swaps to work better, boosting revenue and improving profitability. Unless that happens, Annaly will have difficulty moving closer to perfection despite its impressive dividend yields.

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 out the best investments from the rest.

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