Annaly Capital - Where Do We Go From Here?

| About: Annaly Capital (NLY)

It has been almost a year since I first warned investors to stay away from Annaly Capital Management (NYSE:NLY) and its peers in the mREIT sector. Since Annaly is a "darling stock" for many retirees, I have been bashed right and left over my doom and gloom prediction for Annaly.

As it turns out, my prediction was spot-on, and this past year has been one of the worst years for this sector as a whole, and for Annaly in particular. Just take a look at the graph below.

nly chart

Share price of Annaly has dropped by as much as 33% over the past 12 months. And its dividend payout has been significantly trimmed from 64 cents a quarter to a current 40 cents a quarter, a staggering 40% decline.

Time to consider Annaly..Again

Having being extremely bearish on Annaly for the past year. I now believe that there are some strong positive signals in the market right now that Annaly's downtrend might finally be coming to an end. These three signals are flashing a "BUY" flag.

Signal #1: Insider buying

Insiders can sell shares for a variety of different reasons, but they buy shares for only one reason - they believe that shares are undervalued. That's why it's crucial to pay attention to insider activity.

In Annaly's case, more than 200,000 shares were purchased by insiders in the month of August alone. These shares were bought by a few of the highest ranking officers in the company, including the CEO and CIO. In addition, it's also worth noting that there wasn't a single sale of shares by insiders over the past six months.

Signal #2: The 10- year U.S bond

The yield on the 10-year U.S bond, which serves as the main interest benchmark for most interest-rate correlated products, has leaped recently. In a few short months, interest rates have jumped from a mere 1.8% to just under 3% today. This implies a horrific 83% loss to investors who rushed and bought the "safest security on earth".

How does this affect Annaly? The common adage in the market right now is the fear of "imminent refinancing" by households. This means that people will rush to refinance their existing mortgages at much lower rates. In turn, this will shrink Annaly's revenue because Annaly will be forced to invest in mortgages with lower rates, which will ultimately shrink its spread (the difference between what Annaly pays to borrow money and what it receives as a lender).

I, on the other hand, believe that the very same fact (the leap in U.S bond rates) will eventually lead to a more profitable Annaly. Yes, refinancing will, at first, bite into Annaly's revenue because more mortgages will bear lower yields. But the most important (and one of the most ignored) factors in this equation is the unprecedented pace of the rise in interest rates.

You see, when rates jump from 1.8% to 3% in just a few short months, some households will be able to rush in and refinance. But the majority of households has already missed the train. In addition, this trend isn't likely to reverse. With house prices on the rise and more positive economic signs, interest rates will eventually return to normal and tick much higher than today's levels. This, in turn, will play right to Annaly's hands because more and more of the mortgages it buys will bear higher yields. Instead of settling for a 3% mortgage portfolio, Annaly will end up owning a 5% mortgage portfolio. And this makes all the difference in the world.

Signal #3: Ridiculously cheap valuation

Sometimes, when a certain security gets cheap enough, it's time to hold your nose and buy. The most important valuation metric for mREITs is book value. Since almost all profits are returned to shareholders in the form of dividends, shares tend to trade at or around book value.

But with the media panicking over Annaly right now, the market isn't pricing Annaly correctly. Annaly's share price currently reflects a 12% discount to book value. This means that we are facing an upside of 14% in price appreciation, only by returning to the old "normal" again. It's only a matter of time before this gap closes.

My takeaway

I used to be extremely bearish on Annaly. But the market is very dynamic, and so you should be too. With high levels of panic in the market, unjustified valuation and insiders buying, the risk-reward ratio is now highly in our favor. Buy shares of Annaly up to $12.5.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.