Annaly: Never An Investment Vehicle For The Fainthearted

| About: Annaly Capital (NLY)

As we look at the recent stock price movement in Annaly (NYSE:NLY), it's not easy to keep things in historical perspective, as long-term investors are supposed to. To understand what's happening, you need to dig into the company's history and business model. This is necessary to discern whether what we are seeing is structural, as in driven by recent company management changes and acquisitions, or market-related. As an investor, if I lose faith in a company's management then I will dump the stock, regardless of the P&L. On the other hand, if it is market-related and if the stock is owned fundamentally and not for technical trading, then it is faith in the company -- or, better yet, faith in my analysis of the company -- that lets me keep the holdings until a better day.

Annaly was formed in 1997 by Michael Farrell and Wellington Denahan. Farrell passed away in October 2012. Annaly has been providing serious dividend yield to its investors since its inception. As of this writing, the yield is 13.32%. After all, as a REIT, NLY is mandated to distribute the bulk of its profit to its shareholders. To enable such handsome payout, returns are created through complex swaps. In such an operation, the longer-term -- higher yielding -- mortgage-backed securities (MBSs) are financed (effectively, leveraged to the limit) with shorter-term borrowing. The equity the company owns is the basis for the leverage. In reality, this business model should truly have a "do not try this at home" label. Even for institutional investors and hedge funds, this is far too complicated to manage on their own -- hence the 44% institutional ownership in Annaly.

As the borrowing is based on assets, Annaly's book value is important to watch. That is why this value is prominent in the company's quarterly presentations. This is also the reason the company issues stock every now and then. In addition, three market factors mainly affect Annaly's business model and its profitability: short-term interest rates, long-term interest rates, and MBS redemption (mortgage refinancing). It is clear why the first two are important, as it is the swap between these that generates revenue. Yet, mortgage refinancing enters the picture in the sense that it perturbs the "hedge structure" that the company chooses for a given MBS instrument long after the structure has been put in place.

To further our understanding of these market factors, I have plotted the 10-year monthly charts of Annaly against the iShares Cohen & Steers REIT ETF (NYSEARCA:ICF), the five-year treasury yield (FVX), and the 30-year treasury yield (TYX).

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You can easily discern the negative correlation with the short-term borrowing cost (FVX). This is expected. Yet, if we compare NLY to ICF in the charts, we see frequent breakage in correlation. If you believe that Annaly's fortunes should be dependent on the health of the mortgage market, then this negative correlation is not to be expected. The reason for the negative correlation you observe is mortgage refinancing.

You see, if the mortgage market is "too healthy," then people will refinance frequently to take advantage of newly created equity. This is good for banking and good for real-estate companies, but it moves Annaly away from its sweet spot. That is, whatever hedge-structure taken, once a position is built, is no longer optimal. To drive the point, if you look at the 10-year chart, you will see that the most trouble NLY ran into was during the run-up to the subprime crisis (year 2005 and 2006). Actually, Annaly fared better, even though not very well, during the subprime crisis (2007) and the financial crisis (late 2008) when it was evident that ICF was in a complete tailspin.

If you look at the more recent charts of Annaly, there seem to be two specific dates at which the current downslope started. The first is at mid-September 2012, and the second is at late March of this year. The two events can be clearly seen in this two-year weekly chart.

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The problem I had with the September 2012 slope-change in Annaly's stock price is the fact that it coincided with Farrell's death later in October. The fear that investors, myself included, then had was whether the company would change afterward. What added to this fear is the fact that the quarterly market reports that we, the investors, were awaiting to get Annaly's macroeconomic perspective, ceased. If you look at a couple of these reports (here is the last one I could find, and here is what it would have looked if the company still issued them), you would immediately agree that they shed some light on an otherwise opaque business model.

In reality, I am sure that Farrell's absence from the company did change things, but if you read the two above market commentaries, you will see that the company was warning that The Fed is becoming a major competitor. In fact, if you look at the Fed balance sheet you will clearly see the infliction point in October 2012, where the Fed's balance sheet started expanding at a much faster rate once their MBS purchases started as part of QE. That is, the September 2012 infliction point in Annaly's price is easier explained by this pre-warned event than any other.

Now, the March 2013 slope change in the price of NLY did coincide with its acquisition of CreXus, but this is not the first time such an acquisition was made. What happened in the market at the time was the taper talk. In particular, if you look at the above two-year chart and the behavior of the shorter-term treasuries (FVX), you will see a sudden jump relative to the longer 30-year treasuries (TYX). Mind you, both climbed, but Annaly's business model relies on the spread and less so on the actual value.

What is bothersome to me, and why I am not adding new money to my existing position, is that the company has seen this before, in the mid-2000s. Furthermore, the old quarterly market update reports issued by the company have spelled out what to expect and the ill effects of the Fed as a competitor. I cannot understand why Annaly was not hedged well enough against such market events. In one sense, you can view their acquisition of a different line of business as a hedge. They have also, looking at the latest quarterly supplemental information, seriously scaled down the balance sheet. Yet, clearly this was not sufficient.

On the other hand, as we are dealing with a company that continually paid dividends and as dividends are judged by yield and not amount, I am less bothered with the scaling down of dividend payout -- as long as the yield remains in the two-digits. Furthermore, a look at the company's performance listed in the table below -- with dividend-adjusted prices obtained from here -- shows that over any reasonable period (say five-plus years) relative to the SPDR S&P 500 Trust (NYSEARCA:SPY), the dividend-adjusted return of the company was lucrative enough to justify a hold.

Dividend Adjusted Return to Closing of 11/12/2013

(1 Year = 252 trading days)

Over Period of

(years)

Yield

NLY

SPY

1

-18%

31%

2

-17%

49%

3

-13%

55%

4

2%

74%

5

46%

120%

6

42%

40%

7

79%

48%

8

137%

71%

9

53%

82%

10

94%

106%

11

111%

145%

12

190%

98%

13

447%

58%

14

529%

67%

15

822%

105%

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As a conclusion, it is important to remind that Annaly's business model is no different than a very sophisticated hedge fund. Hence, investors need to be aware of the events and circumstances that affect the viability of the business. In my case, now that I explained away the prospect of a structural change in the company, I am not rushing to dump my position. My trigger to add to the position would be a satisfactory stabilization of the spread between shorter-term treasuries (FVX) and the longer-term ones (TYX). I will also look at the real estate market to watch for signs of overheating. These will guide my trading in NLY rather than any company-specific event, such as insiders adding to position.

Disclosure: I am long NLY. 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.