By Mark Bern, CPA, CFA
Annaly Capital (NLY) is the granddaddy and arguably one of (if not the) the best managed mortgage REITs in the U.S. Annaly's portfolio is dominated by government-backed mortgage securities guaranteed by Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). Even though as much as 50% of its portfolio may at times be fixed rate, the company uses a hedging strategy with interest-rate-sensitive derivative instruments that effectively make nearly its entire portfolio of a floating rate nature when interest rates are rising.
The company does best (makes the most profits) when the difference between short-term and long-term rates are widest, since the company finances the purchase of long-term assets (mortgages) with a combination of primarily short-term debt and equity. When interest rates are falling, the company pulls off its hedges and becomes more profitable yet as the spread between the fixed-rate portion of its asset portfolio and short-term interest rates widens. As recently as the 2006-2008 period, when interest rates were falling, Annaly posted yield spreads of over 5%. Today the spread is slightly below 4% and narrowing very gradually. Management is very conservative and currently is not using as much leverage as allowed under current pre-set debt-to-equity limitations. The company could use more leverage to make up for the narrowing spread, but due to the fragile nature of the financial industry, management seems unwilling to do so.
Obviously, Annaly has been a great holding for many investors for quite long time. If we take a look at the last 10 years, almost all of the return realized by investors over that period has been from the dividends. But that's okay since the current yield is 13.8%. Total appreciation from January of 2002 to January of 2012 has been about $0.50 per share as the price back in January 2002 averaged about $16 a share and the current price is about $16.50. Over that same period, the dividends have totaled $18.96.
So taking the long-term buy-and-hold position, this stock has provided an average annual return of 12%. That doesn't seem very painful even if there were a couple of down years, because there was always a dividend. Now let's look at the returns from a rolling 5-year stand point. The worst period, 2002-2006, ended up providing an average annual return of about 9%. The highest 5-year rolling average return was 30%. The point here is that if an investor takes a long-term view and doesn't sweat the few bad years, Annaly can prove to be a great investment.
It's when investors look at Annaly on a year by year basis that occasionally things don't look so good. The table below illustrates the swings that investors need to be able to withstand from a total return point of view. The price is an approximation of the average price during the month of January; the % Change is the change in price from January to January of the following year; the dividend is the total dividend paid during the year; total return is the change in price plus the dividend all divided by the price at the beginning of the year.
| Year | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Price | $16 | $19 | $20 | $20 | $12 | $14 | $19 | $15 | $16 | $17 | $16.50 |
| % Chg. | 5.7% | 2.9% | 2.0% | -7.0% | 2.6% | 6.0% | -2.0% | 3.5% | 3.7% | 1.9% | |
| Dividend | $2.67 | $1.95 | $1.98 | $1.04 | $0.57 | $1.04 | $2.08 | $2.54 | $2.65 | $2.44 | |
| Tot Return | 35% | 15% | 10% | -35% | 21% | 4% | -10% | 24% | 23% | 11% |
The total return, of course, is calculated on the price at the beginning of each year. So, why, you may ask, did the total return increase in 2006 as the dividend dropped? The price rose by 16.7% that year because on June 29th of that year the Federal Reserve made is final upward change to the discount rate and indicated a neutral stance going forward. The belief during the latter part of the year was that the next interest rate move would be downward. As short-term interest rates move lower, the spread Annaly earns increases and since the market is forward looking, the price of Annaly's stock began to rise. The worst was over, or so it seemed during the plunge of 2005 as the Fed increased the discount rate eight times, at virtually every Fed meeting or shortly after.
Conversely, at the end of 2008, even though the Fed lowered rates to historic low levels because the mortgage market was in turmoil and fear gripped Wall Street, the stock of every company that held mortgage-backed assets fell. But Annaly paid a hefty dividend of $2.08 that year which offset much of the impact of the falling stock price. That made it easier to hold on while the stock tumbled. So, as we look at Annaly on a year-to-year basis, there was really only one year that was truly scary. In 2005, the dividend was cut almost in half and the price of the stock dropped like a rock.
So, there are really two ways to play Annaly. The first is the obvious 'hold on'. That's because it will always get better when you own a quality company with top-notch management, using the stock as a means of reducing overall volatility and to collect the dividend. It's an income play, not a growth story.
The other way to play Annaly is to watch the Fed. If you hold the stock in a tax-deferred account, you can sell the stock when the Fed indicates that there may be a need to raise interest rates to curb inflationary pressures in the immediate future. That sort of signal usually spooks the institutional investors and a number of them bail out of stocks like Annaly, taking the price down. You should still have a small capital gain but it doesn't matter one way or the other because you are moving to cash and waiting for the interest rates to finish rising. And then when the Fed indicates that no further increases to the discount or Fed Funds rates will be immediately necessary, the price should be beaten down adequately enough to provide a great entry point. Just think of having bought Annaly at near $12 or lower during 2005 or early 2006. Or consider how great it would have been to have added Annaly during 2008 when the financial panic gripped us all and the stock got down to $10 a share! The dividends have done nothing but increased since then drawing the stock price right back up with them.
For shorter term investors there will be a time to sell Annaly again as interest rates begin to rise, but not yet. The dividend is just too good to pass up right now and short-term interest rates are not going anywhere for another year and a half according to the Fed. When the Fed speaks, we need to listen. For Annaly followers, it may spell opportunity.
Disclosure: I am long NLY.
