Annaly Capital (NYSE: NLY) is an mREIT. For those that are not familiar with the business, the company's entire operation can be described as a carry trade: borrow short, lend long. Because the slope of the yield curve is positive, the company is able to execute this strategy successfully. Now, there is no free lunch in the finance word, if it was so easy everyone would do it. The problem with carry trade is that the underlying assets are highly sensitive to the shape of the prevailing yield curve. For example, if the curve flattens, the spread would decline. Valuing Annaly Capital is fairly straight forward in theory. Assuming that the book value is accurate, the fair value would be the book value. Recently the company has attracted a lot of interest due to its high yield (10%+) and substantial discount to book value. At a glance, the company looks cheap. However, I believe that this is a classic case of a value trap.
There are two main reasons: lack of a catalyst and what I like to call the window of opportunity. Let's talk about the lack of catalyst first. A catalyst is not necessarily something that changes the public opinion (if Gundlach pitches the stock, you can be sure that public opinion isn't too pessimistic), but also something that can help the company realize the value. I concur that the company is trading at a discount to book value, but from an absolute value perspective, the discount doesn't mean much unless the value can be extracted. For Annaly Capital, the value can only be truly realized (i.e. shareholders profiting from the discount) if the assets are liquidated and the proceeds are distributed to shareholders. Of course, such a plan of action will certainly be off the list. I'm sure that the management has no intention of exiting such a lucrative business. Perhaps an activist could enter the battle, but I don't think that is a dependable catalyst.
While the company is unlikely to realize the value immediately, it can still deliver returns over the long-term, right? Unfortunately, there is really no "long-term value" to speak of. Unlike other businesses, Annaly Capital's entire strategy relies on something that it has absolutely no control over: the yield curve. In fact, the management stated the following in the annual report:
We believe that future interest rates and mortgage prepayment rates are very difficult to predict.
This means that the window of opportunity is finite. Now I'm not saying that the company can only "lose" going forward, there are many ways that the yield curve could change. For example, if short-term rates rise substantially without corresponding increases in long-term rates, the liabilities used to fund the assets would decrease in fair value, enhancing the present book value at the expense of future profitability (spread decreases). Of course, the curve could also steepen, increasing the spread (and thus future profitability) in exchange for lower book value. Because the underlying assets (and by extension shareholder's cut) are sensitive to extrinsic factors, if the window of opportunity is missed, then the company may no longer be undervalued. The point is that the discount to book value is by no means a sign of a cheap company, which is what I think should be one of the most important criteria when investing for asset value.
To conclude, I would like to draw a parallel between Annaly Capital and one of the more famous "wins" on Seeking Alpha. If you are not familiar with Essex Rental (NASDAQ: ESSX), you can read some articles about it here. The stock gained investors' attention after it was discovered that shares were trading below liquidation value. Investors piled on the stock and shares surged 50% in a couple of days. Since then, shares have lost most of their value.
Why is that? Perhaps the shares were worth the book value at the time, but the company never liquidated, and now it's too late. This is extremely important to understand. Just because assets are trading below book value, there is no guarantee of profit unless the valuation gap is closed through a tangible catalyst. If you are interested to see what a successful liquidation investment looks like, read my piece on Automodular here.
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Disclosure: I/we 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.