Ready To Rise: Annaly Capital

Summary

• The discount to estimated book value on Annaly Capital Management remains quite large.
• Shares trade around a 25% discount to book value. We picked up shares of NLY to take advantage of the opportunity.
• We closed out our position in CMO to fund the trade, capturing 59% in less than 3 months. We don't expect to repeat that performance.
• There are risks to the current dividend level, but the discount to book should be more important. Investors who bought when spreads were wide and sold when they were thin got wrecked. Not a typo.
• Beyond being bullish on NLY, we're also bullish on NRZ and NYMT.
• This idea was discussed in more depth with members of my private investing community, The REIT Forum. Get started today »

We haven't had very many opportunities to get bullish on the common shares for Annaly Capital Management (NYSE:NLY).

Since Annaly Capital Management is a mortgage REIT, we build our analysis around book value and the price-to-book ratio. This has been a very successful technique over many years.

Shares often carried a price-to-book ratio greater than we wanted to see for buying opportunities. However, there has been a substantial decline since late February. The book value fell substantially, but the share price fell much further.

Even after a rally from the lows reached in late March and early April, NLY is in a bullish range:

Source: The REIT Forum

NLY trades about 18% under the target "buy under" price of $8.30. That's a substantial discount to our target. They trade at an estimated discount of 24% to book value.

This is built on a recent estimate for book value of $8.30.

Note: Shares of NLY dipped on June 2nd, 2020, shortly before the market closed, increasing the discount from 24% to 25%.

Prior Outlook

We warned investors about the high valuation prior to the plunge:

Source: Seeking Alpha

We didn't know the pandemic was on the way at that point. We didn't get really concerned about that until the first few days of March. However, we did know shares were already trading at a premium to book value and the spreads were relatively thin.

Net Interest Spreads

If there's one thing too many investors like to focus on, it is the net interest spread.

The term refers to the difference between the cost of financing the portfolio and the interest earned on the portfolio. It is an important number, but it also gets WAY too much focus. For instance, investors were bidding up shares of NLY in February 2020. Remember, that was the single worst time to buy shares in over a year. So why did investors love NLY so much at that point? Well, their yield on assets looked great and their net interest spread was exploding higher.

Source: NLY

What a difference a single quarter can make. That slide comes from the presentation for the Q4 2019 earnings, a presentation delivered shortly before the market completely and utterly fell apart. On the back of strong yields on assets, NLY was expanding its net interest spread. Yet, investors who bought at that point got screwed.

If you wanted a buying opportunity (outside of the last few months), the best opportunity was around August 2019. What was happening at that point? The net interest spreads were collapsing, yet that was the other buying opportunity.

If you look at the price chart for the last year, you can clearly see that there was a dip at that point, a recovery, then a plunge in late February/March.

So, how did that dip and recovery occur?

1. NLY traded at a large discount to book value in August.
2. NLY recovered to trade above book value by mid-February.
3. In May, book value plunged and the price-to-book ratio plunged at the same time.
4. The plunging price-to-book ratio meant the share price was overreacting and created a buying opportunity.

Book Value or Net Asset Value

We may use the term BV (book value) and NAV (net asset value) interchangeably when talking about mortgage REITs. For Annaly Capital Management, either term gives us the same number. It is the amount of capital, per share, the company has available to invest for shareholders.

When you can pay significantly less than $1.00 and get $1.00 of equity, that's a pretty good deal. When you have to pay more than $1.00 to get $1.00 of equity, that's usually a bad deal.

Pretty simple.

Book Value Changes

The book value changes over time. That's true. We have Scott Kennedy running new estimates for book value week after week. That gives us the ability to evaluate price-to-book ratios without waiting for management to provide an updated book value. We have new estimates frequently, so we have a pretty good idea of what to expect before management speaks.

Recent Trades

We bought shares of NLY on 6/1/2020 at $6.32 per share (rounded to the nearest penny). To free up the cash, we closed out our position in shares of Capstead Mortgage (CMO) at $5.20 per share. The returns on that trade are shown below:

Source: The REIT Forum

In a little over 2 months, we generated a total return of nearly 59%. That's excellent.

How did we know when to buy CMO? The price-to-book ratio was extremely low.

Is this message getting through?

Sector Return Comparison

CMO is one of the agency mortgage REITs. They emphasize adjustable-rate mortgages.

Since 3/20/2020, the day we bought shares of CMO, they tied for first place among agency mortgage REITs:

Source: The REIT Forum

We caught those shares pretty close to the bottom. Glad to see such strong returns. We disclosed our purchase in real-time:

Source: The REIT Forum

The last bullet point highlights a major factor in play. We could see that fundamentals for CMO were looking pretty nice, yet shares traded at an absolutely massive discount to book value. We weren't predicting that book value would go up. We didn't need book value to go higher. We simply needed the price-to-book ratio to increase, and that's precisely what happened. Since then, the estimated book value for CMO declined.

Buying at a discount to book value creates a margin of safety, so we had plenty of upside despite the declining book value.

Imagine the pain for investors on the other side of that trade. Book value continued to fall, but we score a huge profit because we recognized that the share price had disconnected from the book value.

Dividend

There is some risk to the current dividend level. There is a decent possibility of a moderate reduction in the dividend. That appears to already be priced in, given shares trading at such a large discount to book value.

Investors who are buying only for the dividends should be looking at the preferred shares, instead of the common. Of course, I told investors that back when the common dividend for NLY was $1.20 per year. Did they listen? A few did, and those few were able to protect themselves from the plunge.

Extra Ratings

It can be difficult to make sure enough ratings reach the public side of Seeking Alpha, so sometimes we need to build in a few extra ratings. This way I don't have to prepare an entire article to highlight a few more opportunities.

While we're talking about shares to buy, we want to highlight New Residential (NRZ) again. Shares of NRZ plunged hard through early April before delivering a major recovery. NRZ is currently trading at $7.39 (near market close on June 2nd, 2020). NRZ carries a bit more risk with one of the largest risk factors being their use of MSRs (mortgage-servicing rights). However, NRZ also originates mortgages. That segment has given the REIT a major boost to earnings in several quarters. We still see a great bargain there.

New York Mortgage Trust (NYMT) still looks good. Shares trade a bit over half of their current estimated book value. If management can arrange some longer-term financing for their assets, they could be in a great position. They dropped leverage quite dramatically to bring risks lower. They are emphasizing credit risk in their portfolio, but the lower leverage helps a great deal. Due to lower leverage, their net interest income could also be quite a bit lower. That's fine, they simply need to protect book value while they line up new long-term non-recourse financing. Despite the bullish rating, we need to remind investors that this is a very high-risk position. We think there is a high probability of success, but it is far from certain and the potential downsides are significant.

Conclusion

Annaly Capital Management is trading at a significant discount to estimated book value again. That's a positive sign. That's when investors should be interested in shares. Book value took a substantial hit in Q1 2020, but the remaining book value is enough to offer some significant upside.

This is precisely the kind of opportunity investors should be seeking, but few do. We will treat this as a trading position, like any other position in mortgage REIT common shares. We will follow the same process that enabled victory so many times before. We will evaluate changes in book value through the sector, prices throughout the sector, and price-to-book ratios throughout the sector. Then we will emphasize whichever mortgage REITs trade at the most attractive valuations. That doesn't necessarily mean the lowest price-to-book ratio. All mortgage REITs are not created equal. Each mortgage REIT should have its own target range. Currently, NLY is one of the highly attractive options.

Ratings: Buy NLY, Buy NRZ, Buy NYMT

Analyst’s Disclosure: I am/we are long NLY, NRZ, NLY.PF, NLY.PI, NYMTM, NYMTN. 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.

We trade our positions in mortgage REITs actively to take advantage of an inefficient market. This is a critical part of our strategy for the sector and relies on intense research. We may trade any of our positions abruptly if we see a change in fair values throughout the sector.