Description

In a market where about 80% of VIC members admit to finding too few ideas of compelling investment value, Annaly Capital Management’s nearly 12% yield, low-leverage, nearly-zero credit risk, 20% discount to an already-decreased book value is a worthy place to park money.

Brief Background:

Annaly Capital (NLY) has been written up on VIC in the past, so this is not a new name and probably doesn’t deserve a great deal of background. 

In a nutshell, it is a mortgage-REIT that invests almost exclusively in no-credit risk Fannie/Freddie/Ginnie mortgage backed securities. Annaly is essentially a bank-like entity with no branches and fund their MBS assets with repurchase agreements.

This is clearly a borrow short/lend long situation with extensive use of interest rate swaps, swaptions and other derivatives to help mitigate interest rate risk and to manage interest spreads.  

Use of Leverage:

Annaly can leverage up to a 12:1 level, but since the credit crisis they have decreased their leverage considerably. Today, they are leveraged about 5:1.

In the good environment, where mortgage spreads and both the shape and expected calmness of the yield curve are more conducive to capturing greater net interest spreads on incremental investments, Annaly will be able to gradually increase its leverage, earn greater ROEs and then pay a higher dividend.

That environment is not now in place, but it will likely come again.

Discount to Book Value:

After a 2-year decline in book value of 15% to 20%, the effect of the tough conditions have very likely passed. Now it is a matter of having some patience for improvement and getting paid while waiting in a market where there is little else to do.

Currently, Annaly trades at an historically wide discount to its book value. At today’s approximate $10.50 per share and with its book value of $13.10 as of December 31, 2014, this represents a than 20% discount. This is not a normal occurrence for Annaly.

The current dividend now rests at $1.20 per year - yielding about 12% today - down from the $2.40 range back in the 2010-11 time period when the stock trading at a small premium to book.

While there is always a risk for further dividend cuts as profitability continues to be squeezed, I view this concern as swinging at the last pitch kind of thinking. If it occurs, I think the market at this discount to book would absorb the initial disappointment.

For value investors, this is very likely the correct time to be in Annaly.

What went wrong in late 2012 and 2013:

In early 2013, in response to the Taper Tantrum and in an effort to shrink and deleverage in a hunker-down mode, they precipitously curt their assets from a peak of $130 billion down to the low $80 billion range.

Volatile declines in the 2/10 year spreads as well as the tightening of mortgage spreads versus Treasuries don’t describe a pretty environment for mREITS. The Taper Tantrum shock caused a major disruption in these relationships and their book value took the hit.

Since that big portfolio restructuring, Annaly’s book value has stabilized in this $13 range. It’s common stock has not recovered from its much more volatile plunge from the plateau trading range of around $18 per share during much of the 2010-12 period. This period represented the polar opposite environment to invest in Annaly as today - premium to book value, higher leverage, during the heart of QE with the Fed on hold with ZIRP, etc.

In response to these issues, Annaly consolidated its sister commercial mortgage REIT (CreXus) into its operations with the longer-term aim of increasing its ROE and gaining greater investment flexibility. They restricted the level of commercial real estate related assets to up to 25% of their equity. Today, on an equity base of approximately $15 billion, Annaly’s commercial real estate portfolio is just under $2 billion in size.

The CreXus acquisition/merger does allow for yields closer to 9% and does have the effect of squeezing out greater returns in an environment of low leverage, tighter MBS spreads and lower longer-term rates. It also aligns it with the investment policies of other mREITs.

Hedging and Accounting Complexities:

I’ve followed Annaly for a long time and it is one of the best operators in the mREIT world with a long-term record of high quality and relatively conservative management decisions. I do bank on this continuing, even with internal management changes occurring over time.

As I would admit regarding my review of most large financial companies, the sophistication necessary to grasp the technical hedging operations is great. My view is, at these prices and at a big discount to book, the sophistication needed is not as great as it is in different circumstances.

With regard to the longer-term profitability in a classic borrow short/invest long situation - which is not a foreign concept for many financial investors - I feel the complexities and cost of hedging assets is really about the pace of unexpected movements in the shape and level Treasury yield curve as well as the level of the mortgage spread curve.

When these relationships calm down - no matter if the curve is inverted or not - the profitability returns to a steadier state. At that point, the level of leverage is a dial that can be turned. The current Annaly investment thesis is based on the expectation that these relationships are not calm today and - given the hunkered down leverage decision by management today - the profitability is at its near nadar.

Finally, given my belief that both stocks and bonds are priced for (very) low returns over the next five to ten years - that is, if passive investing is the strategy followed, which is becoming almost a religious-like movement for many - owning a 12% yielding Annaly Capital while at a 20% discount to book value is a rational move.

Catalyst

None identified.