Annaly Capital Management, Inc. (NLY): How to Buy a Dollar for 95 Cents

In a zero percent interest rate environment, hungry-for-yield investors are willing to look into any security which offers them an extra percentage point in dividends. Often times, they are willing to settle for a low quality company just to get the stream of dividends that it offers. Usually, this turns out to be a bad investment decision and the investor ends up regretting his hunger for dividends in the first place. Other people tell him that he can either buy a high quality company which pays a low dividend, or buy a low quality company (aka- “junk”) which pays a high dividend. But he can’t have both.

Well, sometimes you can eat the cake and have it too. The cake at hand is called – Annaly Capital Management, Inc. (NYSE:NLY).

How this business works

Annaly Capital Management, Inc. (NYSE:NLY) is a mortgage real estate investment trust. As such, the company owns, manages and finances a portfolio of real-estate related investments. If it sounds boring to you… that’s OK. Because Annaly elected to be taxed as a REIT, it’s obligated to pay 90% of its net income back to its shareholders in the form of dividends. Now it’s getting more interesting.

Annaly‘s business model is simple. It borrows money at low interest rates (thanks to the Federal Reserve) and invests it at a higher interest rate in government-guaranteed mortgages from Fannie Mae and Freddie Mac.

The difference between the rates Annaly Capital Management, Inc. (NYSE:NLY) pays to borrow and the ones it collects from its investments is called the “interest-rate spread.” Annaly has an interest rate spread of 2%. At six times leverage – or six times more debt than equity – that’s roughly a 12% return on its money. And that’s what allows it to pay out such large dividends.

Why it’s worth paying attention to Annaly

It isn’t very useful to use valuation metrics such as price/sales or price/earnings on Annaly Capital Management, Inc. (NYSE:NLY). In a sense, Annaly is sort of a bank and not a retail company, which is why using price/sales is futile. In addition, its earnings don’t mean a whole lot because most of the money is paid out in the form of dividends….so there’s no inherent growth to the business. That’s why using price/earnings is futile. The most accurate metric to use is book value. Book value is essentially the value of the assets on a company’s balance sheet. Here’s the thing about Annaly’s book value… It’s not just an accounting number. It’s the actual liquidation value of the business.  Annaly could sell its book of mortgages on the market today for around $16 a share. At its current price of $15.50 a share, Annaly Capital Management, Inc. (NYSE:NLY) is trading at roughly 95% of book value

Based on history, you want to own this stock any time you can buy at or below book value. Simply buying Annaly when it’s at or below book value – and holding for 12 months – leads to average gains of 38% (including dividends). That’s huge. You see, prices always tend to regress back to the mean, which in Annaly’s case – is book value. Otherwise, it makes no sense for dollars to be picked up for 95 cents.

Not the only player out there

There are other companies whose core business is to trade the interest rate spread. Among the more well- known names are Chimera Investment Corporation (NYSE:CIM) and American Capital Agency Corp. (NASDAQ:AGNC). But I believe that Annaly is much superior to either one of these companies for two main reasons. First, Annaly is the 500 pound gorilla in the room of interest rate players – at a $15 billion market cap, Annaly Capital Management, Inc. (NYSE:NLY) is greater than both Chimera Investment Corporation (NYSE:CIM) and American, combined. Second, Chimera Investment Corporation (NYSE:CIM) has seen its net income cut by half from last year which raises some doubts in my mind as to the capabilities of its management. I prefer the long proven guidance of Annaly’s management. In addition, American invests in mortgages which are classified below investment grade. Annaly Capital Management, Inc. (NYSE:NLY) is much safer in that sense. It invests 75% of its portfolio in U.S backed securities and the remaining 25% in investment- grade securities. Nothing below that.

The fool looks ahead

I believe that low interest rates are here to stay for at least the next 2 years or so. If you wish to be paid 12% on your investment, Annaly is the safest investment you can make. It’s by far the biggest most sophisticated player in the interest rate arena. It plays a safe game, and most importantly – it’s highly committed to paying you dividends all along the way.

The article How to Buy a Dollar for 95 Cents originally appeared on Fool.com and is written by Shmulik Karpf.

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