Should You Buy Annaly Capital Management?

A 12.8% dividend yield! That’s the most obvious appeal at Annaly Capital Management, Inc. (NYSE:NLY), a real estate investment trust which manages investment securities (most notably mortgage-backed securities). With three quarters of the year in the books, the company had paid $1.60 per share in dividends in comparison to the current stock price of just under $16. Its dividend payments have declined in the past few years- quarterly payments crossed above 60 cents per share in 2009 and dropped below that figure last December- so it is possible that the company will cut its payments further. Annaly has also been downgraded recently by a number of analysts (read our coverage of the downgrades and discussion of Annaly as a QE3 play).

In the second quarter, net interest income at Annaly Capital Management, Inc. was down 15% from the same period in the second quarter of 2011; the first quarter had been about flat from a year earlier on that figure. Annaly also trades at the book value of its equity. The stock had been up about 8% for the year in mid-September, but has dropped 7% in the last month (likely partly due to the analyst downgrades). It therefore has underperformed the market for the year. In the company’s defense, it is very disconnected from the broader indices- its beta is 0.1- and its dividend yield provides investors with substantial cash gains. The Board of Directors has also recently approved a large-scale repurchasing program of up to $1.5 billion over the next year.

Bill Miller

The largest holder of Annaly Capital Management, Inc. at the end of June in our database of 13F filings was Legg Mason Capital Management. Legg Mason, managed by Bill Miller, had actually cut its stake in the company over the second quarter but still owned 5.3 million shares (research more investment activity at Legg Mason Capital Management). Michael Lowenstein’s Kensico Capital kept its position unchanged between April and June at about 4 million shares. Find more stocks Kensico Capital owned at the end of June.

We would compare Annaly to other high-yielding real estate investment trusts such as Capstead Mortgage Corporation (NYSE:CMO), Redwood Trust, Inc. (NYSE:RWT), Chimera Investment Corporation (NYSE:CIM), and Two Harbors Investment Corp (NYSE:TWO). All four of these companies have considerably smaller market caps, with Two Harbors being the largest at $3.3 billion; Capstead and Redwood actually have market caps smaller than Annaly’s new repurchasing program. As REITs, and therefore required to distribute cash to shareholders, they all pay high dividend yields. Redwood is the only one to pay a yield below 10%, and Chimera’s yield is actually larger than Annaly’s at nearly 14%, while Capstead and Two Harbors pay their stockholders 11.8% and 12.6% respectively. Given the fluctuation of dividend payments at Annaly that we’ve noted above, and in fact the decline that the company has seen over the past couple years, we don’t think that it has a particular advantage over any of its peers but Redwood on an income basis.

In terms of valuation, both Redwood and Two Harbors trade at a P/B ratio of 1.2. This represents a premium, in terms of book value, to the considerably larger Annaly. With higher betas as well- representing more exposure, in statistical terms, to the economy- we don’t think that they make as good buys. Capstead and Chimera also carry higher betas, though less than 1 in both cases. They both trade at small discounts to book value, with Capstead’s P/B ratio being 0.9 and Chimera’s being 0.8. These are lower than Annaly’s, and we’ve already noted that they are comparable from a dividend perspective.

If an investor doesn’t mind looking at a smaller, statistically riskier REIT, Capstead and Chimera seem like they could be good values relative to Annaly. However, an income investor could certainly like the greater security that a larger market cap and lower beta provide and stick with the dividend and buybacks that come with being a shareholder in the company.