SUMMARY
Annaly Capital Management trades at nearly a 20%
discount to its book value, which is comprised of highly liquid securities. Annaly
has recently delevered and hedged, which should limit further losses. The stock
is currently priced for a disaster and anything short of that should lead to
attractive gains. An end to tax loss selling season or putting the taper behind
us could be the catalyst for gains.
BUSINESS
Annaly Capital Management is a mortgage REIT that primarily
owns a levered portfolio of agency securities. Through Annaly’s acquisition of
its subsidiary, Crexus, Annaly has diversified modestly into CMBS as well. Annaly
now deploys 11% of its capital in the CMBS market. Additionally, Annaly owns a
small asset management business.
Annaly has been in the agency RMBS business for over 15
years. The way the business works is that Annaly owns a levered portfolio of
agency securities. Annaly makes money through two spreads, the spread between
longer rates and shorter rates and the spread between agency securities and
treasuries. This is a very simplified explanation of the business. Annaly has
to choose what securities to own, how much leverage to employ, how to fund the
portfolio and how to hedge based on the current environment.
WHAT
HAPPENED
For nearly 15 years Annaly had been in a great business with
some minor bumps along the way. Over this period Annaly was able to offer a
dividend that averaged in the double digits plus capital appreciation. When QE came
along it compressed both the spreads that Annaly was profiting off of. QE
succeeded in lowering interest rates and the spread between agency securities
and treasuries collapsed.
Instead of backing off the trade as the spreads became
narrower many agency mortgage REITs increased or maintained leverage in order
to sustain returns. When the Fed announced a possible taper in May this caused
rates to go higher & spreads to widen. This led to losses across these leveraged
portfolios. Most agency mREITs have locked in these losses and delevered their
portfolios since.
PRESENT
Annaly’s book value has fallen from $15.85 at the beginning
of the year to $12.70 at the end of the most recent quarter. This is partially
due to the large dividend they continued to pay out despite losses but mostly
due to the increase in rates and spreads. In reaction to these large losses
Annaly has delevered and hedged more aggressively. At the end of the latest
reported quarter Annaly was levered 5.4 times, which is at the very low end
historically. Annaly is 74% hedged, which is at the very high end historically.
It is estimated that Annaly would lose 4.4% if yields were to go up by 100bps.
Annaly has historically traded at approximately a 10%
premium to book value. After this past years missteps it currently trades at a
roughly 19% discount to its book value. The most common response I get when pitching
Annaly is that rates are likely to go higher and spreads are likely to widen as
the Fed tapers. However, even if rates went up by 125 basis points and spreads
widened its unlikely that book value would fall much more than 10%. If that
were to occur the Annaly would still trade at a 10% discount to book and the
spread would come back into the trade that they do, making it attractive again.
All the while one is likely to be paid a 10% dividend to wait (currently the
dividend is 14% but likely to go lower). In November four different insiders
purchased shares in Annaly at prices higher than current levels.
CATALYST
It is likely that much of the recent selling has been tax loss
selling as Annaly is down more than 45% from its highs. Tax loss selling ends
at the end of December and these sellers will no longer be present in January,
paving the way for a higher share price. It seems that every time somebody mentions the
word taper that Annaly gets hit. Getting the big, bad event behind us will
likely be a positive as Annaly is hedged for higher rates and the fear of the
taper is likely worse than the taper itself.
3 comments:
How can you write this case with zero mention of Annaly's reliance on repo financing and how that will be impacted by coming regulation on bank's leverage ratios?
Annaly has lower leverage than ever. With such strong collateral and low leverage, financing is simply not an issue. In 2008, with leverage significantly higher financing was not an issue. Might as well worry about a meteor hitting the earth.
I appreciate exactly what you’ve supplied to those people who wish to learn as often about
Positive cash flow investments USA
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