Right now, Annaly Capital, a mortgage real estate investment trust, is trading at $11.62 per share. That is intriguing because the firm’s book value is currently $12.13 per share. Anytime a company is worth more dead than alive according to the stock market valuation, it’s worth a look to see what’s going on (especially given Annaly’s long-term tendency to trade at valuation ranges of 10-25% in excess of its book value).
What causes this to happen? There are three reasons why a mortgage REIT can become cheap: (1) no one wants to touch it because dividends and earnings are all over the place, (2) they are highly leveraged, (3) and they tend to get whacked around a bit when interest rates rise sharply. I’ll elaborate a bit on that last point—the general strategy of most mortgage REITs is to borrow money at the short-term rate and then park in a fixed rate, mortgage-backed security for the long term. When interest rates rise sharply, they tend to run into trouble because they have to borrow at a higher rate to make new short-term investments, while their existing portfolio of mortgage-backed securities is baked into lower rates than what the new normal has become.
The dividend fluctuates in ways that, frankly, the average individual that is relying on income will not be able to tolerate (this isn’t necessarily problematic—what’s important is to know yourself. It is okay being someone who can handle extreme volatility in dividends, it’s okay being someone who can’t handle extreme volatility in dividend payments, what is not okay is being someone who thinks he can handle extreme volatility in dividend payments but can’t actually do so).
Say you owned Annaly in 2002. At the time, you collected $2.67 per share in dividends. Given that you could’ve bought the stock for $17 at the time, that’s not bad—where else in the world can you get 15% dividend yields? Well, the catch is this—they don’t stay 15% dividend yields for long. The payment dropped to $1.95 in 2003, $1.04 in 2005, before hitting a low of $0.57 in 2006. Assuming you weren’t reinvesting, that 15% dividend yield turned into a 3.0-3.5% dividend yield. That’s a substantial decline, and there is no requirement that you make this type of income volatility a part of your investing life.
However, for people that are able to stomach that kind of volatility and think in terms of complete business cycle performance, the results are much more interesting—the dividend payout crossed $1 in 2007, crossed the $2 per share mark in 2008, and then hung out in the $2.44-$2.68 range for the next three years. Now, the dividend payment is hovering a bit over the dollar annual threshold again.
To do well with Annaly, it helps if your thesis is one of the following:
(1) I’m going to reinvest dividends in this security hell or high water, so that after a few years of annual dividends that get reinvested, I’ll almost be certain to be collecting more annual income from Annaly than I did at the time of initial investment, and that’s what counts.
(2) I’m going to recognize that dividend yields above 10% have a somewhat ephemeral, illusory quality to them, and I won’t take it personally or get affected when the dividend declines substantially. It is clearly part of the terms of the investment, and the normal and good times compensate for the lean years that are inherent with this type of security.
I’ll give an example of how dividend reinvestment can ease the pain. The year 2010 was the last time Annaly’s dividend peaked; shareholders received $2.65 per share, which has steadily declined since then. That worked out to an initial yield of 15.2%, assuming purchase at a price of $17.35 per share that year. Someone that reinvested along the way would have seen his share count increase 75% (that’s what happens when you combine a high dividend payout with a low reinvestment price for a few years). What are the implications of that? Someone who bought Annaly in 2010, at the height of its recent dividend payout trajectory, would be collecting 72% of the annual income in 2014 that he collected in 2010 despite the decision of Annaly management to cut the dividend by more than half over the past four years.
If dividend cuts bother you, Annaly isn’t the stock for you. If stock price volatility bothers you, Annaly isn’t the stock for you. If protected periods of weak profitability as the recent of potentially increasing interest rates bother you, Annaly isn’t the stock for you. However, if companies selling at discounts to book value (in the case of Annaly, the stock has only traded less than book value in 2013 and 1998 in the past generation) and companies that return significant amounts of income to shareholders over the course of a full seven-to-twelve year business cycle interest you, then Annaly is worth a look. If your attitude is, “I’m super diversified, it’s cheap, I don’t care about my annual income from this holding in a particular year”, then you’ve found fertile ground for future research.