“Earn $15,528 in Extra Income as This Market-Beating Stock Continues its Meteoric Rise”

by Travis Johnson, Stock Gumshoe | August 30, 2010 1:17 pm

I don’t write about Mark Skousen[1] all that often, in part because he doesn’t regularly barrage us with detailed stock teasers … but I’ve had a lot of readers write in to ask me about this latest teaser ad for his Forecasts and Strategies newsletter, an ad in which he says his favorite stock kept going up even on days when the Dow dropped precipitously in recent weeks … and then he slathers on the butter:

“This single stock has been a virtual cash machine for years.

“Since 2006, dividends[2] have increased by a whopping 518%. The yield this year is sitting at a fat 16% and may go as high as 22%.

“It’s no wonder analysts are calling it one of a ‘rare breed’ of stocks “that begins and continues raising dividends.”

“But it’s not just dividends that make this stock so attractive right now…

“The capital gains are nothing short of spectacular. Over the last 10 years — while the Dow dropped 8% — this one stock handed investors an astounding 107%.

“I call it the ‘Holy Grail of Safe Income Investments.’

“And I believe it could be the key for you to earn an extra $15,258 in income every year… Starting right now.”

Given the incredible rush to bond funds as investors lunge for yield and perceived safety in a world where savings accounts don’t keep up with inflation, and where disinflation has led to big capital gains for bonds that makes them sound even safer, it’s no surprise that the teaser I’m getting asked about is called the “Holy Grail of Safe Income Investments.”

Heck, even I want to know what that is. Take a sip, and enjoy everlasting dividend growth? Ooooh, it just gives you a little shiver of joy, doesn’t it?

So let’s find out who this little “grail” is, shall we?

Thankfully, the clues are ladled on nice and thick:

“… it’s a stock that receives preferential treatment from the government. Right now — because of this special situation — you can earn a safe, government-backed 16% dividend by investing in this stock.

“That’s 8 times better than the S&P’s average dividend of 2%!

“How can this company afford to pay such a huge dividend?

“It’s simple really. The government allows this favored company to borrow money at a tiny interest rate. Then, the company turns around and invests it in a group of 100% government-backed investments that pay a higher rate.

“All this company does is ‘pocket the spread.’ And forward the profits straight to you….

“As I said earlier, dividends have increased by 518% over the last four years. In fact, this year the company paid out the largest quarterly dividend in its 13-year history.

“It’s no wonder this stock keeps going up even when the markets are down. On August 11th it went up even as the Dow dropped 265 points.

“And on June 29, the stock market dropped another 268 points… While this stock was in the green — again!

“In my opinion, there is no better way to protect yourself from whatever economic calamities are headed our way.”

Sounds pretty nice, I must admit — going up when the markets are down, pocketing a steady yield and a government guarantee … of course, it’s all stuff we’ve heard before, from time to time. This is the playbook for promoting a small class of stocks called Mortgage REITS (MREITS) — some of which are very aggressive, and others which take fewer risks and invest solely in government-backed mortgages and use more modest leverage[3].

And yes, these stocks make money in a way that would have been familiar even to bankers a couple hundred years ago: They borrow money short at low interest rates, and they lend it long at higher interest rates. The spread in between those two rates is what they earn, and the amount that they earn is basically dependent on four things: The short-term interest rate for their borrowed funds; the long-term rate at which they lend; the costs of operating the business, including the cost of hedging against disadvantageous future events (like short term rates climbing faster than long term rates, or mortgages getting repaid); and the amount of leverage they use (if the “spread” is only 2 percentage points, then an equity holder would need to see them borrow ten times their equity base to make “earnings” of 20 percent per year — just as an extremely basic and rough example).

So that’s what this class of company does — and they are REITs[4], so they pay out 90% of their earnings and don’t pay taxes, which means the money you earn as dividends on these stocks is taxable as income, one reason that a lot of folks hold REITs and MREITs and similar vehicles in their retirement[5] accounts.

So which stock of this type is Skousen teasing today? Sorry to disappoint you with the lack of a surprise, but this one must be our old standby Annaly Capital Management (NLY)

Annaly is indeed 13 years old, having started operations in 1997, which makes it one of the deans of the MREIT space (the only one I know of that’s been around longer is Capstead Mortgage, CMO, though there may be others). And they are certainly the largest player in this sectory, by a wide margin — their market cap is about $10 billion, few of the others even surpass $1 billion. So they do get a bit of a cost advantage there, since the overall business is fairly scaleable — you don’t have to have ten times as many people to manage 10X as much money.

But what has helped Annaly stand out as a leader in the business — and grow to such a large size — is a very active role in hedging their interest rate exposure, solid performance through a few different kinds of interest rate environments (including the dreaded “inverted yield curve” when short term rates were briefly higher than long term rates), and a very public stance on most issues, along with regular monthly commentary from management about the state of the business.

The dividend has varied quite a bit, as has the share price — so you certainly can’t peg this as a consistent dividend growth stock, but then again you can’t exactly count on a current 16% yield from dividend growth stocks, either … the dividend is high because investors don’t trust the future, and this has been the case many times with NLY in the past. Their highest quarterly per share dividend in history was for the fourth quarter of last year at 75 cents, but since they also raised another billion dollars recently by selling shares it wouldn’t be surprising if the overall payout for the latest quarter (68 cents/share in June) was the highest dividend in their history. They’ve had similar per-share payouts in the past — back in 2002, when all had been roses and rainbows for these guys, they paid 68 cents/quarter, but they were a bit smaller then … and they’ve had far smaller payouts, too, back in 2005 and 2006 when yield-curve-inversion was the talk of the town the dividend briefly dipped as low as ten cents per share, though the stock never fell much below $12.

And yes, they are trading quite close to book value once again — they have sometimes traded at a discount to book, though not usually for very long, and right now, according to Yahoo[6] Finance, they’re at 1.02X book with a share price of $17.36. The book value fluctuates considerably, but has generally averaged out to about 1.2X book, with spikes when people love Annaly and troughs down to book value or a bit less when it’s out of favor.

These companies are always a bit more complex than they first appear, in part because they have some other moving parts (including, in Annaly’s case, subsidiaries that manage funds for Chimera and Crexxus, two other publicly traded vehicles that invest in non-agency mortgages and commercial mortgages, respectively), and in part because a mortgage portfolio is a living beast, with management required to keep up with prepayments, interest rate changes, and borrowing rates and hedge risks to keep their earnings as stable as possible. Their big hiccup last quarter came from the fact that the feds bought up a bunch of their mortgages, which brought in a quick wave of effective “prepayment risk”, mortgages that they had planned to hold for at least several years but which were snatched away at prices they couldn’t control (investors often buy mortgage bonds at a small premium, so if they get repaid early the investor can sometimes lose money or make far less than expected).

I’ve dabbled with Annaly competitor Hatteras Financial in the past, but really, if you like the sector it’s hard to bet on one of the smaller players at a time like now, when the biggest player trades at a higher dividend yield than many of the smaller companies (MFA Financial and Capstead, for example, both trade at a 10-12% yield, far lower than the 16% of both Hatteras and Annaly). There are reasons for this, of course, and most of these stocks have taken a substantial hit over the past month or two with repayments and falling mortgage rates, but if I were to bet on a mortgage REIT now Annaly would be my first stop for further research.

The largest difference among the various MREITs, as far as I can tell, is the type of mortgages they buy — NLY buys almost all fixed-rate agency bonds[7] (government guaranteed), but many others either venture out into more adjustable rate mortgages, which would theoretically offer protection if rates rise, or into non-agency bonds that don’t have the explicit or implicit federal backstop. NLY does enough hedging that they end up being more or less effectively half exposed to adjustable rate mortgages and half to fixed rate, but it is also true that their income can fall — we know that the feds can’t cut short term rates any further, but as they try to keep other rates low mortgages keep falling, and the window for profitability gets squeezed. The interest rate spread as of the last quarter was down to 1.56%, which is substantially lower than a year ago … as rates get closer and closer to zero, the possible profit window just naturally closes in a little bit. Still, they also have significantly less leverage than they did before the credit bubble burst, with their assets levered up only 5.9X now per their reports, significantly less than the average leverage of 10-12X that they’ve carried for much of the past ten years. I wouldn’t be surprised to see NLY waver or fall in the coming year, but it’s largely going to depend on what mortgage rates do and what happens with the broader business — you can see their monthly commentaries and additional white papers[8] and other information about their perspective on the industry here.

And yes, in case you haven’t noticed, Annaly is one of those stocks that sometimes pays out in dividends substantially more than they actually make in earnings, which is rarely an indicator of a sustainable yield, it’s usually the case that either the company has to start making more money or they have to cut the dividend in order to make their income statement a bit more sustainable. The Motley Fool[9] profiled NLY as one of their faves a few weeks ago and had a good article about why Annaly is a good buy here if you’d like to get another mostly positive perspective on the shares.

Basically: very low short term rates are great for Annaly, and it seems unlikely that the Fed will move to goose short term rates upward anytime soon; but dropping long-term rates are bad for Annaly, all else being equal, because it means not only that their margin gets squeezed over time, but that they face more prepayment risk in their portfolio as people refinance. Things have been very good for NLY for the past year, whether you think things will be great for them in the coming year largely depends on what you think will happen to those rates — though personally, given their history and scale I’d rather trust NLY than one of the littler players to manage a turbulent rate environment.

Oh, and just to complete the circle here — Skousen did tell us that we could book $15,528 in extra income per year from his teased stock — now that we’ve figured out this must be Annaly, how does that work?

Well, of course the easiest thing to do is to start with $100,000, then you’d get to a bit more than $15,000 in dividends before taxes … assuming the dividend doesn’t change (which it easily could).

But he doesn’t assume we’re starting with $100,000 — he starts with $25,000. Here’s how he does the math:

“How to Earn $15,258 Per Year in Extra Income…

“Over the last 3 years — and this includes the darkest days of the financial crisis — this stock has offered an average annual return of 25% per year in dividends and capital gains.

“Compare that with the 3-year return of the Dow — negative 26%.

“At its current growth rate, which has held steady for over 10 years, a $25,000 investment would be worth $76,294 in just five years.

“Your yearly income on that would be $15,258!”

So that’s how he figures it — I’d be cautious about predicting that NLY will continue to do as well for the next five years as they have for the past three, since they’re coming off of such a sweet spot with super-low short term rates, but I suppose it’s possible. If you choose to invest in NLY, I’d be careful to keep an eye on their monthly commentaries so you don’t get surprised by the state of their business, and keep in mind that if interest rates move in the wrong direction NLY can see their profits shrink very quickly.

I know that many of my readers have enjoyed the big NLY dividends over the past few years, and others have held the shares and also sold covered calls, further increasing their income, and I’m sure that many of you know the stock much better than I do — feel free to share your views with a comment below.

And if you’ve ever tried Forecasts and Strategies, please take a moment to share your opinion with a brief review[10] — we have a few reviews of this letter on file[11], and so far they average out to, well, “average.”

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