Book value

Annaly: Ignoring tangible book value is a risk (NYSE: NLY)

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The past few months of tumultuous markets have presented splendid opportunities to buy cheap assets and lock in gains on the loftier ones. Based on how he traded, it’s safe to say that Annaly Capital Management (NYSE: NLY) is cheap. The 28% price drop over the past year was only surpassed by one of its mortgage REIT peers, AGNC Investment Corp. (AGNC) and lags the S&P 500 (TO SPY) by about 27%.

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We take a look at the key elements driving your returns for NLY and tell you where we see them going over the next 12 months.

Tangible book value (and fate) is everything

NLY’s returns over time can be broken down into two distinct periods. Investors who confuse the two timeframes are likely sitting on rather mediocre returns. Let’s explain this further. The first period was just before the bursting of the dot-com bubble until the beginning of the last decade. You can use any arbitrary threshold, but we used May 28, 2012 to give us an exact decade for the next chart.

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The returns look and, well, look fantastic! Returns of 841% from January 1999 to May 2012. Outperforming the S&P 500 by 800%. Truly remarkable. The last 10 years have been really, really bad.

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Data by YCharts

Annaly generated total returns of 25.10% including those big dividends. SPY outperformed by almost a factor of 10X. What happened ? Well, there are certainly a lot of moving parts here, but the key factor was NLY’s ability to defend its tangible book value. During the first period, he not only preserved it, but he actually developed it. This happened even during the crisis of 2008-2009. The tangible book value as of May 28, 2012 was 62% higher than that of January 1, 1999.

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Of course, you know what’s coming next, but we have to show it.

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Data by YCharts

Ha! Almost exactly the same number, but in the opposite direction! This tangible book value per share dictates leverage ratios, cost of equity and, ultimately, returns. Tell us again how meaningless this tangible book value is?

Where do we go from here?

NLY tends to only issue shares when it is accretive to do so and the recent $100 million issue was aimed at repairing book value and restoring leverage. Over the next 12 months, NLY will likely benefit to some extent as mortgage-backed securities tighten against Treasuries.

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NLY Q1-2022 Overview

This is also why NLY has suffered so much over the past 12 months, as it is much more vulnerable to this spread than it is to raw interest rates.

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NLY Q1-2022 Overview

Another thing to note here is that NLY is not benefiting much from lower interest rates. The net asset value will only increase slightly if interest rates fall. Our forecast here is for rates to be range bound and tangible book value between $6.00 and $7.00 over the next few months. That might seem like a huge range, but when you consider how leveraged mortgage REITs are, general ranges are all you can extrapolate.

More interesting will be the tighter grip around spread income as the yield curve flattens over time. NLY has swaps that lock in short-term rates for a while and we’ll really see a full impact as we move forward into 2023. Earnings estimates have come down, but we think there’s more room there- down.

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Looking for Alpha

We would be looking for an 80 cent figure in 2023 and a dividend cut at some point in 2023 at a quarterly rate of 20 cents.

Verdict

Mortgage REITs are a terrible asset class. According to NAREIT, mortgage REITs delivered nearly exactly 0% total returns from February 2004 to April 2022.

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NAREIT

So your current account has done better than mortgage REITs over 18 years and with much less nausea. Equity REITs did much, much better and outperformed SPY. Another point to note here is that NLY’s outperformance versus the index ran from February 2004 to October 2012. It has actually lagged the index for the past 10 years. We can see the same by comparing the total returns of NLY to those of the VanEck Vectors Mortgage REIT Income ETF (MORT).

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Data by YCharts

In the short term, some long-term trades are certainly possible, and if the markets start to think that a slower economic climate means fewer rate hikes, you might see a slight increase in tangible book value. But the bulk of those losses don’t come back in our view. We are pricing this neutral/hold for now and will look for long opportunities in the event of a sell-off.