Author: Bill Deshurko, 401 Advisor
Covestor model: Dividend and Income Plus
Disclosure: Long NLY
For many investors, one attraction to dividend investing is that it’s generally considered a long term, buy and hold strategy. The thinking is that once initial selection work is done, the process requires little more maintenance. I believe this approach is bound to lead to disappointment.
Investors usually take one of two approaches to dividend investing. They either pick stocks that pay a modest dividend but have historically increased their dividend payouts over time, or they look for high yielders – stocks that pay a dividend well above the going rate. A good example of the former would be Procter and Gamble (PG). PG started paying a dividend in 1896 and has increased its dividend for 55 consecutive years. PG comes as close as any stock can in my book to “a buy, hold and forget about it” stock.
On the other extreme is Annaly Capital Management (NLY). Annaly will come up on any screen for high dividend stocks. NLY has a 14.72% yield according to Marketwatch.com, as of 11/11/11. This kind of yield can scare away conservative investors who could benefit from the dividend, while simultaneously attracting investors looking for yield but not understanding the company or know how to manage the risk.
Let’s look at how an investor should approach and benefit from holding NLY in their portfolio. NLY is a mortgage REIT. Simply put, they borrow money at low rates and reinvest in higher yielding mortgages. Before buying NLY, an investor needs to look at the fundamentals of P/E, cash flow, sales and earnings estimates, among other metrics. But what I want to look at is the sell decision. If you own, or decide to buy NLY, when would you look to sell? For this, let’s look at their business model.
First, Annaly needs to borrow at low rates. The Federal Reserve has stated that they will maintain current low rates into 2013, based on their outlook of the economy. While economic data may be pointing to an averted double dip, we are hardly in danger of overheating and forcing the Fed’s hand to raise rates any earlier. This is good for NLY.
The other side of their model is that they need to buy mortgages at a high enough rate that the spread between the rate at which they borrow and the rate of return for what they buy can generate earnings at least equal to what they have been generating. This is probably the biggest area of concern, as the Fed has undertaken HARP II, the refinancing program for underwater mortgagees. Concurrently, the Fed is pursuing Operation Twist, the purchase of longer term debt securities aimed to keep longer term interest rates low. Both programs have been in operation through the third quarter, with nominal results. Interest rates are more influenced by macro conditions, especially Europe. And Harp II seems to be limited, as borrowers still must qualify for a new lower mortgage based on debt-to-income ratios and credit scores. With un- and under-employment over 16%, HARP II will find a limited number of borrowers who can qualify.
The rap against high yielders is that they either will not keep up with the market in terms of capital appreciation, or that a drop in price will offset the advantages gained from the high yield. When I invest in high yielders, I am not buying them to keep up with the market. I’m looking for income. Period. Capital gains are a bonus. If I feel I can identify why the stock is out of favor (who would buy a mortgage REIT in this environment?) and have a game plan for when to sell (flattening yield curve), then I’m a buyer of high dividend stocks, especially in this environment.
In the short term, NLY’s dividend looks relatively safe. However, at some point, rates will rise and NLY’s profits are likely to be squeezed. But my investment thesis is pretty simple. As part of a multi-stock portfolio focusing on dividends, NLY can give me a boost to overall portfolio yield with risks that I find manageable. In other words, I can identify when conditions turn against NLY, such as a flattening of the yield curve. In the meantime, I’ll collect a nice dividend to add to my accounts’ cash flow.
Disclosure: We hold shares of NLY in client portfolios.
