Greg Merrill is owner and portfolio manager of Tacoma, Washington based Strategic Asset Management, a private investment management firm that manages private accounts for individuals.
We recently had the chance to ask Greg to share his highest conviction stock holding in his portfolios.
What is your highest conviction stock position in your fund - long or short?
My highest conviction stock is long Annaly Capital (NLY) which is a mortgage REIT. As Annaly describes itself:
Annaly primarily invests in what we believe to be the premier asset-backed securities in the world — U.S. residential mortgage-backed securities (MBS) issued and guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae (Agency MBS).
These securities carry actual or implied AAA ratings. Thus, we take virtually no credit risk. We enhance the return on our investment in these securities by using leverage. We seek to earn positive net interest income from the difference between the yield on our securities and the cost to finance them.
The primary risk of the investment strategy, interest rate risk, is managed through the Annaly Barbell Strategy through which the natural hedging characteristics of floating-rate, adjustable-rate, and fixed-rate securities are intended to enable us to perform through a wide range of interest rate environments. The hedging process occurs when, in general, a portion of our portfolio is expected to perform better in a rising interest rate environment via improved spread income and lower price volatility, and a portion of the portfolio is expected to perform better in a falling interest rate environment via capital gains.
While there is much discussion as to the precise value of Annaly (its swaps books, leverage ratio, etc.) I find it is important not to get too granular analyzing the company.
The major factors driving Annaly's earnings are:
(mortgage rates - short term rates + skill ) x leverage
Skill is a factor which is magnified by their leverage, and leverage right now is relatively low and has been consistently falling. Annaly also manages other mortgage REITs (CIM) as well as private accounts, but the majority of its income and risk comes from its mortgage portfolio.
Due to the current and past dislocations in the residential mortgage market (which are too numerous to mention here, but I'm sure all Seeking Alpha readers are familiar with most of them), the company has been slowly reducing its leverage (click to enlarge):
To show the total risk of the company, the above graph is based on total assets and total equity of the company, not just its mortgage portfolio.
Like most financial companies, an examination of their relative price to book value is also instructive. While Annaly has other operations that provide value, the bulk of its earnings and risk come from the mortgage program described above.
Amazingly, even with the massive dislocations of the last 2 years, price/book has rarely fallen below 0.90. Naturally there have been some wild swings, but due to the liquid nature of their portfolio and implied threat of stock buy backs (none have occured in recent history that I am aware of), the stock has spent most of its time above book value (click to enlarge):
Aren't you concerned that Annaly is still not marking its MBS properly - that is, its overall book value remains overstated? And what about the still precarious condition of outstanding U.S. residential mortgages?
Considering the MBS are all Ginnie Mae, Fannie Mae, and Freddie Mac, no, I'm not concerned. Ginnie Mae is a direct obligation of the Treasury, and Fannie and Freddie are in receivership and have a huge line of credit with the Treasury. Also, the Federal Reserve owns 1+ Trillion of Fannie and Freddie MBS. The line of dominos falling is the Federal Reserve and then Annaly. Regarding this one risk factor, considering the political power of the Fed I doubt that is a risk.
I agree the U.S. housing market is precarious, but Annaly does not purchase private label MBS. Also, the MBS they purchase are pretty vanilla and such ready prices are available. Their auditor would cry foul if they were improperly marking them.
Their balance sheet is light years cleaner than any large U.S. bank with Type 3 assets (mark to model, or as the current pejorative, mark to make believe).
Compare NLY to any large U.S. bank. Which would you rather own on a metric of balance sheet security OR leverage ratio? Also, during the financial crisis they came through, survived, and were able to roll over their repurchase obligations. They have been battle tested.
To what extent is this an industry pick as opposed to a pure bottom-up selection?
This stock is a macro play on my expectation short term interest rates will remain pinned near zero for the forseeable future. It is also a defensive trade. As you can see from the following graphs, credit is not flowing to the consumer nor will it anytime soon. As the consumer is ~70% of GDP this limits potential economic growth.
The first picture is the year over year percent change of total consumer credit outstanding (source: Federal Reserve). As you can see, consumer credit growth has been negative and is accelerating downwards. As compared to previous recessions, this is exceptional. Until we see total consumer credit outstanding stop falling, short term interest rates will most likely stay very low (click to enlarge):
One may ask why even look at consumer credit? Won't consumer spending alone bring us out of the recession? This line of thought may have been correct when consumer debt / GDP was a much smaller ratio, but now consumer borrowing dominates consumer activity. Consumer debt / GDP nearly hit parity before the financial crisis (click to enlarge):
It is not only the consumer retrenching; banks as a whole are reducing their lending:
Without the additional demand created by credit growth, the U.S. economy will not rebound strongly and absorb the excess labor and factory utilization available. The credit crunch will force the Fed to keep interest rates very low as banks and consumers attempt to repair their balance sheets.
Considering my expectations and reasoning behind why short term interest rates will remain low for an extended period, Annaly is more a defensive stock pick. A steady rise in book value and monster dividend of nearly 17% provides a nice return and downside protection if the economy stumbles along doing nothing for several quarters.
While mortgages rate spreads will most likely rise as the Federal Reserve ends their MBS purchases, this is actually an intermediate term positive for the company as they can invest in new MBS paper with a larger spread versus short rates. Their current leverage ratio also allows them to lever up when management deems it proper.
In my opinion, the recent raising of the discount rate is more of a a return to non emergency financial policy and does not indicate an imminent increase of the Fed funds rate.
There are other mortgage REITS out there, but NLY is large, liquid and well run in my opinion. Your readers may want to examine other mortgage REITs or the ETF REM for some variations on risk and return on this macro play of an extended period of low short term interest rates.
How do you assess NLY's valuation?
Right now I think the stock is slightly undervalued due to the expectation short term interest rates will start to go up sometime this year, cutting into Annaly's spreads and thus its dividend. (The company usually pays out the minimum 90% of earnings.)
Price to book is on the lower end of the historical range and provides a good buffer to any serious fall in price. One may want to purchase some now and either wait for a pullback or sell some naked puts at lower strikes with the hope a short term dip causes an exercise against your naked puts.
The company also has a preferred (NLY-A) which pays a high dividend of 7.88% Considering the leverage ratios and balance sheet it is also a good buy. I would not buy above 25.00 as the preferred can be called at any time.
What catalysts do you see that could move the stock?
Movements in short term lending rates and mortgage rates are the primary movers of the stock. Rising short term interest rates will reduce their lending spreads and thus harm the dividend. Rising mortgage rates would help the company, as new mortgage purchases would provide a higher lending spread.
Falling mortgage rates would do the opposite. If the company decides to relever their portfolio, you could see the dividends and stock price rise.
What could go wrong with this stock pick?
The primary risk factor in my opinion is that I am wrong and short term interest rates rise sooner instead of later.
I consider credit risk very minimal. The U.S. Government has backstopped the GSEs and considering the Federal Reserve holds the same mortgage paper on their balance sheet, it is highly unlikely the government's support will be removed.
Thanks, Greg.
Disclosure: Greg Merrill personally owns NLY, NLY preferred A; in client accounts, Strategic Asset Management owns NLY, NLY preferred A, short naked puts on NLY.
Read more High Conviction Picks »
If you are a fund manager and interested in doing an interview with us on your highest conviction stock holding, please email Rebecca Barnett.
No comments:
Post a Comment