When I am Wrong
Research for Online Investors

by John Dalt

9/23/10

Even when you are wrong, can you be right? Sometimes an overabundance of caution can blow up in your face. Investors are wise to “sit on their hands” rather than jump at every concern.  Conversly, we must act to avoid problems before they consume us.

Last week we wrote about Annaly Capital Management (NLY).  NLY is a great company that is organized as a Real Estate Investment Trust (REIT).  Because of this, they do not pay income taxes.  They pay out 95% of taxable income to shareholders, who receive a 1099-Div. to report on their taxes.

NLY does not own real estate, but invests in mortgage backed securities (MBS) that are backed by the government.  They borrow money at a low interest rate and buy MBS at a higher rate, making an interest rate spread.  Then because their assets (MBS) are guaranteed by the U.S. government, they leverage their balance sheet for higher marginal returns.  These leveraged investments don’t make as much margin, but are ‘add on’ sales.

NLY has been a core holding in Galt’s Long-Term Portfolio for over a year.  We took a small detour last spring to sell when we felt it was overpriced, and bought it back a few weeks later at a much lower price.

Last week we looked at NLY’s business model and became concerned their next dividend could be reduced because mortgage rates have been driven down in the last 45 days.  Not only are their new MBS supplying lower margins (spreads), but the low mortgage rates are creating re-financing opportunities.

Homeowners pay off their older mortgage when they refinance.  This means NLY’s book was being “called” early and they had to replace it with lower yielding mortgages.

NLY announced their dividend last night after market close.  They maintained a quarterly dividend of $0.68 per share.  This dividend rate roughly equals a 15% return on the stock.  We sold NLY last Thursday at $17.95, and this morning entered a buy order to replace the position at $17.95

We are watching, as expected NLY has bid up so far today.  If the market goes into a sell-off we will lower our buy limit price to $???

Wait a minute, this is what our subscribers pay for...  The moral of this story is there are times to err on the cautious side.  We sold NLY at a nice capital gain since last spring and received one dividend in that time.  We have until next Thursday (ex-dividend date) to buy it back and receive the current dividend.  If we don’t buy it back by then, we will lower our target buy price by at least the amount of the missed dividend, maybe more!

Buying stocks at the right price allows us to sell later at a higher price, buying discipline is important.  Selling discipline is also important.  We have to be willing to sell when a stock is overpriced, or there are storm clouds on the horizon.

In the past we have sold stocks on news of accounting irregularities or a delay in reporting earnings.  If they can’t keep books, how do you trust them?  A major industrial accident.  We waited too long to sell RIG after the gulf oil spill, but got out with a small gain.

We sold one of our favorite companies last year when they had a mining accident that resulted in loss of life.  We instructed our subscribers to sell the day after the accident.  We waited a few days to understand what had happened and read all we could.  We felt comfortable after a few days and jumped back in (at a lower cost).

Accounting problems immediately make us want to reach for the sell button.  Once a company publicly admits there is a problem, it generally gets worse.  Accounting problems seem to hang around for a long time.  They don’t just last for one news cycle.  Six months can easily go by while auditors examine overseas units, branch offices or divisions.  The blood continues to flow as the company must correct or restate previous earnings statements.

Our advice is to err on the side of caution; you will be right more than you are wrong.  If you manage it correctly,” When you are wrong, you can even be right.”

Quote:
Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.---Warren Buffett, #16 Investor Resources, Warren Buffett Quotes.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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