Hot Stocks for a Cool Market: Annaly Capital

Summer's heating up, but apparently the stock market didn't get that memo. Still, there are plenty of places for burned investors to find respite. In this series, we highlight companies that have the potential to warm up your portfolio's returns.

I love a stock that does well when the rest of the market does poorly. That's the appeal of Annaly Capital Management (NLY). While other stocks wilt under the heat of unemployment and an uncertain economy, Annaly thrives under these conditions. And then there's the company's dividend yield: a cool 14.2%.

Annaly's Foul-Weather Business Model

The recession has been very good to Annaly and its investors. That's because its business -- borrowing money at short-term rates and buying long-term mortgage-backed securities that are backed by the government -- got a boost when interest rates plummeted, thus lowering Annaly's cost of funding. Since the company is a mortgage real estate investment trust, it pays out almost all of its earnings as dividends.

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Because it does well in a poor environment, Annaly makes a nice hedge to a diversified portfolio. As long as unemployment remains high, interest rates remain low, and the recovery seems spotty, Annaly's a keeper. While consumer stocks might get hurt in a downturn, Annaly should hold up and continue paying its fat yield.

What to Watch

While Annaly thrives during times of gloom and doom, its foul-weather model isn't bulletproof to the whims of the Federal Reserve.

If and when Chairman Ben Bernanke signals that he might raise rates, you'll want to quickly reevaluate your position. That said, I see two reasons to remain bullish on Annaly:

1. The Fed has promised that it won't engage in a third round of quantitative easing, meaning that monetary policy will provide limited benefit to the broader economy.
2. Second, Congress has refused to provide more stimulus money and is engaged in cutting fiscal stimulus by balancing the budget (or at least, rhetoric to that effect), meaning that there will be no boost to the economy from that corner.

Even if the powers-that-be do take the proper economic course and increase stimulus, it'll be years before unemployment gets back on track. And I certainly see little sign that our leaders are taking the right course.

The biggest risk to Annaly is a hike in interest rates, which will come with a clear economic recovery and rising employment. Any decline in its interest rate spread will hurt its profitability, because the company uses a lot of leverage to generate its huge yield. To wit, Annaly has a leverage ratio of about 6.3, or about $6.30 in debt for every dollar of equity. Such high leverage helps the company in boom times but can really hurt when the bust comes.

The Bottom Line on Annaly

That said, Annaly's management is one of the sharpest around, and they keep a very close eye on interest rates and are willing to make the necessary changes to keep the company in good shape. The managers behind Annaly also run Chimera Investment (CIM), a similar company that invests in riskier mortgages but uses less leverage.

With its giant dividend, Annaly makes a great stock for a period of lackluster market action. Just remember: This is a company that can -- and will -- experience significant downside when it's clear that interest rates will rise and the economy gets back on track. But that time looks far-off yet, and I've placed my money where my mouth is and own shares of Annaly myself and for the public-facing portfolio that I run.

Jim Royal, Ph.D., owns shares of Annaly. The Motley Fool owns shares of Annaly and Chimera.