CIM -- Michael Farrell & Annaly Capital Management Inc.

At this point CIM has been in existence for just over 1 month. The company has not filled a single financial statement. There have been no conference calls or presentations beyond the IPO road show. The only piece of tangible news out of the company is the first minuscule dividend of $0.025 per share announced last week.

So why is the stock trading at $17.75 while it has an estimated book value of just over $14 per share?

The only explanation is that the market believes the involvement of Michael Farrell and his associates at FIDEC warrants a premium.

While CIM has no operating history, we can certainly use Farrell’s 10 year track record at the publicly traded Annaly Capital Management (NLY) as a guide. NLY has the same structure and business model as CIM with the big difference being that NLY’s assets are of the highest quality while CIM will invest at the lower end of the quality spectrum.

Looking back to 2006 with NLY shares slightly off the lows after being cut almost in half and the great credit orgy reaching its climax, here is the key quote from the 2005 annual letter (published in March 2006)

“As 2005 played out, we prepared our business for the inevitable change in sentiment and shape of yield curve. While other stretched for returns in the form of credit risk, mortgage derivatives, new business models or extra leverage, we stuck to our discipline of using AAA mortgage backed securities. It cost us some earnings …..but I believe this discipline will only be appreciated by investors when viewed through history’s rear view mirror.”

While this scenario benefiting NLY seems “inevitable” today, it certainly was not so in early 2006. This group stuck to their guns despite earnings and share price plummeting while it seemed like everyone else in the mortgage business was printing money.

NLY’s net interest spread – the main source of NLY’s and CIM’s income -- shrunk from 1.51% to 0.53% meaning that all other things being equal NLY would earn $1 in 2005 for every $3 earned in 2004. This happened because the yield curve flattened and this is a risk of being in this business.

One way to deal with a flattening yield curve is to buy less credit worthy assets which have a higher stated yield. The name for this strategy that clients and shareholders never hear is “reaching for yield.” The problem with this approach is while your net interest spread benefits initially, you are exposing your portfolio to bigger problems later if these higher yielding, less creditworthy borrowers start defaulting. Instead of buying, NLY was selling.

In the fourth quarter of 2005, NLY took a substantial loss by selling assets that they felt were unlikely to meet return expectations. Also, they did not buy any of the most recently issued loans made at higher yields but to less creditworthy borrowers. They cleaned housed. They shrunk their book of business just as the environment was at its most euphoric and it seemed like borrowers could refinance or sell their constantly appreciating homes forever.

By now Farrell and his group have been proven right and NLY is now growing and in a position to buy when everyone else is selling. The stock has regained much of what it lost in 2005.

What does all this have to with CIM?

CIM will make money the same exact way as NLY and will be run by the same exact people that manage NLY. The actions this group took in 2005 show that they are willing to sacrifice earnings, share price, and their reputations in the short term to protect and reward shareholders in the long term. This is a rare quality that certainly deserves a premium and should be a key consideration for every potential CIM shareholder.

* DISCLOSURE: I or accounts I manage may be long or short any and/or all stocks mentioned in this post. This is not a recommendation to buy or sell any security. For informational and educational purposes only.