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We are a successful trading firm, but one area we got crushed in was the mortgage real estate investment trusts, or mREITs. The rising rate environment wreaked havoc on their portfolios, and the entire mortgage market is facing tremendous pressure. It just has not been a good sector to be in. We had some buy calls a few months ago thinking we were getting a bargain, and the situation worsened heavily in September unfortunately. Overall, we still like income names to comprise about 20% of your long-term portfolio. Within those long-term income holdings, we endorse having dividend paying names, blended with dividend growth, or high-yield. Generally, mREITs would fit this bill. One name we liked for diversified income that was further crushed with the entire sector in September was Ellington Financial Inc. (NYSE:EFC). Today we check back in on the stock after the company just reported earnings.
Diversification of Ellington is great, but did not help prevent the selloff
EFC the stock, fell hard, despite the company’s diversification. Look, there are many different mREITs out there, with a lot of different styles. But just about all of them have been under pressure this year as interest rates have moved and the real estate market weakening. Of course, EFC stock had been hit hard, but it has started coming back on. We still like that the company has a diversified portfolio. The portfolio has income from several sources, including CLOs, CMBS, and non-Agency RMBS strategies. Of course, anything tied to mortgages has been obliterated over the last few months.
We like the strategy here, despite the terrible performance of the stock. The value of the assets have been creamed. But it is sector wide. To earn money, like many other mREITs, they employ an Agency RMBS strategy, but as we know investments there have been incredibly tough in recent months with volatility in rates. We like that the company has had some exposure to non-qualifying mortgages, or non-QMs, which are risky but often have high rates of returns. Overall, we like the diversified approach to the portfolio. That is one of the reason we like EFC for income, and liked it a few points ago on the share price.
The company just reported Q3 earnings. In the release, Laurence Penn, CEO summed up the situation nicely:
The challenging market conditions of the first half of 2022 intensified in August and September. As the third quarter progressed, hawkish messaging from the Fed, elevated inflation and recessionary concerns, and sharply rising interest rates pushed volatility higher and drove an inversion of the yield curve, all of which stressed equity and fixed income markets alike.”
That is a great summary, because this is what crushed these companies, a severe inversion in the yield curve, which is ongoing. So we saw a loss in the quarter. Yes, that hurts. Elaborating further Penn added how they made moves:
Our diversified portfolio, stable sources of financing, and dynamic hedging helped limit our book value decline… we were able to increase adjusted distributable earnings sequentially as we continued to rotate the portfolio into higher reinvestment yields
The diversification that we love helped. While the market is horrible right now, the fact the company is putting money to work still shows they are working to maximize earnings. They were able to increase earnings sequentially. The company lost money. In fact EFC had a net loss of $33 million, or $0.55 per common share. Making some adjustments, the adjusted distributable earnings (a measure for dividend coverage) were $26.5 million, or $0.44 per share. This was up from $24.9 million, or $0.41 per share. What is most important is that this level of earnings did not cover the now $0.45 in dividends being paid quarterly. While the macro situation is tough, we think the dividend continues to be paid, but this cannot go on much further, or the dividend will be cut.
While the diversification of EFC’s portfolio protected the earnings power, it is tough all around. But the best thing is the company is investing in its future. They just closed on the acquisition of the other half of its affiliate reverse mortgage originator, Longbridge Financial. The final purchase price of $38.9 million was substantially lower than the initial estimated price of $75 million that they originally thought in February, and reflected a discount to Longbridge’s book value with everything happening in the space. We expect this diversification to continue to pay off for the company versus companies that have concentrated ports, and that the future earnings potential from this acquisition are strong.
The company has a lot of cash available still to put to work. There are many opportunities and spreads are wider, but the hawkish Fed is a risk. Still, having funding to put to work is key because the hefty dividend of $0.15 per month needs to be covered by earnings. And the dividend coverage has been mixed. It definitely was not covered in Q2 and Q3..
Valuation
The market has created a massive discount-to-book here.. Book value per common share as of June 30, 2022 was $16.22, and then at the end of Q3 it was $15.22. So the falling book value is why there is a discount. At this level you are getting a $1.88 discount-to-book, or a near 12.3% discount.
The reason to own shares is for the income. Any share appreciation is a bonus. The annualized yield at this pricing level is 14%, as the company just announced another $0.45 dividend.
Final thoughts
The whole situation for mREITs is tough right now, and with a few more rate hikes we expect yield inversion to persist for a few more months, but better days are ahead. The company is working to preserve book value and maximize distributable earnings. It is making a nice acquisition for half the cost. Further it looks really good from a discount-to-book and dividend yield standpoint. Despite the selloff the last few months, we like an investment on weakness here for income.
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