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Ellington Financial (NYSE:EFC) is a difficult stock to categorize. It is a specialty finance company that is structured as a partnership. Its assets are varied, including high quality agency back mortgages, and less than savory non-agency mortgages, also known as subprime loans. Due to this, Ellington is a high-risk, high-reward stock. Ellington currently offers a compelling quarterly dividend of $0.77 per share. At current prices, this equates to a dividend yield of about 12.5%.

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The primary objective for Ellington is to generate attractive, risk-adjusted total returns for its shareholders. Since August of 2007, Ellington has managed just that, returning a net asset value ("NAV") total return (book value plus cumulative dividends) of 94% through Q4 2012.

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Ellington has been able to generate these returns due to its very high yields on assets and net interest margins ("NIM"). As of Q4 2012, Ellington has an average yield on non-agency assets of 9.72%, while agency assets had a yield of 2.73%. The total yield for the combined assets was 5.70%. As of Q4 2012, Ellington had a non-agency NIM of 7.60%, an agency NIM of 2.32%, and a total NIM of 4.71% for its combined assets.

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During 2012, Ellington has been shifting its capital and assets towards whichever assets provided the best overall return. As of Q4 2012, the majority of Ellington's capital was deployed towards non-agency mortgages. Ellington has not been shy with its use of leverage to boost returns, with a leverage ratio of 11.86X for its agency assets. However, the non-agency assets only have a leverage ratio of 0.52X. The aggregate leverage ratio for its combined assets was 1.79X as of Q4 2012.

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Ellington's shift to non-agency assets proved to be very profitable in 2012. During 2012, Ellington's non-agency assets returned a total of $129.8M, for a gross profit of 30.02%. This is a significant increase from 2011, where the same assets only returned $1.5M, for a total return of only 0.39%. Meanwhile, Ellington's agency assets only produced a gross profit of $37.7M, or 8.72% in 2012. This is much less than the $63.6M, or 16.47%, of gross profits generated in 2011.

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A clarification on the February 2013 book value and the special dividend

Ellington has a good habit of reporting its book value on a monthly basis. Below is a list of estimated book value per share for the prior three months:

Book valueNet ChangeDividend
November 30, 2012: $24.02
December 31, 2012: $24.37Plus $0.35
January 31, 2013: $25.69Plus $1.32
February 28, 2013: $24.52Minus $1.17$1.52

Notice that Ellington's book value suddenly dropped $1.17 in the month of February. However, this can be explained by the effects of Ellington's regular dividend of $0.77 per share plus an additional special dividend of $0.75 per share. Ellington went ex-dividend on February, 27. This is a total cash dividend payment of $1.52. Adjusting for these dividends, Ellington actually saw a gain in its book value of $0.35 in February.

Conclusion

As I stated in the intro, Ellington is a high-risk, high-reward type of stock. The assets that generate its income are very risky. However, the book value gains shown by this stock during the previous three months should not be ignored. Using the adjusted February figure, Ellington has managed to achieve an increase in book value of $2.02 per share, or 8.4%. This leads to an annualized book value increase of nearly 34%. Due to this possibility of outsized returns, I feel that Ellington is worth a small position in my portfolio.

Source: Ellington Financial Offers A 12.5% Yield And An Annualized Book Value Increase Of 34% So Far In 2013