Resource Capital Corporation (NYSE:RSO) was more than a falling knife - it was a falling sword. Shares plunged dramatically a week ago and created the best buying opportunity the sector has seen since around the middle of the second quarter. It was an incredible sale, with shares falling as low as around $7.50-7.60 before a rapid rally began. Shares were up to $9.47 by the end of the week, but on Monday, they closed back at $9.28. (Note: I broadcast that this was a great sale event and acquired shares around $7.88.)
Thoughts on RSO at $9.28
The mortgage REIT still offers an attractive value and is still superior to most mortgage REITs in the sector using prices as of the close on 11/21/2016. Trailing book value per share is $14.71. Since management indicated they were still looking at applying a few additional impairments, we should expect book value will probably end a little lower than it began. However, a substantial number of mortgage REITs may report declining book values, since several of them carried positive duration into a period where the yield curve rose and steepened significantly.
The price-to-trailing book value ratio is now resting at 63%, which puts RSO at the lowest level in the sector by a significant margin.
Some investors may try to argue that Five Oaks (NYSE:OAKS) is trading at a very similar discount to book value and may not be applying impairments in the fourth quarter. I believe those investors fail to understand how the stock dividend paid by OAKS will influence book value per share. I'll have some public analysis submitted on it soon. Suffice it said, I firmly believe RSO still carries the largest discount by a substantial margin among the mREITs I'm covering frequently.
(Disclosure: I have a bearish view on OAKS and may enter a trade that reflects the view.)
Why RSO Still Gets a Buy Rating
The company isn't trading around 53% of trailing book value anymore, but a 63% ratio is still extremely attractive. Further, despite expecting some impairments, the new book value should be dramatically higher quality than the older book value because the new management team went through to scrub the balance sheet of inflated values. The challenge with having so many level 3 assets is that it is very difficult for shareholders to verify their value. My arguments fell on deaf ears at times over the summer when RSO regularly ran over $13 per share, but it seems to be catching hold. If only investors would take the next step and recognize that after the values were written down, the company should trade at a higher ratio to book value.
Yeah, The Dividend Stinks
Shares carry a dividend of only $.20 per year now based on management's guidance during the earnings call. I can deal with that. The return on my position so far is about 17.7%. That isn't too shabby. In one week, the gain was larger than the yield investors expected to get in a year.
This isn't an income play any longer. Now it is a play on capital appreciation based on the future value the company will have. Management is planning to create a leaner and more efficient company rather than the bloated piece of garbage that I gave multiple sell ratings on over the summer. Management came right out on the earnings call and addressed the failures of their dividend. They stated it had been a return of capital rather than a return on capital, and that it was something that needed to change.
What it Looked Like in Chat
To give investors a feel for what it looks like when an analyst finds this opportunity, I'm providing some screenshots from chat. As you'll see from the time stamps, the work had to be done extremely fast. The exchanges span a total of only nine minutes.
Update to the Chat
When I was chatting in the subscriber room, I didn't know RSO would end the AFFO strategy and bring out core EPS. Management indicated this point very clearly on the earnings call (see link above). Consequently, I had to assume the worst and determine if RSO would still make sense as an investment. Due to the very low share price, I determined that the risk/reward profile was heavily skewed in favor of reward.
Management also provided guidance indicating they expected to record another material loss within the fourth quarter, but it looks like RSO is moving to have very reliable accounting. I can't complain about that. I'm not going to put RSO in the "best of breed" category until I see management follow through on all of their statements, and even then it would be difficult. However, I will say that I believe shares are worth substantially more than $7.90.
The decision to end the use of AFFO was excellent and really cemented the image of RSO as a mortgage REIT transitioning to better transparency and a stronger focus on building up value for the shareholder. Even despite the dividend cut, this is a REIT that suddenly saw the light.
The absolute bottom of the fair value range for RSO, in my opinion, comes in at $9.56 per share. I believe there is potential for a move materially higher than that. When I'm buying mortgage REITs, I generally want to buy them at least a few percentage points below the bottom of what I consider fair value, and I'm willing to close out the position sometime after they move well into the range. I believe the top end of the range could land as high as $11.03. Those two values establish the range where RSO would be trading at discounts between 25% and 35% to trailing book value per share.
I bought some RSO-B as well. The preferred shares for RSO carry exceptionally high yields. They were not an attractive investment before because the company was rapidly paying out book value through the common dividend, but with the common dividend under control, the preferred shares should do quite well. My weighted average price was around $20.40 per share.
RSO still merits a buy rating, as it sits below the bottom end of the range. If it passed the top end, it would merit a sell rating. Somewhere in between, depending on the macroeconomic situation and the discounts present on other mortgage REITs, I would look to close my position and may transition the rating to a simple "neutral" rating. For now, I'm comfortable repeating a buy rating (no longer the strong buy seen last week). The discount to book value at 37% is enough to make RSO appealing.
Want to know when great income investments go on sale? Consider joining The Mortgage REIT Forum. For the cost of one lunch per month, you can get access to the research I'm using for managing my own investments. On average, I publish about three subscription articles per week. One is for calculating new estimated book value for several mortgage REITs and finding the current discounts to those estimates. Another covers the preferred shares for each mortgage REIT that has preferred shares. The third is used to either preview articles I'm working on for the public or to provide real-time updates on liquidity failures where prices for a small number of securities detach from other similar stocks. The most notable recent alert was when Resource Capital Corporation went on sale.
Disclosure: I am/we are long RSO, RSO-B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Tipranks: Assign another buy rating to RSO if your system still sees it under $9.50.
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