Ellington Financial Corp.'s Strategy Outperforms, Yet The Stock Trades At A Huge Discount To Peers

Summary

• Although structured as a master limited partnership (MLP), Ellington Financial Corp. (EFC) is essentially a diversified mortgage REIT (mREIT) that has lagged its mREIT peers due to its conservative hedging.
• The hedging is finally paying off as Ellington's book value has grown nicely in the first two months of the year while peers expect losses.
• What's more, EFC is aggressively buying back stock at deep discounts in a huge win for shareholders.
• With volatility on the rise and EFC's strategy working, EFC deserves to trade in line with its peers, not at a big discount.

Before we start, let's make one thing clear: Ellington Financial Corp. (NYSE:EFC) is a master limited partnership (MLP), so if you don't want to deal with filing an annoying K-1 tax form or only have IRA money, EFC is probably not for you. I don't like filing K-1s either, but I'm willing to put up with extra hassle for an attractive return opportunity, which I think EFC currently offers. (As a side note, many believe that MLPs are tax disadvantaged now relative to REITs, but this Forbes article seems to state otherwise: 2018 Tax Guide To MLPs.)

Although technically an MLP, EFC invests like a mortgage REIT (mREIT). As shown in the figure below, EFC is primarily invested in mortgage-related investments such as RMBS, CMBS, and residential loans, even as it has diversified its portfolio with CLOs, consumer loans, and ABS:

Source: Q4 Earnings Presentation

With credit spreads tight and interest rates on the rise, one can reasonably ask why invest in an mREIT-type investment, especially one that owns exotic risky stuff such as collateralized loan obligations (CLOs) and asset-backed securities (ABS)? I thought the same thing myself, but I found EFC too compelling to ignore for the following reasons:

• EFC is trading at 22%+ discount to diluted NAV and aggressively buying back stock, allowing investors to benefit from a 22%+ risk-free arbitrage.
• EFC has a strong long-term performance record of consistently growing book value per share. Notably, this includes navigating the last financial crisis in which many credit-related mREITs went bankrupt.
• EFC has a conservative philosophy with substantial credit and interest rates hedges to preserve book value through difficult market conditions.
• The buyback and hedges have been working. EFC has been growing book value in 2018, while its hybrid mREIT peers have had flat-to-declining book values.
• EFC offers an 11% attractive dividend yield.

Sizable Discount to Book Value

EFC announces its prior month book value around the 7th of every month. This is in contrast to most mREITs that publish book values quarterly with occasional mid-quarter guidance given during earnings calls. I particularly like EFC's monthly disclosure, as it helps reduce investor uncertainty in volatile interest rate markets.

EFC just announced a book value per share of $19.05 as of February 28, 2018. With a recent market price of $14.76, EFC is trading at an attractive 22.5% discount to book value. What makes the discount even better is the fact that EFC is taking advantage of it by buying back shares. I discuss the logic of buybacks at deep discount in a blog on FSIC:

Heavily Discounted FS Investment Is Attractive, But Needs To Buy Back Shares - MicroValue

EFC's CEO Larry Penn understands the power of deep discount buybacks. Here is an excerpt from the Q4-2017 conference call transcript from Seeking Alpha:

Larry Penn

During the fourth quarter with our share price trading at a significant discount to book value we saw an attractive opportunity to repurchase our shares aggressively. We bought back nearly $10 million worth of our stock or more than 2% of our shares outstanding which was accretive to book value by $0.08 per share. Since quarter end we have purchased an additional 1.5% of our shares outstanding and last week our board of directors reloaded our repurchase program with an additional 1.55 million shares or about 5% of our total shares outstanding.

3.5% of outstanding shares is an aggressive buyback and makes me extremely happy. Soaking up selling pressure, the buyback more importantly earns huge risk-free returns for shareholders, returns that show up in accretion to (i.e., improvement in) book value per share. For example, Mr. Penn mentioned that share repurchases in Q4 added $0.08 to book value per share.

EFC will continue to benefit from book value accretion as long as EFC stays heavily discounted and the company stays committed to repurchasing shares. The company just demonstrated that commitment by reloading the buyback authorization by another 1.55 million shares or roughly 5% of shares outstanding. In prior calls. Mr. Penn indicated that when EFC trades at a 20% discount or greater, they want to be actively buying back shares. The 20% discount level thus appears to be an important level for gauging potential buyback activity.

Strong Long-term Track Record

Any high-yielding instrument entails significant risk, particularly in this low-yield environment. The market is strewn with the bodies of investors chasing yielders without understanding the risks of their investment.

One major component of due diligence is looking at the long-term track record of the investment manager. In the case of EFC, the chart below demonstrates their solid long-term track record of positive returns on book value:

Source: Q4-2017 EFC Earnings Presentation

EFC has grown book value an annualized 10.2% per year over a roughly 10-year time period from August 2007 through December 2017, a period that includes the financial crisis. In fact, EFC's portfolio held up quite well in the financial crisis even as some of their credit-related mREIT peers experienced huge losses or even went bankrupt. This exemplary performance in that historic downturn makes me more confident that EFC will be able to navigate future economic turmoil as well.

This performance also gives me some comfort that EFC will properly manage its portfolio of complex and diverse investments. In the hands of a savvy portfolio manager (think PIMCO), exotic and diverse investments can lead to outperformance as the manager has more choices for finding the best risk-adjusted opportunities. In the hands of a poor portfolio manager, such exotic investments can become weapons of mass(ive) book value destruction.

Conservative Investment Philosophy Employing Significant Hedging

All mREITs hedge interest rate risk to varying degrees because there is a big trade-off: The more interest rate risk you hedge, the lower your core income. By keeping hedges low, mREITs can throw off huge income, but then book value gets decimated in a rising-rate environment.

Below EFC shows the instruments that it uses to hedge the interest rate risk in its portfolio of mortgage-related investments:

Source: Q4-2017 EFC Earnings Presentation

The purpose of these hedges is to decrease the sensitivity of book value to changes in interest rates. This can be characterized by an interest-rate sensitivity table that all mREITs publish:

Source: EFC Q3-2017 10-Q

For an mREIT, EFC has an amazingly low sensitivity to interest rates. A 100 basis point increase in rates is forecasted to lead to only a 1.41% decline in book value.

In contrast, consider MTGE Investment (MTGE), a hybrid mREIT peer that currently trades at a premium to EFC. From MTGE's latest 10-K, a 100 basis point rise in rates is forecasted to lead to a whopping 8.2% decline in book value.

Source: MTGE Dec. 2017 10-K

Now, these estimates are just approximations based on a shift across the yield curve. In reality, rates and book value don't exactly move that way. However, these tables do give you an indication of relative interest risk, and EFC appears to be much less risk prone with respect to interest rates.

What about credit risk? EFC is invested in instruments like CLOs, non-agency RMBS, CMBS, and ABS that have significant credit risk. With credit spreads tight, these investments can keep me up at night. However, EFC is one of the few mREITs that actually hedges its credit risk by shorting other credit-sensitive instruments as shown below:

Source: Q4-2017 EFC Earnings Presentation

The downside to credit hedges is that they can be a significant drag on income as credit hedging involves paying out what are essentially insurance costs. These costs are one of the reasons EFC has lagged its peers over recent years. However, credit hedges can be indispensable in times of crisis, and now seems like an appropriate time to be "playing defense" by hedging the credit portfolio.

I can't guarantee that EFC's credit hedges will offer sufficient protection in the event of a financial crisis. What I do know is that EFC survived the last financial crisis and has had much more stable book value returns than its peers, as evidenced in the chart below:

Source: Q4-2017 EFC Earnings Presentation

EFC's book value standard deviation is far below that of all of its peers, which is yet another indication that EFC could hold up better in a downturn.

Strategy is Working Well So Far in 2018

In 2018, hedges and share buybacks have been working great for EFC. From December 31, 2017, to February 28, 2018, EFC has grown book value per shares from 18.84 to 19.05. The return is 3.3% if you factor in the 0.41 dividend.

This is excellent mREIT book value performance in a rising rate environment and exceeds the expected performance of EFC's hybrid mREIT peers. Here is a sample of company Q1 book value guidance from recent earnings calls. The guidance is all flat to down:

• Chimera Investment (CIM): "down less than 1%"
• Dynex Capital (DX): "down less than 3%"
• MTGE: "down 1% to 2%"
• Two Harbors Investment (TWO): "roughly unchanged"

By the way, agency mREITs are taking it much worse than the hybrid mREITs. When an analyst asked CYS Investments (CYS) if book value could have declined by a "high-single-digit decline" percentage, CYS indicated that "Yes, I think you can there with the math pretty easily."

Net-net, although EFC has lagged its peers in recent years due to its conservative approach, in recent volatile markets its strategy has significantly outperformed.

Dividend is Attractive But Has Been a Source of Criticism

There are a couple of reasons I put dividend yield last. First, if a company is taking too much risk or has a bad long-track record, I don't care how high the yield is. I have seen too many "yield trap" investments lead to disastrous investment results.

With a 0.41 dividend, EFC currently yields 11%, which is more than ample for me. However, a valid criticism is that EFC has not been fully earning its dividend, which it has had to cut it in recent years. I personally am content with a lower yield (even just 7% or 8%) if I get steady returns with low book-value volatility. I'd much prefer that to a high yielder that pays 13% a year but loses 5-7% in one bad quarter and then has to cut its dividend to preserve its liquidity. That said, underearning the dividend is never a good thing.

While not yet fully earning its dividend, EFC has indicated it will continue ramping up credit investments and hopes to start fully earning its dividend by the middle of this year. It has not kept similar predictions in the past, so such guidance should be taken with a grain of salt. On the positive side, this year's book value performance has been excellent so far, which bodes well for the prospect of EFC maintaining its dividend in the near term.

Target Return

I think EFC deserves to trade at least in line with its peers due to its conservative hedge strategy and aggressive buyback plan, the latter of which helps put a floor on the stock while building shareholder value. For years, EFC has been punished for its conservative strategy as its returns have lagged that of its peers. Now that strategy is finally paying off, yet EFC has not received the credit it deserves: EFC's strategy is outperforming, but it still trades a large discount relative to peers:

	EFC	MTGE	DX	TWO	CIM
Price	14.76	17.55	6.33	15.305	17.405
Book value	19.05	20.75	7.34	16.31	16.85
Discount	-22.52%	-15.42%	-13.76%	-6.16%	3.29%
Book value date	28-Feb-18	31-Dec-17	31-Dec-17	31-Dec-17	31-Dec-17

Click to enlarge

Recall that other mREIT book values were forecast to be flat to down for 2018, so I believe this discount comparison is more than fair to EFC's competitors.

As EFC continues to prove the value of its strategy, I believe that market will eventually afford EFC a valuation more in line with its peers. In fact, if interest rate volatility persists and EFC can maintain a stable book value, it will have the capital to scoop up cheap assets with which to generate attractive long-term returns.

Using a target discount of 15% (from the current 22.5% discount) along with a dividend yield of 11%, I project a potential total return of 18.5% over the next 12 months.

Risks

• EFC makes investments that have significant interest rate and credit risk and does so utilizing leverage. Although EFC strives to hedge its portfolio risks, there is no guarantee that it will successfully do so, in which case, it could experience a major decline in book value. Recent book value gains should not be expected to continue indefinitely.
• EFC has not been earnings its dividend. If EFC does not improve its core earnings, EFC could end up cutting its dividend in the future.
• If interest rates continue to rise or credit problems start to occur, negative investor sentiment could lead to a sector-wide sell-off of hybrid mREITs, including EFC.
• It would be a significant negative if EFC were to discontinue the share buyback program. Discontinuing the buyback would remove a key support to the stock price and end the benefits of accretive share repurchases.

Analyst’s Disclosure: I am/we are long EFC. 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.

Comments

[tadsuhm]

Thank-you

[metronome44]

Disagree with DVL above. Mgmt is very smart and experienced. Look up there resumes. EFC hasn’t performed well because they have been conservative with hedges not because they don’t know what they are doing. Most mreits & bdc’s just go long and pray. These guys operate more like a hedge fund and like hedge funds they have underperformed because we’ve been in a bull market and they haven’t gone all-in long.

[PennyPlanSupporter]

There is "underperformance" and then there is "terrible performance much worse than a random toss of a dart at a page of equity and debt listings".

[MicroValue]

You have to differentiate portfolio performance from stock performance. Management directly controls the performance of the investment portfolio. Management does not directly control stock price performance, which can deteriorate significantly if the manager's investment approach goes out of style.

This is which happened in the case of EFC, which is now trading at a 20%+ discount. EFC has gone out of favor as its hedged approach has been underperforming. It has been underearning its dividend, while its less-hedged peers have been earning double-digit ROEs in the recent stock and bond bull markets. Note that EFC has been earning positive portfolio returns, just not enough to cover the high dividends.

Now, however, we are finally starting to see the benefits of EFC's hedged strategy. For instance, AGNC just announced a large drop in its February NAV, while EFC is up nicely for the year.

Also, EFC is finally taking aggressive action to buy back stock at deep discounts. If they continue to do so, this should support the price to prevent further discount widening. Even better, these share repurchases are very accretive to NAV.

This may be cold comfort to those who bought earlier and see the stock trading at 20%+ discount, but for those buying now I feel EFC's discount offers an attractive entry point. And there is always the possibility the discount will narrow as the company's hedged approach may come back into style.

[MicroValue]

One clarification. They did have a horrible 2016, with a negative book value return due to losses on corporate credit hedges, but other than that yearly book value returns have been solid if not spectacular.

[PennyPlanSupporter]

Terrible management and a history of dividend cuts

[Hampton108]

Have owned EFC since it paid .77 cents per quarter dividend...and though I won’t see the entire return of my investment, the dividends have taken the sting out of my losses. At today’s price and lower is a good entry point. Don’t foresee another dividend cut for awhile...

Long: EFC

[MicroValue]

Yes unfortunately investor returns can be much worse than book value returns when a company goes from a premium or modest discount to a deep discount. That is why I mostly avoid companies at premiums, but then I miss out on some great businesses such as NRZ or MAIN, so there is no perfect solution.