AAIC - 12% Or Higher Dividend Yields With 15% To 32% Discounts

2023-05-31 18:07:28 ET

Summary

• Big yields and even bigger discounts on each share here.
• A buyout drove one of our positions up about 40% in a day.
• The REITs we're highlighting here don't unusually trade at such large discounts to book value.

Get ready for charts, images, and tables because they are better than words. The ratings and outlooks we highlight here come after Scott Kennedy’s weekly updates in the REIT Forum. Your continued feedback is greatly appreciated, so please leave a comment with suggestions.

I’ve got several shares to mention here.

EFC and AAIC

Ellington Financial ( EFC ) has a 14.4% dividend yield and trades at an estimated .85 price-to-book ratio using our estimate for current book value (as of 05/26/2023) at $14.70. Shares dropped hard on the announcement EFC was acquiring Arlington Asset Investment Corp. ( AAIC ). You may recall in prior articles that we were very bullish on AAIC. We’ve given it plenty of rude labels over the years, but we still said the discount to book value was too large to last. AAIC was positioned in a way that would generally protect book value from big declines. That meant it was a waiting game. It took quite a while, but the buyout came through. While we made that argument, it was refreshing to see another analyst do the same. Koneko Research made a compelling case for replacing the CEO (J. Rock Tonkel) with an actual rock.

EFC is getting a reasonable deal in this transaction. Most of the purchase is in a stock-for-stock deal, and the valuation is comparable. EFC should see slightly improved scale on operating costs. For AAIC, it's a huge improvement. EFC is technically issuing stock at a discount to book value, but they are also buying AAIC at a discount to book value. The impacts should offset, so it is basically neutral. From an accounting perspective, it may actually turn out well.

AAIC’s portfolio has extremely low leverage. That was good for AAIC, since it kept the value relatively stable while waiting for a buyout. However, when EFC acquires them, they could leverage the portfolio by buying MBS at market rates. Due to the way portfolio yields are calculated using historical amortized costs, REITs buying assets today are reporting much higher yields. That could improve market perception because the market simply doesn’t understand mortgage REIT earnings.

With EFC at $12.53 and AAIC at $4.12, shares of AAIC are still the cheaper option. Even after adjusting for differences in expected dividends, AAIC is cheaper by about 4.5% to 7%. Of course, changes in dividend expectations would move the math.

RC

Ready Capital ( RC ) has a 15.8% dividend yield. Will it be sustained for the next decades? Probably not. I doubt investors get 158% of the price back in dividends alone over a decade. However, they're still offering a great yield combined with a substantial discount to book value.

We’re estimating the price-to-book ratio is about .68 based on a share price of $10.12 and an estimated book value of $14.85.

Is it normal for the price-to-book ratio to be this low? No.

The following chart provides the ratio of price to trailing book value per share.

Price-to-book ratios below .70 are not common. Outside of the pandemic, premiums to book value were common than discounts greater than 30%.

You should ask if RC simply destroys book value over time while they pay out their dividends. No. Book value is lower today than it was in early 2017, but it fell by less than $2.00 over that time.

That’s pretty good for a mortgage REIT. They took a hit during the pandemic, then stabilized and pushed BV higher. We’re forecasting a modest decline since late 2022, but it’s still a modest impact.

RITM and PMT

How about Rithm Capital ( RITM )? The dividend yield is 12.2% at $8.17 per share and price-to-book is around .71.

Or PennyMac Mortgage Investment Trust ( PMT ) at $11.64? The dividend yield is 13.7% and price-to-book is around .74.

How do those shares look on the chart?

Contrast the drop in RITM’s share price with the performance on book value:

Keep in mind that these REITs are spitting out big dividends. You’re not expecting book value to trend higher. Relative to the start of 2022, book value per share was slightly up. On the other hand, the share price was down quite a bit. We want to catch opportunities where the share price is more likely to increase than fall. The odds are better when we start with a share price that is well below book value.

What about PMT? Book value declined more for PMT than for RITM, but most of 2022 was pretty rough for mortgage REITs. It’s been quite rare to see PMT shares dip this far below book value:

Recap

AAIC is still the cheaper way to get EFC. We own some AAIC. We bought it months ago because we expected eventually we would either see a dividend declaration or a buyout. Either one would drive a much higher price-to-book ratio. Since I’m saying we bought shares when the dividend yield was 0% because we expected an eventual catalyst, I really should back that up with some evidence. As an analyst who actually buys the stocks he covers, here’s the evidence every analyst should provide :

Oops, that one turned out a bit early. Notice that the order was for 2,200 shares, but 2,060 shares didn’t execute. We only got 140 shares in that trade.

We went back twice more in January 2023:

Schwab changed the way they do trade confirmations, so I had to use the new page:

Looking at our other common share positions, we also have a big position in RITM and a small position in RC. You’ll see a full list of our positions for the sector in the disclosure.

We trade our positions actively, so they will change when we see better values in other shares.

These unusually large discounts are even more attractive because the spreads between MBS and Treasuries are unusually wide. That pushes book value lower, but increases the expected future income.

Bullish views on RITM, PMT, and RC. The discount on EFC is moderately attractive. However, that’s not enough for me to hit with a rating today.

Plenty of preferred shares I wanted to cover, but we're out of time. Thanks for reading and enjoy the charts.

Stock Table

We will close out the rest of the article with the tables and charts we provide for readers to help them track the sector for both common shares and preferred shares.

We’re including a quick table for the common shares that will be shown in our tables:

If you’re looking for a stock and I haven’t mentioned it yet, you’ll still find it in the charts below. The charts contain comparisons based on price-to-book value, dividend yields, and earnings yield. You won’t find these tables anywhere else.

For mortgage REITs, please look at the charts for AGNC, NLY, DX, ORC, ARR, CHMI, TWO, IVR, EARN, CIM, EFC, NYMT, MFA, MITT, AAIC, PMT, RITM, BXMT, GPMT, WMC, and RC.

For BDCs, please look at the charts for MAIN, CSWC, ARCC, TSLX, TPVG, OCSL, GAIN, GBDC, SLRC, ORCC, PFLT, TCPC, FSK, PSEC, and MFIC.

This series is the easiest place to find charts providing up-to-date comparisons across the sector.

Residential Mortgage REIT Charts

Note: The chart for our public articles uses the book value per share from the latest earnings release. Current estimated book value per share is used in reaching our targets and trading decisions. It's available in our service, but those estimates are not included in the charts below. PMT and NYMT are not showing an earnings yield metric as neither REIT provides a quarterly “Core EPS” metric.

Second Note: Due to the way historical amortized cost and hedging is factored into the earnings metrics, it's possible for two mortgage REITs with similar portfolios to post materially different metrics for earnings. I would be very cautious about putting much emphasis on the consensus analyst estimate (which is used to determine the earnings yield). In particular, throughout late 2022 the earnings metric became less comparable for many REITs.

Commercial Mortgage REIT Charts

BDC Charts

Preferred Share Charts

I changed the coloring a bit. We needed to adjust to include that the first fixed-to-floating shares have transitioned over to floating rates. When a share is already floating, the stripped yield may be different from the “Floating Yield on Price” due to changes in interest rates. For instance, NLY-F already has a floating rate. However, the rate is only reset once per three months. The stripped yield is calculated using the upcoming projected dividend payment and the “Floating Yield on Price” is based on where the dividend would be if the rate reset today. In my opinion, for these shares the “Floating Yield on Price” is clearly the more important metric.

Preferred Share Data

Beyond the charts, we’re also providing our readers with access to several other metrics for the preferred shares.

After testing out a series on preferred shares, we decided to try merging it into the series on common shares. After all, we're still talking about positions in mortgage REITs. We don’t have any desire to cover preferred shares without cumulative dividends, so any preferred shares you see in our column will have cumulative dividends. You can verify that by using Quantum Online. We’ve included the links in the table below.

To better organize the table, we needed to abbreviate column names as follows:

• Price = Recent Share Price - Shown in Charts
• BoF = Bond or FTF (Fixed-to-Floating)
• S-Yield = Stripped Yield - Shown in Charts
• Coupon = Initial Fixed-Rate Coupon
• FYoP = Floating Yield on Price - Shown in Charts
• NCD = Next Call Date (the soonest shares could be called)
• Note: For all FTF issues, the floating rate would start on NCD.
• WCC = Worst Cash to Call (lowest net cash return possible from a call)
• QO Link = Link to Quantum Online Page

Second Batch:

Strategy

Our goal is to maximize total returns . We achieve those most effectively by including “trading” strategies. We regularly trade positions in the mortgage REIT common shares and BDCs because:

1. Prices are inefficient.
2. Long term, share prices generally revolve around book value.
3. Short term, price-to-book ratios can deviate materially.
4. Book value isn’t the only step in analysis, but it's the cornerstone.

We also allocate to preferred shares and equity REITs. We encourage buy-and-hold investors to consider using more preferred shares and equity REITs.

Performance

We compare our performance against four ETFs that investors might use for exposure to our sectors:

The 4 ETFs we use for comparison are:

When investors think it isn’t possible to earn solid returns in preferred shares or mortgage REITs, we politely disagree. The sector has plenty of opportunities, but investors still need to be wary of the risks. We can’t simply reach for yield and hope for the best. When it comes to common shares, we need to be even more vigilant to protect our principal by regularly watching prices and updating estimates for book value and price targets.

Ratings: Bullish on RC, PMT, RITM

For further details see: