ORC - Orchid Island Capital: Looks Like A Yield Trap

2023-07-07 09:13:34 ET

Summary

• Mortgage REIT company, Orchid Island Capital, is attracting investors with its 18% yield but may be a yield trap due to its poor performance.
• Despite a high dividend yield, the company has seen a price return of -86% and a total return of -29% over the last decade, with dividends also eroding.
• There is little reason to expect the company's performance to turn anytime soon and investors have many other places to put their money including risk-free treasuries yielding 5.25%.

Orchid Island Capital ( ORC ) is a mortgage REIT company that focuses on sub-sector of residential mortgage-backed securities. The company's business involves investing into agency-backed (government guaranteed) RMB securities, focusing on single-family homes in a leveraged way using borrowed money. The company basically makes money from the yield curve difference between its interest spend (margin interest) and its interest income (mortgage payments). The company is organized as a REIT for tax purposes and its assets are managed by a third-party firm called Bimini Capital Management, so Orchid Island's expenses also include fees paid to this company.

The company seems to attract a lot of attention from yield-hungry investors with its 18%, but it also has makings of a classic yield trap. Yield traps are types of stocks or funds that attract investors with a tempting high dividend yield but they usually lose so much value in principal that large dividends don't even help recoup losses let alone resulting in profits. After all, there is little point in investing your money in a stock or fund that pays $1 in annual dividends when it drops $2 in value every year.

Yield traps don't become yield trap intentionally. It's not like the management of these companies or funds are trying to scam people or anything. It just happens that most of them are badly managed, suffer from poor execution or just happen to be at the wrong industry at the wrong time. The best way of identifying a yield trap is to look at a stock or fund's total long-term returns in relation to its yield. If a fund has a zero or negative long-term total return after reinvestment of dividends, that's a pretty big red flag. Ideally, a stock or fund's total return should be at least half of its yield but hopefully more than that. For example, if a stock or fund has a yield of 10%, its total return (after reinvestment of dividends) should not fall below 5% and ideally be above 10%.

ORC currently enjoys a dividend yield of 18%, but the stock has a price return of -86% and total return of -29% in the last decade. In other words, even if you collected all those rich dividends and reinvested them all, you'd still lose a third of your original investment and this is before we even include inflation in the calculation.

Many times dividend investors seeking high returns make the argument that they don't care what happens to the share price as long as dividends keep coming. After all, they are invested in these types of stocks for the dividend, and they don't plan on ever selling as long as the stock keeps paying a high yield. These investors usually plan on living off dividends until they pass from this world and possibly even pass it to their children and heirs. The problem with ORC is that its dividends keep eroding as fast as its share price is. In the last decade, the fund's dividend per share dropped from 80 cents to 16 cents. If you had bought this stock a decade ago because of its 20% yield, your current yield on your original investment is only about 5% and likely to keep dropping in the future too.

One might look at ORC's book value history and find that the company's book value rose by 900% in the last decade. It looks impressive until you realize that the company's number of diluted shares rose by more than 5600% during the same period. Basically, ORC's book value per share dropped by about 85% during the last decade which also explains why its dividends kept shrinking.

Mind you, this performance came during a decade of prosperity where residential home prices had one of the strongest decades in history and mortgage delinquency rates kept dropping. In the last decade, home prices in the US doubled, while mortgage delinquency rates dropped from almost 8% to 1.7%. There is no excuse for mortgage companies to underperform under these conditions other than bad management, bad execution, and overleverage. It also makes one wonder if this company performed this badly during one of the most favorable periods in modern history, how will it perform when things get tough?

I've seen people blame the rising Fed Funds Rate and yield curve for this company's underperformance, but I don't buy it. The Fed has been hiking rates for a little over a year, and we've seen the yield curve go negative during this time, but this company has been underperforming for over a decade. When we look at the company's earnings history we see a lot of ups and downs but more downs than ups.

Investors can do a lot better than this, especially when the risk-free treasury rate is 5.25%. I am personally not a big fan of Mortgage REITs to begin with because most of them underperform in the long run, but at least there are a few Mortgage REITs that perform nicely in the long run such as Arbor ( ABR ). This is not one of those rare mREITs that outperform, though. If anything, it underperforms even the average mREIT. There are very few Mortgage REITs that outperform in the first place, and if you must absolutely buy a mREIT, there are better options out there.

If something appears too good to be true, it probably is. If a mortgage company offers a dividend yield of 20% while mortgage rates are around 4-6%, you must be very careful about investing in it. At the best-case scenario, it's a well-managed but overleveraged company. At the worst-case scenario, it's a badly-managed and overleveraged company, the worst combination. ARC might be one of those companies, unfortunately.

Does that mean investors should short this company? I'd say not. Markets can remain irrational far longer than you can stay solvent, and there are periods where even stocks like this can outperform. For example, between March 2020 and December 2020, the stock's total return was 128%. If you short this stock, you could get caught in a rally like this, and I don't think the risk is worth it.

Valuation-wise, the company trades for a P/E of 30, but the company's P/E history is a bit spotty because it has a history of swinging between being profitable and posting a loss. This is why the P/E chart of the company below has many gaps. Meanwhile, ORC trades at a price-to-book value of 0.84 which means it is currently trading at a 16% discount to its book value. This is slightly below the company's historical average, but it's probably not enough to warrant buying considering the company's chronic performance issues. Also, many investors believe that REITs should be priced based on price to FFO (funds from operations) metric instead of P/E (Price to Earnings) but ORC hasn't posted a positive FFO since last year which makes it difficult to use this metric as well. In fact, it posted a negative or zero FFO in four out of the last five years, making it difficult to calculate its value from this particular metric.

Investors should be much better served by building a well-diversified portfolio with different types of assets that have a long-term track record of outperformance and stay "long" in the long run. There is no need to waste your time or money on an eroding asset when there are so many assets that might help you grow your wealth, income, or both.

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