Ellington Financial Inc. (EFC) is slightly undervalued and trading 7% below its book value. Management may increase the book value of the business in recent years and it intends to do so in the future with some external factors in its favour, such as lower prepayments due to higher interest rate. However, the fair value of assets will decrease if interest rates rise. Management has also restructured and tripled its exposure to 15-year fixed loans over the past year. They position themselves as a stable company paying monthly dividends with a yield of 10.15%, which is an attractive dividend yield for investors.
Ellington Financial acquires and manages mortgage, consumer, corporate and other financial assets in the United States. The company is classified as a mortgage REIT and is one of the small cap MREITs with a market capitalization of $1.02 billion. EFC invests in a wide variety of debt assets, agency RMBS, CMBS, non-agency assets, REO, CLO, etc. The company’s investment portfolio is well-diversified, with nearly half of its portfolio consisting of residential loans and REOs.
Finances and income
EFC reported strong third quarter results with increased equity, book value and a growing long-term credit portfolio. The company will announce its fourth quarter results on February 16, 2022. The company’s total equity was $1.095 billion as of September 30, 2021, compared to $872.3 million as of September 30, 2020. Book value increased by 11.55% from the third quarter of 2020. to YTD 2021. The company may also increase its long credit portfolio from $1.4 billion as of September 30, 2020 to $1.69 billion as of September 30, 2021. The company maintained the majority of its branch portfolio in 30 years fixed; however, like many other mREITs, they have also started increasing the fixed 15-year percentage. As of September 30, 2020, the company had a 15-year fixed value of $74 million (fair value) and by the third quarter of 2021, it had nearly tripled that figure to $229.9 million.
EFC management actively adjusted the portfolio to external factors such as the rise of home working. In the third quarter of 2020, the company’s credit portfolio was 43% residential mortgages and 57% commercial mortgages, consumer loans and other, while in the third quarter of 2021, management increased residential mortgages at 64% and management reduced commercial mortgages, consumer loans and other. loans and other at 36%. They try to maintain a flexible approach to allocating capital to sectors where they see the best relative value as market conditions change. EFC issued 6.303 million common shares in a follow-on common stock offering in July, increasing its total capital by $113.1 million (approximately 12%).
EFC is fairly valued at the moment with the potential to be a bit undervalued. The company is trading 7% below its book value and the book value has been rising for 3 years. In the third quarter of 2020, the company’s book value per share was $16.45 after total declared dividends of $0.27, while as of September 30, 2021, the BV per share was $18.35 after the declaration of total dividends. We also have an estimated book value per share for December 2021, and it’s $18.39. I like to see companies that can grow their book value over a long period of time because it means management is allocating shareholder capital well. EFC has been successful in preserving book value through market cycles, such as the pandemic, while delivering strong results for investors. Based on these numbers and the current portfolio, I calculate 5-10% growth in EFC’s book value per share for the next few years. 2022 could be less rich in growth due to increases in interest rates which can affect the fair valuation and the overall book value of the portfolio.
EFC yields 10.15%, which is a very attractive figure for income investors. If we look at this number against the current valuation, we can see stocks that are a bit undervalued. Based on its dividend yield, the company is back to “normal” pre-pandemic dividend yield levels and investors can buy the company at a better yield than in 2021.
Company specific risks
Rising interest rates will affect the fair value of EFC’s assets. However, they hedge the entire yield curve to hedge against volatility, defend book value and better control interest rate risk. They do this through swaps, US Treasury securities and other instruments to hedge interest rate risk.
EFC’s portfolio includes non-agency RMBS that are secured by residential mortgages that do not meet Fannie Mae or Freddie Mac underwriting guidelines. Therefore, the principal and interest of non-agency RMBS are not guaranteed by the GSEs. Non-Agency RMBS are subject to many of the risks of the respective underlying mortgages. Fortunately, a large portion of the portfolio is not made up of non-agency RMBS, but this risk factor is worth noting. A similar risk is the default rate. Certain securities they acquire are considered by rating agencies to present a significant vulnerability to default in payment of interest and/or principal. Many securities that the company acquires are subordinated in cash priority to other more “senior” securities of the same securitization.
Because many assets are not publicly traded, the value of some of the Company’s portfolio assets is not readily determinable. On a monthly basis, they value these assets at their fair value, as determined in good faith by the manager, under the supervision of the manager’s valuation committee. Prepayment risk rates generally increase when interest rates fall and decrease when interest rates rise. Since many RMBS, particularly fixed rate RMBS, will be discount securities when interest rates are high and will be premium securities when interest rates are low, such RMBS may be affected by variations in prepayments in any interest rate environment. As the FED and many analysts expect 4 interest rate hikes for 2022, this may help reduce prepayment risk on the company’s portfolio.
My take on the EFC dividend
EFC has been paying dividends for 10 consecutive years and yielding 10.15%. Management had switched to paying monthly dividends in 2019 and since then has made a cut due to the pandemic. The current dividend has been restored to pre-pandemic levels at $0.15 per share per month. This means that EFC has a one-year consecutive dividend growth record from 2020.
EFC has a payout ratio very close to 100%. In recent years, this distribution rate has been changing dynamically between 50 and 150%. It also means that management has actively adjusted the dividend payout to EPS. As they transitioned to monthly dividends from pre-2019 quarterly dividends, management had a simple goal: position the company for income-seeking investors and provide them with reliable monthly income. I think it will be a difficult task in 2022 due to the high payout rate but not impossible. The investment portfolio is healthy and diversified towards asset classes that can outperform office and retail REITs.
For investors looking for income, a dividend yield above 10% is more than attractive. Management has every intention of keeping the monthly dividend stable but I don’t expect any significant increases. The company is trading slightly below its book value and the dividend yield is fair compared to 2021 levels. I think EFC can be a decent part of a portfolio with growing book value and reduced prepayment risk for this year when interest rates begin to rise.