Description

* Please note this security is relatively illiquid (Avg $600k/day) and may only be appropriate for small funds and personal accounts.

We believe this is a good time to be hunting for value investments in the mortgage REIT space.   Valuations are low across the board at low 80’s of book value for agency mREITs and mid 80’s of book value for hybrid mREITs (agency and non-agency).  In speaking with Wall Street analysts, we’ve heard that there is very little interest in this asset class among investors.  After all, most investors believe interest rates are headed up.  Investors are fearful of holding any levered fixed income investments with interest rate risk.  We believe much of the pessimism of Wall Street is priced in at these prices, and the current price provides an attractive entry point for generating attractive risk adjusted returns over the next 2 years in the range of 50%. We expect EARN to generate core earnings of $2.60/year (of which $2.20/ year is paid out in dividends) and trade up to .95x of estimated 6/30/17 book value of $17.50.

There is a good writeup of EARN by Gandalf from January 5, 2014 that provides an excellent background on the company.  There have been recent writeups of other mREITs on VIC such as NLY and MFA that I would suggest as background material for the mREIT industry.  This writeup is meant to provide and update and reiterate the investment case for why EARN is a compelling investment at current prices.

Investment Thesis

1. Investor pessimism is largely priced in at current prices

While the stock market indices are close to all time highs and equity prices are discounting a fair degree of investor optimism, investors have largely fled the mortgage REIT sector as evidenced by the low valuations. The sector is trading in the low 80s to mid 80s of book value with a few outlier exception on the high and low end of the valuation spectrum.  Most mREITs disclose book value on a quarterly basis with a few reporting more frequently.  The book value disclosures provided by companies are pretty accurate as the underlying assets are mostly highly liquid MBS securities.  There are very few hard-to-value or illiquid securities where investors would have to rely on management estimates.  Intraquarter, the book values of some of the mREITs can fluctuate quite a bit as the the investments teams of the mREITs can reposition their assets and hedging to reflect changes in the macro picture or to generate trading returns. Thus, estimating intra-quarter book values can be challenging for some of the more active managers. Here is a comp sheet of current valuations:

The sector valuations have been depressed since the Taper Tantrum in 2013. Most of the mREITs got religion in 2013 and sharply increased their hedging to prepare for the Fed exiting QE, tapering its purchases of agency MBSs and the eventual rise in interest rates. Many investors fled the sector as they suffered two large draw downs in 4 years (during the financial crisis in 2009 and during the Taper Tantrum in 2013). Add to this the fear of rising interest rates over the next few years, which is already baked into the interest rate forward curve, and we can see why many investors have largely shunned the sector.  As a result, the sector has essentially been depressed for almost two years.  

EARN has generally traded in line with the sector valuations as the market doesn’t seem to be discerning the difference between well-managed mREITs and poorly managed mREITs. In investing in the mREIT sector, management is very important as good management can protect book value and generate good returns over a cycle versus a poor management team which can destroy book value and possibly bankrupt the company as a number of them did in 2009.  We believe the management team that is investing on behalf of EARN (and EARN’s companion fund EFC), Ellington Management Group, is one of the best in the MBS industry.  With one of the best managers managing the investments at EARN, we believe EARN should trade at a higher valuation than the rest of the sector.

2. EARN has one of the best management teams in the MBS industry

Ellington Management Group, lead by Michael Vranos, a well-respected veteran investor in the sector, manages $6.1 billion in various private funds and in two public vehicles, EARN and EFC.  A profile of the key managers can be found at http://www.ellington.com/Leadership.  The key team has been together for over 20 years and has developed proprietary analytics for MBS security analysis over the last two decades.  

The history of how the team managed EFC from inception in 2007 to today is a good example the team’s investment acumen.  EFC was a vehicle set up to invest principally in non-agency MBS securities, including subprime MBSs.  It was launched at the peak of the last economic/housing/economic cycle.  Rather than losing value and going bankrupt during the financial crisis, the team was able to maintain stable book value throughout the crisis by aggressive hedging of its assets with short positions in subprime mortgages and derivatives (similar to what some Paulson, Bass and Burry did as chronicled in the book “The Big Short”).  The team was nimble enough to remove the aggressive hedges as the subprime MBSs traded down to 10-60% of book value starting in 2009 and go long subprime MBSs.  The team did an exceptional job of maintaining book value during what was a once in a lifetime financial crisis.  Although the team hasn’t performed as well in maintaining the book value of EARN (BV of a little under $20 at IPO in May 2013 to around $17.50 today), we feel the team has a strong track record overall, is aware of the relative underperformance at EARN, and is focused on improving on its performance at EARN.

In following the team over the last 7 years, we’ve been thoroughly impressed with the team.  We encourage you to listen to all the earnings calls of EFC and EARN as well as meet and talk to the management team through the IR contact or the CFO to get a feel for the quality of the team and its investment process.  The team has developed proprietary analytical tools over the last 20 years from its experience in actively trading all different types MBS and pass-through securities, agencies, non-agencies, IOs, multi-family, pay-ups, etc.  The team drills down deep into the MBS pools it purchases and analyzes them on a granular level, not only by state or county but even down to the census tract or individual collateral level and overlay that with analytics developed in-house. We feel the team’s analytical abilities are top-notch and wouldn’t want to on the other side of trade from them.

EARN actively trades its book, turning over 25% of its book on a quarterly basis.  Gain generated from active trading is considered part of the total return the investment team targets for EARN.  Because of the tiny size of EARN ($130mil market cap; $1.36bil of assets) relative to the highly liquid multi-trillion dollar agency MBS and interest rate market, EARN can quickly and easily trade in and out of its assets and adjust its hedges. Being small and nimble affords EARN with the ability to generate alpha much more easily than if it were managing a much larger portfolio.  It’s also important to keep in mind that many of the MBS holders are big sovereign wealth funds, pensions funds and other slow-moving behemoth investors.  As a small, nimble and active trader, EARN is able to exploit some of the pricing inefficiencies created by the participation of these large investors.  The small size works to EARN’s advantage.

Overall, we are happy to entrust capital to a top-notch investment team in a (relatively) liquid investment vehicle without paying the customary 2%/20% fee that we would have to pay if we were invested in one of Ellington’s private funds or EFC.  Given the strong management team, we believe EARN deserves a valuation closer to book value, which EARN should be able to achieve once investors perceive that interest rates have stabilized or are range bound.

3. Other investment considerations

The Board of Trustees at EARN authorized a $10 million stock buyback on August 13, 2013.  As of today, we are not aware of the company having repurchased any of its shares.  We’ve discussed this issue with the company. The company’s response has been that it's concerned that repurchasing shares would reduce the number of shares outstanding and further reduce trading liquidity, which is one of the biggest hurdles it faces in attracting more interest from institutional investors.  We partially agree with the company’s logic, but at the same time, we think that deploying even a small amount of the authorized $10 million could help close the gap between its current valuation and its book value.  A $10 million repurchase program for a company with a $130 million market cap (and $600k of avg daily trading) is not insignificant.  Barring the liquidity concerned, as a shareholder we feel there is no better use of EARN’s capital than to repurchase its own shares at low 80s of book. We’ve engaged in constructive dialogue with management in the past to initiate the share buybacks.  The management team is aware of the issue and thoughtful in its assessment, so we feel that the company will initiate buybacks in the near future.

Risks

There are numerous risks (take a look at any of the SEC disclosures), but we highlight a few below:

- Interest rate risk.  We set forth some possible scenarios for where interest rates could be and how EARN would trade in such a scenario:

• 10 year treasury rates are range bound between 1.5% - 3.5% and short end of the curve stays in the 0%-0.5% range. We believe this to be the most likely scenario (60% probability). This is generally good for the mREIT sector and EARN as the spreads are still attractive and EARN should be able to maintain its book value, earnings, and dividends.

• 10 year treasury rates rise to 3.5% - 4.0% over the next 2 years as Fed raises the short end to 0.5%-1.25%. We believe this to be the second most likely scenario (39% probability). There will be some volatility in the mREIT sector and in EARN shares but the business will still generate attractive returns and dividends.  EARN may lose a few percent in book value in this scenario but EARN should be one of the mREITs in the sector (along with EFC and TWO) that preserves its book value well.

• If the yield curve inverts or flattens, all risk assets are in trouble including EARN and the other mREITs.  However, we believe an inverted yield curve in the next 2 years is highly unlikely (less than 1% chance) and even if the yield curve were to invert, we believe it would only be a temporary phenomenon as the Fed would have to step in a lower rates again and increase the yield curve spread.

• If you are worried about interest rate risk, you could short WMC as a hedge to your long position in EARN. Take a look a how much ORC sold off on Friday this past week when it cut its dividend. ORC was trading at mid 90s of book and was held largely by retail investors for its perceived high dividend. Likewise, since WMC is trading at a high valuation relatively to the sector (1.05x book value) and has a significant retail investor base (or retail-like institutional investors) interested in the high yield, WMC is susceptible to a sell-off in the event of a dividend cut, a management mis-step, or a stock offering by WMC.  Given the high dividend yield, the short position would have to be tactically managed around the quarterly dividend dates.  However, since the management team at WMC is far superior to the management team at ORC and one of the better management teams in the sector, we are not recommending WMC as a short. We don't like to short overvalued securities run by good management teams.

- Management mis-steps: The trading of the book intra-quarter by the management team is opaque.  Management could certainly enter into some bad trades and generate losses.  However, the team does sophisticated analysis of each MBS security it purchases, identifying relative value across the sector and drilling down into granular levels of detail and applying its own proprietary analysis based on inhouse historical data.  We are betting on one of the best jockeys in the MBS space and feel comfortable entrusting capital to this team without having visibility into intraquarter activity.

- Leverage:  EARN is levered 7.5x so any move in pricing of the assets or the hedges could have a large impact on the equity.  However, this type of leverage is not very different (or actually lower) than the amount of leverage you see in banks.  Moreover, as EARN is largely an agency MBS vehicle, there is very little credit risk in the assets, so the leverage is less of a concern as it relates to credit risk.  The agency mREITs are basically like banks with wholesale funding but with very little credit risk on the asset side.  Even though there is significant leverage, EARN’s asset are hedged against interest rate moves (see the p. 17 of the 1Q15 company presentation: http://ir.earnreit.com/phoenix.zhtml?c=251770&p=irol-presentations) and the company actively manages the hedging intraquarter.

Conclusion

When investors perceive that rates have stabilized or are in a trading range, the whole sector will trade up. We wouldn’t be surprised in EARN trades back up close to book value as investors come to appreciate that EARN is managed by one of the best MBS managers in the space.  In the meantime, We are happy to collect a 15%+ annual dividend, own a highly liquid asset at low 80s of readily ascertainable book value, and the have the assets managed by one of the best investment managers in the sector.

Catalysts:

- Earnings

- Dividends

- Initiation of stock buyback under its $10 million repurchase program

- Investors perceive that interest rates have stabilized or are in a trading range

Catalyst

- Earnings

- Dividends

- Initiation of stock buyback under its $10 million repurchase program

- Investors perceive that interest rates have stabilized or are in a trading range