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We’re going to primarily cover Arlington Asset Investment Corp. (AI) in this article. We provided a more extensive view of the sector and our top picks in a recent update on mortgage REITs for subscribers.
We have a neutral outlook on AI. This closes our previous buy rating published on 9/15/2019:
Source: Seeking Alpha
AI’s performance on fundamentals disappoints. Despite a large discount to book, we’re neutral as AI’s total economic return (change in BV + dividends) continues to disappoint.
Note: We still have a small position in the baby bonds and consider them a fine investment. However, investors should be aware of poor liquidity and use low limit-buy orders to build any positions. Scott Kennedy covered AI’s Q3 2019 earnings in a recent article to subscribers. Here is part of Scott’s update, along with slides I’ve added:
AI reported a quarterly core earnings decrease of ($0.05) per common share when compared to the second quarter of 2019. In comparison, I projected a quarterly core earnings decrease of ($0.03) per common share. As such, AI’s core earnings was a minor-modest disappointment/underperformance in my opinion. This mainly centered around three factors.
First, as mentioned above, there was some notable asset/investment portfolio “rotation” during AI’s third quarter of 2019. AI rotated a high proportion of the company’s higher coupon specified pools to lower coupon specified pools. This negatively impact AI’s weighted average coupon (“WAC”) during the quarter which negatively impacted the company’s core earnings.
Second, similar to the first factor, AI both notably lowered the company’s net long TBA MBS position (which led to lower NDR [net dollar roll] income being generated) and migrated into modestly-notably lower generic TBA MBS coupons during the quarter (which led to lower NDR income being generated).
Third, as mentioned above, AI’s interest rate payer swaps sub-portfolio (even with new payer swap contracts towards the shorter-end of the yield curve) only experienced a (0.02%) decrease in its weighted average fixed pay rate. Other sector peers were able to lower this very same metric by (0.30%)-(0.50%) during the quarter (thus showing the magnitude of this difference). In comparison, the weighted average variable receive rate of AI’s interest rate payer swaps decreased (0.30%) during the third quarter of 2019 which directly led to a more severe core earnings decrease versus most mREIT peers and my expectations.
Starting with some charts
We’ll be using charts to compare mortgage REITs. We’re starting with the change in tangible book value since 9/30/2018. For this purpose, we’re simply using the values reported by management from 9/30/2018 and 9/30/2019. That gives us the following chart:
Source: Author calculations
AI delivered an exceptional drop in tangible book value. Over 1 year, the company managed to reduce tangible book value per share by 33.5%. That is a massive decline. The company paid out bigger dividends relative to their book value per share, but the difference isn’t enough to cover the huge gap between AI’s performance and their peers’.
With the first chart giving us a feel for the change in book value, we can move on to evaluating the change in share price (adjusted for dividends). If markets were efficient, we would expect a very strong connection between the two charts. If you’ve been following us for a while, you probably know that the markets will be semi-efficient. You’ll see some correlation, but it won’t be close to perfect. The $100k chart demonstrates how much an investor needed to invest on any day to have $100k today (dividends are reinvested for the model). Below we have the $100k chart for these stocks:
Source: Author calculations
We’ve added some symbols to make it easier to track the most important lines:
- AI: The red line with circles
Q3 2019 Price Movements
You may notice that between 7/1/2019 and 10/1/2019 there is a period where every line dips lower. That reflects a fall in prices throughout the sector, followed by a recovery. The REITs at the very bottom at that point: AI, Dynex Capital (DX), and Cherry Hill (CHMI).
Consequently, we can say that those 3 REITs all enjoyed a much larger bounce-back since late August/early September. The REITs which bounced hardest often have less upside left. This is one of the reasons we think it makes sense to post a neutral rating for AI.
AI: The red line with circles
AI clearly shows the worst returns among peers in the $100k chart. We can tell that because it enters the chart at the highest level. We can also see that until 7/1/2019 it was consistently the highest line. Since AI delivered the worst performance on book value, they should have the biggest fall in the $100k chart.
At this point, AI has disappointed too many times. The target price-to-book ratio for AI is significantly lower than for other mortgage REITs.
Another way to evaluate the change is to put the change in book value next to the change in the share price. Use percentages to make it easier for comparisons. That creates the following chart:
Source: Author calculations
We can see that most of AI’s falling share price reflects a drop in tangible book value per share.
We have Scott Kennedy modeling these book values in real time on a frequent basis. Consequently, we can detect changes in book value as they happen. That means we can see how book values should’ve changed from 9/30/2019 to 11/30/2019, even though the mortgage REITs haven’t reported those values yet.
However, if someone tells you they can already forecast the change for 11/30/2019 to 12/30/2019, that person is lying. It is possible to forecast the values before they are reported, but not before they happen. Based on the current projected price-to-book-value ratio, we believe it is reasonable to have a neutral rating on common shares of AI.
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Disclosure: I am/we are long AIC, CHMI. 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.