Ryan O’Connor of Crossroads Capital Partners presented his investment thesis on Orchid Island Capital (NYSE: ORC) at Wide-Moat Investing Summit 2020.
Orchid Island Capital is an “agency mREIT” that invests solely in mortgage-backed securities (MBS) issued by government-sponsored agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae.
While not all mREITs are created equal, they are the same in one respect: All are in essence simple spread businesses that use extreme leverage to borrow money short term in order to lend long term, augmenting returns as a result. These returns are then paid out as dividends to income-seeking investors stretching for yield. Simplistically, the difference between an mREIT’s “interest income” (i.e., mortgage rates) and “interest expense” (i.e., repurchase funding rates) equals “net interest income”. Subtract hedging costs and operating expense, and what’s left can be distributed to holders as dividends. (It can earn this spread because long-term rates are usually higher than short-term rates).
While mREITs take existential risks, typically blowing up once a cycle in times of severe distress, government agencies cannot default on agency MBS, insulating agency mREITs like ORC from credit risk. Predictably, recent turmoil in short-term funding markets caused panic selling during the COVID pandemic, indiscriminately crushing the share prices of mREITs and agency mREITs alike, creating a rare opportunity to buy shares of agency mREITs like ORC at steep discounts.
Soon after the crash, the Fed stepped in to get the market back on track, cutting short-term rates to zero and announcing it would buy essentially unlimited quantities of agency MBS — two actions that directly benefit ORC’s business, leading to wider net interest margins and higher earnings, while removing the possibility of reflexive negative feedback loops that get mREITs into trouble for at least the next 18 months.
ORC’s Q1 2020 repo expense averaged 1.68% of AUM, but that cost will fall to 12.5 bips in the aftermath of a 0% Fed funds rate brought about by COVID-related distress. As a result, a simple back-of-the-envelope model (see slide 9 of Ryan’s presentation) acts as a proxy for ORC’s forward-looking earnings power: On a $3.4 billion investment portfolio earning a 341 basis point spread that is 9x levered, that is $116 million in normalized net interest income. After subtracting operating expenses, it should have $95 million available to distribute to shareholders, or roughly $1.64 per share on a stock that recently traded at $4.36 per share. Assuming ORC pays out 90% of net interest income going forward as required by the IRS, that puts its normalized annual dividend paying capacity at ~33% annually, or ~$0.12 per share per month.
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About the instructor:
Ryan O’Connor is the President and Portfolio Manager of Crossroads Capital, LLC. Prior to founding Crossroads, Ryan was a portfolio manager at Three Arch Opportunity Fund, a value-centric investment partnership based in San Francisco. Prior to that, Ryan co-managed portfolios at Whetstone Capital and CUSH Capital, two Kansas City based investment partnerships focused on public equities investing. Before life as a securities analyst, Mr. O’Connor studied Economics at Indiana University (Bloomington), spent time as a top producing financial advisor for AG Edwards & Sons (now Wells Fargo) and an options trader on the Chicago Mercantile Exchange. Ryan’s proven history of generating compelling risk-adjusted returns has led to his membership in several elite investing associations, including Joel Greenblatt’s Value Investors Club, a highly selective idea-sharing site where global membership is capped at 500 buy-side analysts. He has also been recognized by SumZero, the world’s largest community of professional investors, as being in the top 1% of the approximately 12,000 buy-side analysts active on the site.