Friday, June 20, 2008

Professional Stock Analyst Opinions: Thumbs Down

I have to admit that I really enjoy Jim Cramer.

Jim Cramer is utterly unafraid to take a strong position. Whether it's to buy Sears (SHLD) at 180 or -- as just recently -- to sell American Capital Strategies (ACAS) at under 28, there's little reason ever to think Mr. Cramer is soft-pedaling his opinion. Not that Cramer is married to his analysis; after preaching the virtues of Sears as a working-man's hedge fund and the turnaround genius of Eddie Lampert in a video touting Sears as one of a series of stocks likely to become Berkshire Hathaway-style single-share retirement funds, Cramer posted about SHLD that folks could short it. And there, I suppose, is the take-home lesson: the folks who get interviewed to opine on stocks aren't in front of the camera because they're right, but because they're entertaining.

That we have a media environment that is based on entertainment rather than truth is something with some interesting and far-reaching consequences as consumers, including as investors. More on that in a later post -- it's a big deal. The main application here is that the story that's easiest to find is probably easy to find because it's exciting, not because it's the most accurate. Excitement means clicks, links, eyeballs, and ad revenue. Truth -- well, who knows whether it's true? But we can tell pretty quickly if it's entertaining. You don't have to be Warren Buffett or Socrates to notice who keeps you on the edge of your seat when they talk.

So let's -- you know, just for fun -- have a look at Cramer's recent thumbs-down on American Capital:
In the end it's a financial that owns very difficult companies to be able to make a lot of money in right now. It's very, very high risk. The dividend sounds almost too good to be true. I don't like the stock
via Seeking Alpha

Let's look at the business for a moment. American Capital Strategies Ltd. has developed three profit streams. And let me be clear: these aren't just revenue streams, or business plans, they're honest-to-goodness, proven profit streams. Allow me to spell this out for those who haven't heard it. Since going public in 1997 at a price of $15 per share, ACAS has paid over $25 in dividends, and last quarter had a GAAP net asset value of over $28 per share[1]. I understand that in the wake of Enron and WorldCom there's a certain amount of skepticism regarding accounting practices and valuations, and I'll ignore for the moment the serious problems applying these concerns to this particular company's assets -- but you can't restate dividends you've actually paid. Those are paid already. While the shares have vacillated between trading above net asset value and trading below net asset value (which spurred a buyback program with a purchasing approval of $500 million), and people buying at any given price might have different total return experiences if they liquidated today, the company has a long-running history of paying quarterly dividends, and consistently raising them.

There's been a lot of cheap talk about ACAS' NAV being basically bogus or at least unknowable by investors, with the illiquid nature of ACAS' holdings cited as proof ACAS could lie and never be caught. The facts speak otherwise. ACAS routinely exits holdings, and gets for them what ACAS says they're worth. If HP didn't think Extream Software wasn't worth $5m more than ACAS had claimed on its prior quarterly report, would HP have paid it? Moreover, last year ACAS became the manager of a private equity fund, American Capital Equity II, that began life by buying a 17% cross-section of ACAS' portfolio companies, paying within 3% of the price ACAS had last said was the fair price for them. If the sale prices in arms-length transactions are really within a few percent of what ACAS says, where's the evidence the valuations are gamed?

Management at ACAS offer this on the subject:
Under our previous valuation policies [before the accounting standard FAS 157 became mandatory and forced hundreds of millions in paper write-downs in portfolio company valuations], the proceeds American Capital realized on $10 billion of investments exceeded the prior quarter valuations on average by less than 1%. In the future, we intend to report the anticipated realizable values on settlement or maturity of our investments as well as GAAP values so investors can consider both.
via ACAS' Form 10-Q filed May 6, 2008.
In other words, before the new accounting rules, ACAS with the aid of outside valuation experts was able to state with something like 99% accuracy the real-world value -- as proven by genuine sales to honest-to-goodness bona fide buyers in arms-length transactions -- of its holdings. To the extent ACAS has been required by regulators to state in its regular filings some lesser valuation, one would suspect the valuations would be understated. Stock movements based on the spurious valuations would be bargain opportunities.

First: What Is ACAS' Business?

ACAS is regulated as a business development company. Unlike most companies whose dividends to shareholders result in double-taxation, ACAS avoids federal income taxes on dividends paid to shareholders provided it pays at least 90% of its earnings to shareholders every year. To keep ACAS' tax status as a BDC and as a regulated investment company, ACAS is required to make the payments it does, because its earnings are so high it can't pay much less and keep its tax status. When Cramer says of ACAS' dividend that it "sounds almost too good to be true" and that therefore "I don't like the stock" he is really saying that ACAS' earnings are scary high, and that the company's high, sustained, and growing profitability makes him hate the shares.

Think about that for a little bit.

ACAS has routinely paid a bit less than its total annual income in dividends, and has retained a small fraction of its earnings in order to roll into future years earnings not distributed to shareholders. This lets ACAS use part of the earnings for investment. Since ACAS doesn't want to be enslaved to some specific quarterly earnings number and doesn't want to have to game its income around some dividend predictions, having the rolled-forward earnings available as a cushion to cover dividends is helpful, but frankly I've never seen ACAS pay dividends that exceeded the year's realized gains so the likelihood is that rolled-forward earnings will simply tend to force ACAS to raise future dividends to keep ahead of its obligation to pay out 90% of its earnings in dividends. In other words, ACAS' performance creates a legal obligation to keep raising its dividends, as the price of its tax status.

Another feature of ACAS' tax status is that its leverage is limited. ACAS can't become too dangerously leveraged and retain its tax status, so ACAS retains a solid balance sheet and a solid credit rating. ACAS can borrow money vastly more cheaply than the going rate paid by companies who hope to borrow money from it, so ACAS can (and does) take advantage of credit dislocations to increase its spread on loans. That is, the difference between the rate at which it (a highly-rated borrower) can borrow money and the rate at which middle-market companies can get loans gets bigger during credit dislocations like the one that we're seeing now, so ACAS' opportunities to profit in debt transactions increases. The very credit issues that drive folks to bash ACAS actually increase its business opportunity.

ACAS' Profit Sources

As I stated, ACAS has three sources of profit:

First (not first in magnitude or in order of development, but in simplicity to communicate to readers), ACAS has contracts to manage other people's money. This means that the third-party funds ACAS manages -- these now total billions -- aren't a hobby, they're a profit center. In other words, instead of paying a fund manager to invest your money in stocks, ACAS' investors are in the happy position that other people are paying ACAS to do due diligence on deals and figure out how to deploy capital.  This is because ACAS deploys its own capital right beside its managed capital;  but ACAS charges clients for the due diligence and dealmaking in which ACAS itself participates.  As ACAS' funds management business grows, so grows ACAS' income that is independent on the behavior of individual investments. With an annual fee of 2% of assets under management, and a 30% participation in profits, ACAS can make a good business out of doing good business.

The same due diligence ACAS conducts for its own investment, it can recycle for use in managed funds. Moreover, managed funds give ACAS free access to capital needed to pull off one-stop, quick buyouts that would force a less flexible company to seek co-investors and partners. Since ACAS gets management fees from the managed funds, and shares in profits, ACAS makes a good business investing managed money in the deals it wants to enter itself. Likewise, third parties are eager to be involved in ACAS' deals because they know ACAS is putting its own money into the deals. When ACAS sells off portfolio companies' senior debt, ACAS gets good prices in part because ACAS' buyers see ACAS happily retaining high-yield subordinate debt and even equity. Since the senior debt buyers know ACAS can't get paid unless and until the buyers get paid, they know ACAS isn't just trying to flee a bad deal -- they know ACAS stands behind the sale and believes in it. ACAS' position as it syndicates senior debt is superior to that of its competitors who deal only in debt and don't hold common shares, or aren't involved in as many facets of the buyout and aren't participating in junior levels of debt. But I'm getting ahead of myself, as this creeps up on ACAS' investment exits and its capital gains.

The second profit stream is devilishly simple: ACAS' portfolio companies make money. ACAS isn't merely a stock trader, trying to flip companies that may not pay dividends; ACAS owns stakes so large it must consolidate the portfolio companies' balance sheets, recording their profits as ACAS' own. Like Berkshire Hathaway has control over GEICO, ACAS has real control over the companies it owns -- though, like Berkshire, ACAS isn't trying to replace good managers with some MBA beanhead who doesn't know the business. And unlike the Cramers of the world, ACAS need never exit a company that has little interest among buyers but is making money. ACAS, like Berkshire, can sit back and just take the revenues. The newly-mandatory accounting standard, FAS 157, that was hailed as the hammer that would shatter ACAS, actually has some interesting effects in this regard:
[A]t the end of the first quarter of 2008, the Company held an investment in a commercial real estate collateralized debt obligation (CRE CDO) which had been depreciated $209 million from its inception to date, including $160 million in the first quarter of 2008. The investment is currently producing approximately $8 million per quarter of cash flow but its current fair value determined in accordance with GAAP is $11 million due to a lack of liquidity in the financial markets for CDO investments which has caused investment spreads to widen. However, the Company anticipates realizing its $220 million investment on settlement or maturity based on its assumptions of future credit losses, which includes a recession over the life of the investment.
via ACAS' Form 10-Q filed May 6, 2008.
So, an investment that is genuinely expected to yield $8m/quarter is required by newly-mandatory rules (FAS 157) to be listed as though it were worth $11m, even though there's no pressure to dump the asset into a market that might pay $11m for it. If I could own an asset that returned 73% per quarter, I'd be a very happy consumer. Unfortunately for me as a buyer, this is an extreme case and ACAS' value isn't this misstated in every investment. On the other hand, if ACAS' valuations have historically been within 1% of correct, and suddenly were required by regulations and not due to business changes to be marked down more than 10% of their stated value, one would expect ACAS' NAV to be misstated by regulatory requirement by about 10% to the downside.

And the kicker? Today, ACAS' shares closed below the last-published net asset value. Thus today, ACAS is on sale twice.

And that brings us to the third source of profit ACAS enjoys. ACAS got its start, way before it went public in the late 1990s, helping employees buy their employers. Malon Wilkus, ACAS' CEO, had spent a stint in a commune making goods to support the commune's operations before giving up in disgust after realizing the commune's "everybody shares" rule had created and sustained a class of loafers who didn't pull their weight, leaving the 20% of the folks doing the work to earn a measly $1500 a year. (The fact that Wilkus' hammock business pulled in a million bucks a year after he bagged Pier 1 as a customer didn't qualify him for a raise: link) Wilkus apparently wanted to help those who wanted to help themselves, and started arranging for working people to become owners of their employers' businesses, so they would reap the profits of their labors.

Power To The People!

Wilkus' post-1983 work proves the tools of capitalism can be employed to empower the workers who make earnings possible. After a stint "at the Calvert Funds, which ran many socially responsible mutual funds" Wilkus quit to form American Capital expressly to help workers take over their employers through stock ownership programs. (link) Workers typically ended up with 80% ownership, and Wilkus was often paid in shares, sharing the remaining ownership with managers. After arranging in the mid-'90s to save breadmaker Four S through a series of transactions that culminated in its sale to the Mexican bread giant Groupo Bimbo (a deal that doubled the money of employees, who took a pay cut to keep the company afloat while the deal was underway), Wilkus seemed to accelerate conducting complex multi-tiered buyout transactions.

In the big bad world, lots of folks have businesses from which they would like to extract value. Entrepreneurs who aren't ready to give up management may nevertheless want to trade the bulk of their shares for an opportunity to pull some cash out out of their essentially illiquid business ownership. Thus, the world is awash in businesses that are doing just fine, but whose owners are worried that there's no easy way to divide the business when they die, or who have some other equally benign reason to want to turn some ownership into cash. Some of the sellers want absurd prices for their businesses, and some are willing to make a deal that leaves a lot of room for everyone to make money. Since valuing these illiquid businesses is something of a trick, and there can be lots of pieces to the transaction (money borrowed to make the transaction affordable, divided into junior and senior debt to be borne by the company; shares sold in both common and preferred classes; intermediate financing while all this is being arranged; loans taken on to fund planned expansions; etc.), it can be a miserable and lengthy task to get all the necessary parties lined up with enough capital to make it happen.

Enter ACAS. ACAS manages over twenty billion smackers for investment in middle-market companies, and has shown historic ability to raise capital by issuing shares above its net asset value (that is, issuing shares that enrich existing shareholders rather than merely dilute them out). It's done this consistently, for years. And because of its present size, ACAS can do what no-one else will: it can offer a single stop for making all facets of the transaction happen in a middle-market buyout. A multibillion-dollar buyout might attract interest from one of the major investment banking firms, but these smaller fish ... there's just no-one else interested in their deals and can make the whole thing happen alone. So ACAS, which has trademarked the phrase One Stop Buyout™, is the buyer of choice. Thus, ACAS sees more deals than its competitors -- and it can cherry-pick the best deals available in the market. When a price becomes too steep, ACAS just walks away: like the song says, there are just too many fish in the sea.  ACAS has a great advantage in its third line of business, in that it gets to cherry-pick the best deals to be had in the middle market.

What's better for shareholders, ACAS is happy to walk away from deals that aren't good enough. As demonstrated in a 2007 conference call, ACAS will readily sacrifice a quarterly number if needed to protect the long-term good of the firm. ACAS is that rarest of companies: one whose management's interest appears -- based on its conduct, not mere press releases -- genuinely aligned with the interests of the long-term shareholders. The number of rejected deals is just outstanding -- but there is such an avalanche, ACAS has no trouble finding a few gems worth buying.

Since ACAS need only swing at the best pitches, ACAS' batting average is excellent. You can check it out here, strikes and home runs alike. You can also have a look at investments not yet exited. Sure, there's some negative return ... but the vast bulk of the deals are good, and the mean is a solid double-digit return.  And while they are in process, there are always those quarterly earnings ....

And what was it Cramer said? American Capital is allegedly "a financial that owns very difficult companies to be able to make a lot of money in right now. It's very, very high risk." Cramer is right that it's hard to make money in these companies the way Cramer makes money, by trading in and out, because illiquidity complicates and adds risk to valuation estimates. If you planned to sell illiquid companies in uncertain times, but had to enter deals under good-case price multiples, you'd need outrageous results just to keep up. High risk, indeed. Thankfully, that's not ACAS' business.

Look at the obverse of Cramer's observation: if nobody can get top dollar for their companies due to illiquidity and its impact on valuation multiples, think what a screaming buy ACAS will be getting on every entry it makes. After all, nobody has a gun to ACAS' head forcing ACAS to liquidate anything, or to go for bad deals. ACAS can patiently pocket the profits from its portfolio companies until it sees good exit opportunities. ACAS doesn't need to make money Cramer's way. Indeed, most of ACAS' profits are operating profits from portfolio companies and management income. Since ACAS routinely models for exits under worse price-to-earnings multiples than those obtaining at the time it enters deals, the possibility that multiples have been compressed doesn't spell doom for ACAS' exit opportunities.

The Upshot

This entry surely comes off as a long, complex sales pitch for ACAS. This is because I'm laughing at the simplicity of the criticisms folks have laid on ACAS when they were paid to do entertain the public. Every criticism I've seen published about ACAS has been rooted in a wild misunderstanding of ACAS' business model, and some have been exactly wrong about the impact on ACAS of the trend they decided would be exciting for people to worry about the day they published. So I offer this thought: analysts aren't risking money when they tell you what is and is not a solid investment. Analysts need not even make sense if they hit enough good high-click terms in their blathering. (Here: iPod, recession, peak oil, interest rates, multiple compressions, accounting scandal. Now, with an Analyst-themed Mad-Libs, you too can sound like you have deep understanding of an impending investment collapse!)

Warren Buffett said a few things that are worth keeping in mind as you consider the wild news that surrounds publicly-traded companies. When American Express was being sold hand over fist in the wake of a scandal involving companies that lied about collateral pledged to back a few million in loans (salad oil floats on water, so tankers that looked like they were full of salad oil were, you know, mostly full of sea water -- oops), Mr. Buffett looked at the company's basic business and looked at the amount of money involved in the suspect transactions, and realized the public reaction was so utterly out of proportion to the news (the purported reason for the stock price collapse) that he invested in the company (and he hasn't sold yet ... this scandal was in the '60s, and he's still taking dividends). In keeping with his now-famous piece of investment philosophy, Buffett acquired a sizeable stake in American Express. (The quote to which I refer, and which Buffett is so often cited for, is: Be Fearful When Others Are Greedy And Greedy When Others Are Fearful.)

Just disagreeing with the public at large isn't enough to do well in investing, however. A thoughtless contrarian could have gone broke in Enron buying on the way down, just to buck the trend. The key is realizing that the public is missing something important and deciding, on the basis of solid business valuation principles, that the investment at issue is not currently priced correctly. There is a whole horde of Econ 101 children with propellers on their heads who will argue that the market is efficient, etc., and therefore everything is priced so as to reflect all the publicly-available knowledge, etc. This tripe has the strength of being easy to find repeated by folks who've had the same freshman Econ class, but the fact remains that the assertion is not true. Were it true, people like Buffett who look for boring, easily comprehensible businesses (like making bread, maybe) and invest in them when it's clear everybody's priced the business wrong, would never actually make a profit because nothing would ever be priced wrong in a way any human with access only to ordinary, publicly-available information could tell. And that's bogus. In 2003, Forbes had this to say after interviewing Warren Buffett:
The most famous investor in the U.S. prefers not to invest in common stocks, because he doesn't see an opportunity to make a 10% after-tax return. "When stocks get mispriced periodically we will buy them if they are in the right relation to intrinsic value," he said. "Occasionally, over a 30-year period, stocks sell at a favorable relationship to intrinsic value."

Lenzner, "Life After Buffett", Forbes 5/5/2003
When an occasional mispricing occurs in publicly-traded shares, of course, life changes. And in shares that are not publicly traded, the opportunity for mispricing is even greater for investors skilled (as are ACAS' personnel) in discerning the likely value of an enterprise. In ACAS, we have both opportunities: a company whose assets are illiquid and hard to price are almost certainly mispriced when valued according to the accounting standards now in force, and the company's own shares have been driven below this discounted rate, in an environment in which pricing on debt and on private companies is likely to be so constrained that ACAS will have the best buying opportunities it's had in years.

Yet, according to the talking heads, ACAS is a scary stock and it's time to run. But that's OK. Run for your life. Short it, even. I've enrolled in the dividend reinvestment plan, and the lower the price is on the dividend date, the more of those shares I get, and every quarter the dividend is getting bigger and bigger so I sure do want more of those shares.

Down, down, down on dividend date, that's my prayer. In the meantime ... just because it's quality entertainment doesn't mean it's quality news.


золотоискатель said...

Excellent post. Thanks

Manoj Padki said...

Excellent profile of ACAS. I am long ACAS as well.

Now you have inspired me to write up a similar post about NRF, my other large holding! It is a mortgage REIT *and* an asset manager (like ACAS).

Thanks for the post.

Anonymous said...

Excellent ACAS analysis. Finally somebody takes the time to study and understand the company before speaking.

Dividend Growth Investor said...

Fantastic post. Very few people try to really understand what a company's business model is before they speak negatively about it. But your post is highly informative.
The only problem with your blog is that it is tough on the eyes to read that black font :-).

Scott said...

Great analysis of this company. One question that always remains for me these days is "what part of their business model is outside of their control?". In other words, it appears that they do most of their financing with equity or debt. Obviously this isn't the best equity environment to raise cash in, and it also isn't the best debt environment to raise cash in. If those options become prohibitively expensive, can ACAS "sit on their hands" so to speak until the crunch is over? Or are they tied to these markets through periodic refinancing needs that could be pulled if liquidity didn't exist for it in the marketplace? If their secondary liquidity was not available, would they become insolvent? Or would their earnings simply decrease temporarily? It seems our whole economy (including our federal government) has become addicted to debt and without it I wonder which companies would survive.

Your thoughts are welcome and appreciated.

Jaded Consumer said...

I appreciate the time you've spent looking at this post. I don't want it to be taken as an uncritical statement of faith in ACAS; it is simply the blog entry I made on June 20. To get a clearer idea of what I may have said differently since, you can track the tag for the ticker symbol ACAS.

I've linked to the comments here in a recent post in which I talk about liquidity, credit, and ACAS

The upshot: there's definitely a handful of questions to ask, but ACAS has managed to de-lever nicely to avoid regulatory issues that might create a regulation-generated liquidity crisis. In doing so, ACAS also protects its credit rating, which in turn means that it's in a much better position to borrow funds than either its customers or its competitors.

And that's a great thing in any economy.