ACAS: Lazy Man's Diversification

You've heard that you need to diversify. You just don't have the time to know enough about ten or twenty investments to feel like you

American Capital Ltd. -- Overview

American Capital Ltd. (ACAS) has been featured on The Jaded Consumer as an example of how stock analysts don't aid meaningful comprehension of investments, so you might want to consider this recent corporate overview to help you see what ACAS does to earn its money. (Or read the earlier posts here.) American Capital Ltd. is a top-performing Business Development Company (BDC). Unlike Berkshire Hathaway, which pays no dividend because it is tax-inefficient to allow income to be taxed twice, ACAS' tax status enables it to avoid paying taxes on profits paid to shareholders as dividends (so dividends are taxed but once, in the hands of shareholders). Dividends at ACAS have steadily increased since the company went public, so deriving liquidity from the shares doesn't require exit; one can join or drop dividend-reinvestment as one pleases, to suit liquidity needs.

American Capital's 280 portfolio companies across North America and Europe provide diversification across industry, geography, and currency. You've probably worn Riddel sport safety equipment, bought Evenflo products for your kids, and seen Piper aircraft in flight. Unlike a bank, which at best gets paid a fixed loan rate that doesn't violate usury laws, ACAS participates all up and down the balance sheet with various classes of equity and debt -- protecting its investment interest in case of failure, and ensuring good upside in case of success. Control over so many of the companies in its portfolio enables ACAS to direct exit whenever opportune, leading to significant liquidity through routine portfolio turnover. This liquidity assures shareholders of ACAS' continued dividends. Indeed, much of ACAS' 2008 dividend has thus far been paid with 2008 capital gains, and ACAS expects to roll $500 milion in taxable income from 2008 into the future pool from which it will pay 2009 dividends.

Shareholders often view subsequent share issuance with fear: issuances conducted by companies in trouble can be done well below market price, the dilution can cripple future earnings per share, and they can result in management influence by outsiders whose interests are aligned in opposition to the interests of early shareholders. If ACAS has done well in the past, might share issuance dilute owners of the "good" assets by pumping new money into less-attractive investments? Might new shares raise less money than ACAS' existing owners have in equity behind their existing shares? ACAS' share issuance has been conducted at an average of 1.5 times book value, meaning that ACAS' old shareholders ended up with a great boost to NAV after new share issuance.

ACAS offers a way to invest in a broad portfolio of presumably undervalued mid-market companies ordinarily unavailable to the small investor. ACAS is sensitive to the impact of valuation multiples because its assets' values (outside of a few publicly-traded holdings, like ACAS-managed AGNC) are estimated on the basis of such multiples. As multiples expand, ACAS' value follows.

As portfolio companies profit, ACAS is required to pay dividends – investment multiple or no. So buy for the capital appreciation, or buy for the income, but I think it's a buy all around.