Thursday, October 9, 2008

On the Analysis of American Capital

This morning opened with heavy volume in American Capital. I was curious whether the volume portended anything interesting (volume spikes don't seem uncommon when one looks at a chart with ten-minute volume measurements, and this volume was less than other recent spikes and cooled). While trolling through my brokers' site for information on ACAS, I ended up looking at a recent spate of reports on the company. In case anyone thinks there's something like agreement on what ACAS' business will deliver investors, I thought I'd share this gem:

Seriously, can views of a company's prospects as an investment get any more scattered across the map?

So I looked at some of the reports.

The bullish report, from MarketEdge, was thin on analysis but offered a whole table of which chart metrics were "bullish" or "bearish". The analysis that did appear said, for example that moving average convergence/divergence (which the authors did not describe) portended a bullish future, and that "Relative Strength is Bullish." Capital letters were in the original. (Some of the comments in the "report" remind me of the output one can obtain from -- you can reload that page for more output, at the top of the page in bold.) This opinion was listed as effective for the week ending October 3, 2008, and the opinion was listed as having been formed when the share price was $25.75.

Since that time, I was able to make a purchase for a relative at $14.50 per share. Just how good are pictures on stock charts for predicting the next chart the ticker will print?

Since I've already lambasted vacuous analysis of ACAS offered by Jim Cramer, I opened's report on ACAS with some anticipation. I enjoy Jim Cramer, don't get me wrong; he is entertaining. He may even be right on his call that SHLD and GS are one-stock retirement funds in the model of Berkshire Hathaway and serve as a workingman's hedge fund, though the fact he later said SHLD was a short tends to make me think he's had a change of heart. I haven't followed up his call on GS, made near 190, but I think the way to buy GS is to be Warren Buffett and to get a sweetheart deal not offered to retail investors.

Looking at the report, I noticed there was some interesting reasoning going on in The's October 5, 2008 analysis of American Capital:
Notional derivatives exposure is a subject of concern for the Federal Reserve since, in aggregate, these companies are holding a notional value of more than $70 trillion in exposure. While firms are reporting improving profitability, there is also a trend of higher risk appetite. We expect the economy to continue to expand in 2005, with the Federal Reserve maintaining a policy of interest rate increases. Ultimately, the presence of tighter regulatory oversight coupled with a growing economy should bolster capital market activity going forward, and the industry’s prospects for increased profitability should remain favorable.
If the authors of the report thought what happened in 2005 was material to likely 2008 or 2009 performance, the authors of the report could be bothered to look up what happened in 2005 rather than talk about "expect[ing] the economy to continue to expand in 2005, with the Federal Reserve maintaining a policy of interest rate increases." Yesterday, the whole planet seemed to reduce government bank rates half a percent. If "2005" were a typo, and they'd meant 2008, I'd say they got it wrong.

I don't think 2005 was a typo, though. They probably meant what they said, and intended to refer to 2005. I've seen vastly-obsolete predictions in reports like this before, and I don't think the authors pay enough attention to notice the reports' content so as to realize they should update the text. I can't work out why the national derivatives exposure is an ACAS-specific concern, unless believes that ACAS has a dangerous derivatives exposure -- which the report does not suggest in the slightest. opined that the economy is growing, and if ACAS hasn't got some identifiable exposure to dangerous-looking derivative instruments, the story on the economy should stop there. (Maybe doesn't think the economy is growing, just that it "will" grow in 2005; the authors should pick up a newspaper from this year, and relate that to the expected future instead of the prognosticated past.)

Other reasoning applied to ACAS involved the earnings metric (rather than the taxable profit metric, which drives dividends) and FAS-157-compliant valuations reporting. At a time that the mark-to-market rules are being examined as a culprit in financial firm failures, one wonders what unrealized but supposed 'losses' mean, exactly, on investments that are performing as expected. One also wonders whether the rules that require performing investments to be written down due to factors other than their actual performance -- such as the resale market for the investment -- will survive much past the close of the study period.

The difficulty of valuing complex derivative instruments certainly gives rise to a host of evils. Warren Buffett explained how two firms could both lawfully claim to have a profit on a hard-to-price derivatives transaction, and how employee bonus structures created incentives to overstate valuations of these instruments. The incentive of parties to create difficul-to-value instruments to carry on the books for a period of time longer than any worker's whole career is clear: they want to cheat. Especially with contracts that aren't due for many years, and whose performance cannot be ascertained, there is risk of deception in valuation.

However, the lack of existence of a secondary market for fully performing loans hasn't caused federal regualtors to cease allowing banks to claim the nominal value of the loan. Performing loans on the books of other financial institutions are arguably much more accurately valued on a similar basis, or on the basis of a present value model for the future payment stream represented by the performing loan, than they are at fire-sale liquidation value in the face of a market characterized by liquidity crisis. Mark-to-market might make a great deal of sense for investments for which a liquid market exists (at least, if control blocks are not at issue), but it has some non-trivial drawbacks in the case of investments that cannot be readily sold (whether due to covenants, or regulations). An investor (as opposed to a trader) is much more interested in the fact that an underpriced mortgage instrument pays millions per quarter as promised (and the knowledge that it need not be liquidated) than in what one might obtain in a fire sale involving commercial mortgage instruments.

I don't pretend that American Capital's price drop to half its last-published net asset value has been enjoyable to watch, but I can tell you that on the dividend payment date next week I hope it's even lower. I hope that it remains low while American Capital reaches a date in which its compliance officer informs management it is not barred from trading in the firm's securities, and can exercise the remaining amounts in ACAS' $500 million share buyback authorization.

At current prices, ACAS is in a position to retire about a sixth of its outstanding shares with the remains of its authorized buyback. ACAS' fairly consistent operating earnings would benefit from a boost like that, and ACAS' concentration of realized investment gains across fewer shares would be a big benefit to shareholders going forward. In the past, ACAS hasnt' had many days in the quarter in which it wasn't barred from making share purchases, however. ACAS' ability to time its buyback may be poor. On the other hand, participants in the DRIP will be able to benefit substantially if the current pricing continues, as ACAS' $1.05 dividend is approaching 8% of the share price -- for one quarter.

Assuming my hypothesis about people misunderstanding ACAS is right, and that ACAS is as sound as I expect, then the outlook for the future is tremendous. In that case, this is a great time to be in the DRIP -- and a very interesting problem for ACAS' management, weighing the benefits of existing investment opportunities against the benefits or a share buyback. If the opportunities in the market involve mispricing as severe as appears the case in ACAS, then perhaps ACAS has other opportunities that make it hesitant to not to invest.

At current price levels, ACAS could take a substantial write-down in asset values and reduce its dividend and still provide an outstanding return. There is no reason known so far that ACAS' capacity to continue dividends should be impaired, however; ACAS has been consistently liquid throughout the recent economic situation, and has been managing its leverage with a prescience that has kept it far from its regulated limits. ACAS seems well-positioned to survive the downturn, and looks to provide excellent returns for anyone with the financial strength to remain invested.


Anonymous said...

I got stuck at "national derivatives exposure" (your statement); as contrasted to The Street.Com report that stated "notional derivatives exposure".

NOTIONAL VALUE (with an "O", not an "A") is a financial term, you can find it on In brief notional value is defined as: The total value of a leveraged position's assets.

Jaded Consumer said...

I can see why you're confused, as the words appear similar in print. The issue raised here is the relevance of the national aggregate exposure of financial firms to a particular notional value of derivatives contracts.

Assuming hasn't any particular reason to think ACAS' exposure to derivatives contracts is alarming, the aggregate exposure isn't important if one accepts's thesis that "the economy [will] continue to expand in 2005" -- that is, that the national impact of the exposure to $70 trillion in notional value of derivatives exposures isn't a problem for the national economy.

Obviously, the exposure to derivative instruments is a serious problem for many financial firms (ask AIG about its derivatives exposures), and illiquidity in the CDS market due to concern about counterparty performance capacity illustrates that the concerns impact the marketplace. One might reasonably ask whether, but for derivatives whose underlying trigger conditions are based on the housing markets, we would have had the same level of broad panic we experienced last week. didn't seem interested in pursuing the implications of the problems raised by derivatives ... and unable to connect ACAS to any of the problems. In short,'s piece seemed puffed full of mindless bloviation and text that was several years out of date.

Why in 2008 would they predict future economic events in 2005, unless too negligent to keep the analysis updated? As of Oct. 12 2008, the 2005 "predictions" still appear in's report.

Trading under half NAV, ACAS is still rated by as a SELL at a price under $14. Crazy.

Tomorrow, we'll see whether ACAS is solvent or not, though.

Thanks for dropping by!