Friday, December 5, 2008

Not Trading

I've been out making money -- that is, working -- and haven't been completing posts I have in the works. I apologize. In the works is a post I started on Berkshire Hathaway when it was at $2500, touting it as a one-stop shopping opportunity for investors looking for fire-and-forget portfolio diversification, which I promised here. I see the company's B shares have been past $3500 since then, and are on the way back down. I'm sorry I haven't been able to spend more time here.

I keep getting posts about my developing thoughts on ACAS. I'm not trading, to get in or to get out.

The stock price collapse since the last quarter has been severe. I believe that the combined effect of ACAS losing its income investor constituency to the dividend suspension (necessary to maintain liquidity; gaming the rules to pay taxable income as late as possible will aid efforts to survive whatever happens in the near term, and will leave ACAS with time to work out whether a different tax structure -- and different accounting treatment -- would help the company survive the current panic) and the share price dropping low enough that some institutional investors are no longer permitted to buy it have created an environment in which the motive and reason to buy ACAS seems hard to fathom. After all, between the quarterly announcements, one hardly knows what's going in at ACAS.

One thing I believe is happening at ACAS is that its investments are paying as expected. ACAS made $0.74/sh in NOI last quarter. Articles suggesting that ACAS got killed because it "dabbled in commercial mortgage-backed securities and structured finance products such as collateralized debt obligations" miss the point that those products are performing according to plan. ACAS isn't hammered because it made a shaky CDO bet. Understanding what's happening at ACAS is trickier.

ACAS has been killed by the accounting rules that apply to BDCs. Berkshire Hathaway, for example, need not report each quarter what GEICO is worth, or Dairy Queen, or any of its businesses that are intertwined with the housing industry. Berkshire just reports its income, and leaves you to work out what the enterprise value must be. Only for certain assets -- like derivatives -- does Berkshire have to apply mark-to-market. Because of its tax status, ACAS lives in a different world. FAS-157 and the use of bond-yield-analysis (for debt holdings) and comparables pricing (for modeling equity values) to create SEC-reportable values have the perverse effect of creating "losses" where there are no investment realizations, and where a company with different tax treatment, like Berkshire, would never have to report trouble. If ACAS were a bank, its performing loans would be carried at face value rather than at the steep discounts that the current credit market gives loans being dumped for liquidity. In fact, ACAS' senior loan syndications are sold at par, and not at a discount at all. ACAS never intended liquidating its subordinate debt in its portfolio companies; those are the tools by which ACAS makes money on its portfolio companies prior to liquidation. Who cares what strangers would pay for debt that yields ACAS regular payments?

ACAS has a problem that has nothing to do with its accurateness in underwriting investments. ACAS' problem has to do with unrealized valuation changes causing a liquidity crisis unconnected to its earnings. Redirecting liquidity into debt pay-down prevents ACAS from investing in good deals as bargains erupt in the marketplace, lest ACAS blow regulatory debt/equity ratio limits. I think ACAS' managed investment AGNC shows us something about ACAS' debt underwriting acumen.

The problem is that ACAS can't just sit back and enjoy the performance of its investments while the market re-values these investments. Ordinarily, a Buffett-like investment horizon (well, until the subordinated debt matures, which isn't really "forever") is no problem for ACAS. These times aren't ordinary. In a liquidity crisis, the long-term accuracy of underwriting is less important than the extent of the fear of the current market participants.

At the moment, I am neither buying nor selling. I think it's possible that ACAS is trading at a huge discount to NAV -- the last quarter's published NAV was easily more than six times current prices -- but the hard cold fact is that with only quarterly snapshots, ACAS' health at this point in the panic (and the market is in a panic) is at best an educated guess. I can't say whether tomorrow will be so much better a buying point that today is a fool's bet, and I can't say that the current panic has driven the price so far down that ACAS' efforts to control liquidity will cause a chorus of euphoric cheers when the next quarterly report appears. Frankly, I expect the current economic macro-conditions to remain bleak well into 2009. The effect on comparables pricing should be harsh. ACAS' announced plan to plow funds into debt reduction and its stated preference to work without leverage are on the mark for how to approach this environment ...

... but ACAS has been de-levering for over a year. ACAS' NAV has been clobbered not by the implementation of FAS-157 -- the bogeyman we were offered last year -- but by the need to mark to market investments which were intended to be held to maturity and are performing to model. Earlier this year, these discounts gave me reason to be confident the company was on sale. Today, the prospect of further depression of valuations of performing investments sends cold chills down my spine: it produces a liquidity crisis while risking breach of net worth covenants that would in turn trigger more liquidity problems (as lines of credit became at risk of withdrawal).

The irony is that I don't dislike ACAS' portfolio. ACAS had, in effect, the same problem I had in my own portfolio: good ideas whose performance have been clobbered by the application of leverage heading into a panic, creating a liquidity crisis. Entering counter-cyclical and non-cyclical businesses was a good idea, and shunning them in favor of debt reduction didn't seem reasonable to me before VIX hit 60. Closing offices and reducing staff aren't what ACAS wanted to do, but it's a solid cost-control measure that will impact ACAS' liquidity in the right direction.

Will ACAS be able to take ECAS private? If so, shareholders of both companies would benefit (ECAS from the increased liquidity of ACAS shares, and ACAS from the accounting impact of buying ECAS below NAV). If not, ACAS will suffer as ECAS' illiquid shares continue to be valued awfully low by a market distrustful of private equity. In the meantime, ECAS is producing nice income for ACAS, to the tune of €0.14/sh this quarter. Buying more of that income below NAV would be good stuff.

Failing to pull off the ECAS transaction would hurt.

My prediction is that ACAS will fight to keep its current tax status, but it's dicey. I believe the fallback position will be something like a bank holding company, which will have radically different accounting rules and freedom from mark-to-market on much of its portfolio (the equity will be, but much of ACAS' portfolio consist of debt holdings that would be carried at face value if performing), or an investment holding company like Berkshire Hathaway. Neither enjoys the tax-efficiency of pass-through tax status -- something that made ACAS as a BDC very attractive in pre-tax/tax-deferred accounts -- but either would position ACAS to weather the current economic storm on the strength of actual investment performance rather than suffer the illusory gain and loss risk caused by FAS-157.

I didn't think FAS-157 would have any impact but to lower my reinvestment price, so I thought it was an entertaining but good thing for me as an investor. The current panic reveals FAS-157 to be a truly dangerous opportunity to whipsaw both asset values and debt ratios on the basis of factors that may be substantially disconnected from actual investment performance. As I previously posted, if ACAS were to lose half its income production to debt-eradication efforts, its NOI would support a price several times current levels. That's a bad case.

That's not the worst case, though. The worst case involves a liquidity crisis that drives ACAS into liquidation. However, that kind of liquidity crisis seems strongly associated with ACAS' tax status, a condition within management's power to change. Conversion into a C corp, and registration for treatment as some different type of investment, would also change the accounting rules Kosher for ACAS to apply to its business. Management is loathe to ditch BDC status, but they've explicitly addressed it and therefore are looking at the factors that would drive them to it. Conversion to a C corp would result in a Berkshire-style dividend (zero, to avoid double-taxation), improved book value, and a share price that should stabilize as it becomes evident that NOI continues to perform and that banks haven't abandoned ACAS as a house of cards.

This last year makes me think diversifying out of Apple was a silly idea. Apple's phone has, after all, just passed Microsoft in smartphone operating system share after passing Motorola's RAZR in sales share ... while Apple is taking sales share from competitors. Apple shares are going to come out of this one very nicely if I'm not mistaken.

2 comments:

Rob-0 said...

Thanks for the analysis and your thoughts on ACAS. It's a tough time for everyone but as an ACAS LONG and holding.... it is so helpful to read your blog.

It is hard to imagine what next year will bring. Best to you.

babycondor said...

What is your opinion of ACAS management's request for shareholder approval to sell shares below NAV in order to fund the acquisition of ECAS AND OTHER unspecified deals?

http://phx.corporate-ir.net/phoenix.zhtml?c=109982&p=irol-sec

(link to SEC filing of Dec 24, 2008)

I am in favor of completing the ECAS acquisition as you outlined in your excellent analysis. However, I am concerned that management is asking for approval to issue more shares than are necessary for that acquisition. Does this seem prudent to you? Won't this be extremely dilutive to existing shareholders? What is the potential upside here?

Your thoughts are appreciated. (I am painfully long ACAS.)