Evaluating A Negative View on American Capital Strategies (ACAS)

Readers can click here for my views on ACAS but for another view, Nicholas Yulico at thestreet.com pans the company and the stock, stating that the company is still overvaluing certain debt assets on their books.

Yulico has written a few negative articles on ACAS before and honestly, my first instinct on any negative piece on a stock I’ve already bought is to dismiss the critique as misguided or the critic as an idiot. These base instincts, if you have them too, should be ignored — any supported critique should be taken into account. While it seems obvious, the need to be right should always be secondary to the necessity to retain and build capital.

Yulico brings up some interesting points such as AmCap writing down equity values on certain portfolio holdings but still retaining relatively high mark-ups on the debt side. He also continues his point of contention regarding the ECAS control premium. For good measure, he points out the low institutional make-up of the shareholder base (45%) , the low percentage (< 1%) of insider holdings and name-drops David Einhorn of Greenlight Capital as a prominent short in the stock.

Here is the telling conclusion to the article:

“…A few months from now, it wouldn’t be surprising if the control premium disappears and American Capital is forced to value this investment like the disappointment it is.

Even if American Capital can get away with all these aggressive valuations, the company is starting to fool fewer and fewer investors.

Just 45% of American Capital’s stock is owned by institutions — which means it has a very heavy retail investor base, which is not a positive. Less than 1% of the stock is held by insiders.

Retail investors continue to chase a very high-dividend yield, now at 12.5%, while their principal investment — the price of the stock — has fallen 35% from its 52-week high.

I’d stay clear of this dog. These days, the smart money in this stock is in the short trade.”

Some of Yulico’s comments are valid and enlightening. I had not been measuring PIK income as a percentage of NOI and this has been steadily rising over the years to come to 38.4% of NOI and 31.% of net realized earnings, which is the first time since at least 2002 and possibly ever, that PIK income comprised over 30% of realized earnings. Also, his remarks on AmCap’s resistance to marking down debt even as they devalue the same company’s equity does raise concerns. And we never like to see negative operating cash flow.

My response to this goes along two lines. On the investment perspective, I recognize his criticisms but remain unconvinced that his bones of contention are a serious threat to our (long-term) investment.

I fully expect and am braced for more writedowns at AmCap. The company has already provided guidance with the baseline assumption of a U.S. recession. But really, how many financial companies can claim to be writedown-free during this crunch? Yulico mentions Einhorn but Einhorn is going on every media outlet he can find to blab about Lehman Brothers. Obviously there are many financial institutions in much more dire straits than ACAS.

What’s more, my investment thesis centers around the security of the dividend and as AmCap has already reserved much of this year’s dividend and plans to do so in 2009 as well, the dividend seems secure at this point. Strangely enough, Yulico does not discuss this aspect of the company at all, even as he accuses retail investors of foolishly (my term based on his implication) chasing the dividend. I’m not sure why Yulico would ignore this aspect which would seem to be a major risk to his bear case but it leads me to my next line of thought.

While acknowledging the rough times ahead for AmCap (I am hoping they can maintain their non-accruing loan percentage to the previous downturn high of 15%, from 8.2% now), the company has 3 pillars that should help it perform better than most other US financial companies:

  1. By law, AmCap can not leverage more than 1:1 debt to equity. While the company may try to aggressively mark its book to free up more capital, it would take a catastrophic financial event to force ACAS into the forced selling situation that has befallen Bear Stearns, CIT Group, etc.
  2. Portfolio diversity: as Yulico points out, the company has over 170 portfolio companies and doesn’t micromanage them (unless the company becomes distressed). As such, the diversity should help buffer against a general downturn. Also note that AmCap has virtually no exposure to residential mortgages and little exposure to the CMBS, CDOs relative to the rest of their portfolio.
  3. Management track record. They’ve had a good run over the last 10+ years but then again, so did Bear Stearns.

Finally, Yulico’s vindictive tone seemed to indicate a personal beef with the company. TheStreet.com claims it’s “distinguished itself from other financial Web sites with its journalistic excellence and unbiased coverage of the financial markets…” but this article undermines that claim. Yes, I’m sure that some readers will make some crack or other about Cramer and journalistic excellence but I generally give the guy a break — people should take responsibility for their own decisions.

First, Yulico’s article, and specifically his conclusion, is littered with emotionally-charged terms like “like the disappointment it is”, “the company is starting to fool fewer and fewer investors” and my favorite, “stay clear of this dog.” Financial journalism should be focused on information to make money, not childish attempts at ego-building or disparagement. Doesn’t bother me personally but readers should take the author’s perspective into consideration when judging the merits of his case.

Secondly, and perhaps most importantly, Yulico makes no attempt to present the risks to his case (i.e. the bear case on ACAS). There IS ALWAYS A RISK/DOWNSIDE. Even Barron’s will make a half-hearted attempt to run down the risk in the last 10 words of a 3 page article. Yulico states that after a 35% fall from its 52-week high, the smart money is on the short side. Wouldn’t the smart money short before the 35% fall, not now? By completely ignoring the risks to his thesis, Yulico does TheStreet.com’s readers a disservice.

As always, I implore readers to make their own judgements. I post my opinions and the reasoning behind them but it is up to the reader to evaluate the stock and its place (or not) in his or her own situation.

More on this topic (What's this?)
American Capital Strategies (ACAS) Dividend Analysis
ACAS is a Bargain Worth Buying
Read more on American Capital Strategies at Wikinvest

One Response to “Evaluating A Negative View on American Capital Strategies (ACAS)”

  1. The Enlightened American » ACAS: Re-examining My Position Says:

    [...] a previous post, I reviewed an article that highlighted the company’s propensity to leave debt valuations marked up even as they [...]

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