Evaluating a Negative View on American Capital Strategies

Readers can click here for my views on American Capital Strategies (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.

Disclosure: Author has a long position in ACAS

Comments

[fxtrader07]

thanks, great article.
it is no coincidence that this wannabe financial journalist Yulico mentioned the Einhorn short position. Einhorn is Cramer's buddy and thestreetcom is frequently assisting Cramers hedgefund buddies (Rocker, Ackman, Einhorn, Tilson...)
There is a clear pattern that has emerged over the years. few people have noticed because almost nobody really analyzed it. To cite Mark Mitchell, who has written one of the most outstanding truly journalistic and investigatiovbe articles ever published on the www: (source: www.deepcapture.com)

"It is that close associates of Herb [Greenberg] and Cramer have seized control of a vast swath of the American financial media. Indeed, if you have seen a negative story about a public company in recent years, the odds are greater than even that it was written by a friend-of-Cramer.
...
Many of Cramer’s friends are former employees of TheStreet.com.... They have included the editor and top columnists for The Wall Street Journal “Money & Investing” section, top business writers for The New York Times, reporters at Fortune magazine and BusinessWeek, the editor of The New York Post business page, the editor of MSN Money, and others. Herb, a CNBC commentator and a star columnist for MarketWatch.com, was among the founding editors of TheStreet.com - “Murderers Row,” they called themselves.
....
I have analyzed well over a thousand stories written by this clique of journalists. The vast majority of them were sourced from a small group of short-sellers who are also friends of Cramer. Other popular sources for this group of journalists include convicted felons, mobsters, dubious private investigators, crooked lawyers, hired stock bashers, and gun-toting goons - most of whom are tied to the Cramer constellation of short-sellers.Some of the stories written by these reporters are accurate enough. But many are not. The journalists misconstrue data with seemingly purposeful intent. They exaggerate and obfuscate. "

[fxtrader07]

btw, ACAS has now been for 74(!) consecutive days on the SEC's RegSho-list, meaning that a huge amount of shares has been sold naked short. that means, they were sold but never delivered. Manipulative bashing on message boards is also on the rise.
It seems the sharks and unscroupoulos stock manipulators like einhorn are stepping up their efforts - and thestreetcom is lending a helping hand, as usual

[paulibloom]

David is quite right in focusing on the dividend. This is the primary and maybe the only reason to own this stock. The discussion about asset valuations is a tired replay of the last cycle, and simply does not get at the underlying dividend producing power of ACAS. For example, ACAS has such a high percentage of its portfolio in equity rather than dividend paying instruments that they could actually sell businesses at a loss and increase the NOI substantially.

Along these lines the really important statistic is the assets on non-accrual, as that figure impacts dividends and cash flow. The shorts never discuss this, as it is in reasonable shape. I will tell you from other investments, that the assets on non-accrual is the key discussion factor for CSE, NRF, AHR, KFN, all best in class financial companies.

The shorts rely on the inexperience of retail investors. In addition, I believe most institutional analysts are focused on short term trading and really do not know how to make money or build wealth(I was an analyst for over 20 years and interacted with many many analysts).

The short argument is long in the tooth. The economy is improving, debt market liquidity is improving, and transactional volume will start to increase. With many marginal players, not able to get financing, this is increasingly a big boys game.

ACAS is focused on turning part of their portfolio into cash and gains. As the recent analyst day presentations, indicate, the company likely has numerous candidates that it has nurtured for years that can now be sold for substantial gains to rational buyers. If this goal is achieved, ACAS will enter 2009 with even better visibility on the dividend and an increasing NOI. While all this is going on the Company has the earnings backlog and ongoing earnings power, to make this a very reasonable risk reward scenario.

The shorts should be nervous -if ACAS announces another big capital gain, their whole thesis is sunk. This is why they replay such weak old stuff. Can you imagine a whole article on SPL which has been discussed for months.

I was an investor in ALD during the BLX situation, which was a much larger issue for ALD. After all was said and done, the dividend was increased, as well as the visibility. In a normal world, you would think that would stop the discussion. But it rattles on, over things that do not make real economic sense for the dividend.

[spartanz]

Well done rebuttal without emotion. People buy acas for the divie., And
as banks tighten their credit requirements, bdc's like acas have the capital to get the small and middies, or subchapters over the hump.
Businesses need cash to operate and cash to grow. AA charges $15 a bag because they need CASH. It amazes me that people really do not understand ACAS business model. As for the financial tv show's,
stick with bllomberg, the others are turning into reality tv hype shows. Next we will have a judge judy for business!

[GregoryY]

Excellent analysis! Thank you.

[jeff moore]

We enjoyed what you have to say. We understand ACAS has a 500
million dollar stock buy back plan it announced early this year also.
We invested in ACAS at $34/share and then they increased the dividend, which increased the dividend yield. We will be reinvesting
our dividends back into ACAS stock as the yield is over 12%.
Thank you for the good information.

[.crazylegs.]

What's interesting is that on Cramer's show last week a caller asked him about the BDC space and he specifically mentioned ACAS in a positive light. He did say that he just couldn't do (or wasn't willing to do) the homework to really understand their portfolio and on this basis he stays away. BUT he did day if you can do the homework and feel comfortable with the portfolio then go ahead.

[.crazylegs.]

fxtrader07 - that "deepcapture"... article is prefaced by Patrick Byrne, the straight up lunatic CEO of that awful retailer Overstock. What is he doing being a "reporter" for deepcapture, whatever the hell that is? This guy at one point was talking about Sith Lords and really weird stuff when a few shortsellers realized his company was awful and started shorted it.

[SteveFrankey]

Excellent article Davy...easy to find a couple poor performing companies (maybe valued a little off) out of 170, but to glorify them and say that represents all companies is ludicrous...PauliBloom... not sure if I understand your comment that ACAS could sell equities at loss and increase NOI, could u explain...If I gave ACAS a $1 and they bought a company for $1, then sold it at a loss, even if they paid me cash, I cant understand how that would be seen as a dividend or an increase in NOI

[winslow]

Management has been fairly straight-forward over the years. The shorts will get squeezed.

[nyka]

Another brilliantly written, well conceived analysis by Mr. Bui. I have done considerable research on ACAS, and an totally comfortable owning several hundred shares of the stock.

[paulibloom]

My comment about selling equity at a loss can be understood this way. First realize that ACAS has the largest percentage of their total investment portfolio of any BDC in non-dividend paying equity. If they reduce that equity by selling companies they free up cash to get higher paying dividends. To be clear, you can not carry this too far. However, the thought is to move equity to dividend paying debt. Management actually said they were doing just that, and in fact last year indicated in trouble times they can sell some of their equity positions and get more NOI. ACAS by virtue of their large and diversified portfolio, as well as substantial assets where they control the sale event, can selectively exercise this strategy.

We should not expect that the buyers are stupid, they are smart aggressive firms looking to make a solid return as well. A large measure of the middle-market buyout business is what can you do with the company after you have acquired it, via cost reductions and importantly bolt-on acquisitions. ACAS has done a good job of just that. My bet is that they have a number of companies in their portfolio where they feel they can realize substantial gains, based upon their detailed knowledge of the market. This is why they were so emphatic about what their spillover taxable income will be into 2009. They made a point of putting it in their annual report. Again to be clear if we had perfect knowledge, then the stock would not be priced where it is. The overall business climate appears to indicate they have a good chance of success.

Lastly, the commentary from many other BDCs is reasonably consistent with their views on pricing and activity.

[CycleGirl]

Thank you, Davy, for your well-written rebuttal to Yulico’s article. I also want to acknowledge the good work you've done in your previous analysis on ACAS.

When I read Yulico’s article, I very much got the impression that the book Fooling Some of the People, All of the Time: A Long Short Story by Einhorn, was specifically critical of American Capital along with Allied Capital. Well, I looked at the book at Amazon and searched through it. I was surprised to find that Einhorn was positive about American Capital and used it as a contrast to Allied Capital!

From: Fooling Some of the People, All of the Time: A Long Short Story ....
" American Capital Strategies was one of Allied's competitors, which we had not shorted or criticized. In fact, we owned it in 1998-1999. It had the same business model as Allied Capital, so some believed that our criticisms applied to it as well. In fact, most of our critique had nothing to do with the business model. I don't believe that there is anything inherently wrong with business development companies. Greenlight's criticisms are specific to Allied Capital, ... "

In my opinion, Yulico was purposely misleading about this fact and is trying to use Einhorn's current stature to help make his case.

Several months ago, I opened a small position in ACAS. However, with the recent price drops, I've been accumulating more and more shares. ACAS is now one of my largest positions. I've lost count how many times I've been through the Q1 slide packet and the thumbed through the annual report to see a favorite graph. I am so impressed with the company's track record of growing the dividend and with the fact that they've set aside funds, in advance, to cover 2008 and 2009 dividends.

Once again, thanks for the article, Davy!

[fxtrader07]

@J lazerow: "straight up lunatic ceo" hm? You have obviously nicely been brainwashed by kudlow, Herb Greenberg, cramer and his thestreetcom folks who utilize every opportunity to charaterize Byrne in highly inflamatory langauage, calling him "lunatic", gay, psychopath, and whatever. You see, herb Greenberg till today denies that naked short selling even exists on any significant scale - but never mind that even the sec has by now acknowledged it! So the "lunatic" Byrne obviously was right in his major arguments.
And the "investigative&qu... Herb greenberg investigates all but the biggest financial scam and manipulation (where he is seemingly involved up to his ears).

Often, it pays to ignore what other people tell you about someone and instead read the arguments of this "someone" and examine them thoroughly on your own. And then either agree or disagree - but based on your own judgement.
It's called independent thinking. but if you prefer to dismiss the entire story based on your or other people's notion of Mr Byrne being "a lunatic" - it's your free choice, of course...

[fxtrader07]

jLazerow: look at CALM, as a prime example how RIGHT "lunatic" Byrne is and how crooked Wallstreet, Greenberg, Cramer#s hedgefund firends and the idly watching SEC is.

With CALM, there are currently 126% of the float shorted!!

Yep, you red that right: 26% more shares are shorted than even exist and thus are available for shorting. talk about selling stuff, collecting money and never ever delivering anything.
That's called robbery, fraud and is a crime - except when it comes to the stock market and wallstreet's profits...

[purline]

Davy,

Thank you for the article. I too found some value in the Yulico article (and especially the PIK income,) but not enough to offset the reasons that I'm long ACAS. Interesting that Yulico points to a 45% institutional ownership in the company as a reason to avoid but this is actually an increase from the institutional investment of 30% according to Bernard Condon's article in Forbes on April 23, 2007.

I would love to hear what you and others think about the viability of ACAS at the current dividend rate. Unless the stock price can find support I think that slashing 2009 yield is going to prove unavoidable.