American Capital (ACAS) has a kind of Lazarus quality, rising from a near death experience in 2009 and then reemerging as a healthy, growing company. I got in below $2.00 a share in early 2009 and have enjoyed the ride up to Tuesday's closing at $11.86. It has sometimes been a bumpy road. Last Fall, John Paulson's hedge fund unloaded a ton of the stock and drove the price down into the $6 range. I thought it was a buying opportunity and said so here on October 6, 2011, when ACAS was trading at $6.50 a share.
Whenever I get in this situation, I ask myself the same question I ask about old cars and old boats - "Am I holding on just because I am sentimental or based on the merits?" I try to make my successful investments pass a higher threshold of validity test because the very fact that they have moved sharply higher is cause for at least some caution. That said, I still think that ACAS at the current price level is one of the better opportunities in the market today.
ACAS is a complicated and often misunderstood company and that can set the stage for mispricing the stock. The bull case is very simple: ACAS as a net asset value (NAV) of $17.39 and at $11.86 it is trading at more than a 30% discount to NAV. NAV has been increasing sharply the last couple of years. Management seems attuned to shareholder interests and has been aggressive in buying back stock with buybacks, reducing share count roughly 10% over the last year. Leverage is low - debt at less than 25% of gross assets and has been declining.
The problem is that ACAS is a little bit like a platypus - part bird, part mammal, part something else. ACAS is a business development company (BDC) and is generally analyzed as part of the BDC universe. BDCs are generally regulated investment companies (RICs) which are subject to special tax rules which allow them to avoid corporate income tax but in turn require them to pay out 90% of their income as dividends. The dividends are generally taxed as ordinary income. Thus, BDCs are ideal for tax sheltered investment pools like IRAs and 401ks and tend to attract yield oriented investors (for some BDC investors, monthly rather than quarterly, dividends are a big plus). BDCs tend to be valued, at least significantly, based on dividend yield.
ACAS is a BDC but has elected to discontinue its status as a RIC. This makes ACAS very, very unusual - I am not sure if there is any other non-RIC BDC. As a practical matter, ACAS is subject to normal corporate tax rules. It has huge net operating loss carry forwards so that it will not actually have to pay taxes for some time (and when this time comes, I guess it may reconvert itself to an RIC). ACAS has also elected not to pay dividends until its share price returns to NAV. This is not some sort of protest like the Cuban revolutionaries not shaving their beards until the objectives of the Cuban revolution were realized (ever notice that they STILL have beards?). Instead, it is management's perception that shareholder interests are better served by using cash for paying down debt, building up the business and share repurchases.
This makes ACAS a bit of an outcast in the BDC community and certainly unpopular among investors who are attracted to BDCs for their dividend yields. This, and the fact that ACAS plummeted from a price in the 40s during the Panic of 2008, explain a certain degree of investor "revulsion" which depresses the share price.
ACAS is also somewhat confusing at the operational level. It has a very large asset manager subsidiary, American Capital, LLC, which manages enormous pools of assets on a fee basis. The assets include American Capital Agency (AGNC) and American Capital Mortgage (MTGE), two large mortgage real estate investment trusts (REITs). Some investors get very confused about this and almost every article dealing with ACAS is followed by numerous comments on this topic - AGNC and MTGE are not subsidiaries of ACAS, they are not owned by ACAS, ACAS stock will not necessarily go down when they go down. AGNC and MTGE are separate companies that happen to be managed on a fee basis by a subsidiary of ACAS. This has worked out well for ACAS as secondary offerings have allowed assets under management (and thus fees) to increase because of the popularity of mortgage REITS. But ACAS is not a mortgage REIT and does not "own" a mortgage REIT.
In recent quarters, NAV and earnings have been impacted by changes in the valuation of the net operating loss. I am not a tax lawyer and I do not even try to do my own tax return. I am left somewhat ill at ease when a big balance sheet asset is called a "net operating loss" for a variety of reasons. There is a sense of cognitive dissonance associated with treating a "loss" (a bad thing) as an "asset" (a good thing). In reality, this item on the balance sheet will probably obviate the payment of a lot of money to the IRS over the next few years and so it does seem to have value and we should trust the accountants to figure this kind of thing out. Anyhow, it is a sizable item but as of the last quarterly financial statement, it was "only" some $511 million of the asset base or roughly $1.56 a share which would still leave NAV at $15.83 a share.
On the other hand, there is a decent argument that ACAS has a large undervalued asset on its balance sheet. ACAS does business in a place called "Europe" (East of the Atlantic Ocean and made up of charming groups of people who make great cheese, wine, clocks and even automobiles, but who occasionally get into wars and other vicious disputes with one another and seem to be heading in a very dysfunctional direction right now). Its subsidiary in Europe is called European Capital Limited (European Capital) and is valued on the balance sheet at $743 million. European Capital owns the typical combination of loans and equity interests in the companies it has provided financing for and the NAV of European Capital assets net of debt is some $200 million higher than European Capital's fair market value on the ACAS balance sheet.
It has already taken most of the article to explain some basic realities about ACAS and its status and its balance sheet. On the operational side, trying to exclude extraordinary items, operational income before taxes is up more than 20% year over year in the nine months ending September 30, 2012. Of course, per share operational income before taxes is up even more because of the massive share repurchases. Confusion about the status of ACAS and its relationship with the REITs, as well as some of the nasty bumps on the road to recovery, may explain why investors are not exactly piling into this stock. I do not anticipate a straight line up or an imminent pricing at NAV. However, share repurchases are a powerful tool for a company priced well below NAV (a company priced at 50% of NAV which uses 20% of its assets to buy back shares will increase its NAV per share by 33% - don't ask for the formula). Share repurchases always make me ambivalent about market dips because the silver lining is that more shares can be retired and share count can be reduced.
I guess the bottom line is that I love buying $1.00 worth of assets for 70 cents. I am also encouraged by the fact that management seems to have shareholder interests in mind as evidenced by the aggressive share repurchase program (at the rate they are going, I may wind up owning the last share). If they were interested only in lining their own pockets, they would leave the cash in the company and justify high salaries based solely on gross asset value rather than net asset per share value. I also agree with them on the proposition that, at this discount to NAV, share repurchases are preferable to dividends. The market has moved up quite a bit from the March 2009 lows and sometimes I find it hard to identify true "bargains" this year. ACAS is definitely still such a bargain.