American Capital Strategies: Why I'm Holding Back

Sep.24.07 | About: American Capital (ACAS)

How can something so utterly predictable still manage to catch the markets off-guard (including yours truly)? Of course, I am referring to the 50bp cut in the Fed Funds Rate this past week.

Our portfolio is focused mainly on energy and precious metals, so obviously, we are expecting inflationary policies from the Fed. But what surprised me was how willingly Ben Bernanke gave up his pretense at fighting inflation to claim his true identity: Helicopter Ben. The violent reaction in the currency, commodities and bond markets left me wondering if the end is nigh and we have progressed from the middle to the end game.

For the last few years, oil and gold related issues have followed almost seasonal patterns of volatility. The market is happy to play along with the Fed's inflation farce while simultaneously ignoring the glaring oil supply shocks headed our way, thus suppressing the true value of both markets. That's fine with us as we'd like to get as much skin in the game as possible before the world wakes up to the situation at hand. We've been taking advantage of the situation to pick our spots, using value-based principles to build positions to hopefully maximize returns above what these secular bull markets will yield. At some point, we will enter the main legs of the gold and oil bull markets at which point these markets will not pull back to attractive levels.

The off-Wall-Street reaction in gold, oil and the dollar index suggests the market is slowly digesting the facts on the ground: inflation is accelerating, energy supplies are strained, the real economy stands on shaky ground and the full faith and credit of the US government doesn't seem to hold much water.

A few numbers have circulated showing how equity markets historically rally when the Fed begins a rate-cutting cycle (the one notable exception being the last rate-cut cycle in 2001). But the present rally seems tenuous and forced. Wall Street's schizophrenic stance is confused. Is the Fed acting to preempt a recession? Aren't corporate profits at record levels due to booming exports? Isn't unemployment still low? Is the consumer maxxed out or are their stock returns offsetting any loss in home equity? Is good news bad or good? Wall Street seems to be talking out of both sides of its mouth but what else is new?

This leaves me at an uncertain junction.

Is it time to adjust our price range when valuing gold and oil stocks? Is the economy headed toward recession? Will the US dollar fall through the 78 support level? If so, should this affect our investment strategy going forward?

Case in point: a possible investment I've been researching, American Capital Strategies (NASDAQ:ACAS), was mentioned Barron's this week, much to my chagrin. ACAS is structured as a business development company [BDC] that is transitioning from a BDC/private equity company to more of an asset management company. They operate primarily in the fragmented US middle market, taking controlling stakes or providing mezzanine or senior debt financing to middle-market private companies. Additionally, they manage various equity funds (including one in Europe) and underwrite debt securitizations. With a 9% dividend and a low market valuation, I've been considering a position.

A few concerns hold me back.

The credit crunch seems to have further to run. In ten years of public trading, the only year ACAS failed to beat the S&P 500 was during the last credit crisis with the LTCM/Russian debt/Asian currency turbulence. So perhaps we can get it cheaper with some patience.

Also, ACAS' non-accruing loans are at a historically low 4.1%. In general, US corporate defaults are near all-time lows. If the economy slows into recession, expect a reversion to the mean. During the last recession, American Capital's non-accruing loans reached 12% in 2002.

Earnings composition is subject to a high degree of volatility and subjectivity, comprised of net operating income [NOI], realized and unrealized capital gains (or losses). NOI has stagnated the last few years as they ramp up spending on talent to transition to more asset management. Their pattern of trend-chasing may work against them as the asset management industry appears to be losing momentum of late. A slow economic environment may dampen their ability to exit portfolio companies at attractive prices, thus lowering realized earnings. And portfolio appreciation is highly subjective and somewhat opaque. During the last slow period (2000-2002), realized and unrealized capital gains markedly reduced total earnings per share. NOI/share averaged $2.29 while EPS averaged $0.30.

To the ACAS' credit, they have never reduced their dividend even during hard times. Management seems to mind shareholder interests and if the American economic outlook stood on firmer ground, I'd be happy to be a shareholder. At $41, I'm waiting for at least a 10% drop before giving it another thought.

At this time, the way forward is unclear. Discretion getting the better part of valor, I'm waiting to see if the game has changed. In the meantime, current conditions and the recent bump suggests now is not the time to open bold, new positions. With all the uncertainty (in my mind at least), perhaps the best path for the time being is selling volatility in relatively safe positions. No one ever lost money picking up dimes and quarters.

Disclosure: none