American Capital: Buy The Recovery

| About: American Capital (ACAS)
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Investors in American Capital (NASDAQ:ACAS) have been rewarded this year with a strong 64% return. This return is noteworthy in that it comes after three years of recovery from the financial crisis of 2008 and 2009. Through this article, I will examine the fundamental drivers which have propelled ACAS through its recovery as well as suggest that investors purchasing this stock stand to benefit in the future.

A History of Returns

The past few years have brought great levels of volatility to ACAS. As volatility increases, investors tend to experience increases in greed or fear. In order to properly analyze a volatile security, I believe that we should rely heavily on objective analysis. In this article, I have used return on assets and return on equity to properly and objectively analyze ACAS. Return on assets is the net income of the firm divided by average total asset. This metric is important in that it tells an investor how efficiently management uses assets to generate profits. Return on equity is the net income of the firm divided by directly-invested shareholder equity and this key metric tells the investor how effectively management uses investments to bring income into the firm. The chart below shows 5 years of return on assets and return on equity for ACAS.

It can clearly be seen that there are two or three noteworthy periods in the chart above. The first noteworthy time period occurred between 2008 and the middle of 2009. During these brief quarters, the firm essentially collapsed from a fundamental standpoint. The first quarter of 2008 was profitable, but within a year, the firm was losing $100 for every $100 invested within the organization, on a quarterly basis. These massive losses almost destroyed ACAS and the stock price declined around 94% in response to the fundamental performance. In the third quarter of 2009, ACAS was finally able to reverse its decline and for the next two years it delivered growing fundamental performance, as measured by return on assets and return on equity. Shareholders during this period enjoyed a 240% return, which signaled a recovery from the darkest days of 2009. Between the third quarter of 2011 and the second quarter of 2012, fundamental performance stayed roughly the same and share price likewise increased a negligible amount. Over the last quarter, ACAS has increased from a fundamental standpoint and shares have surprisingly traveled sideways over this period. The table below shows a summary of these time periods.

The previous quarter of flat share price performance provides a strong investment opportunity. As demonstrated for the past 5 years, the market tends to reward organizations with improving fundamentals. As we have seen, the direction of firm performance has essentially been the direction of share price over the time period studied. This relationship of likewise performance makes intuitive sense in that as a firm betters itself fundamentally, investors will more than likely consider parking capital in the firm's stock in order to receive a strong return. In light of this relationship, I believe investors should consider purchasing ACAS. Over the past quarter, fundamental performance has signaled an improvement and a resumption of the trend established in 2009. This signal has been met with essentially no change in the stock price. I believe that this is an oversight on behalf of the market and a study of history dictates that shares will more than likely increase in the future. For this reason, I believe that investors would be wise to consider purchasing this stock.

Technically Speaking

Even though I strongly advocate purchasing this security, I do not believe that investors should immediately enter a position. I believe that investors are always better served through patience and thinking through the risks of a trade prior to purchasing or shorting a security. Specifically, I believe that investors should wait until the price is able to overcome its 52-week high prior to buying the stock, as seen in the chart below. What this practically means is that if the stock is able to increase above $12.30 per share, then investors should consider buying. I believe that investors should immediately put a stop-loss in place to protect precious capital in the even that this idea turns out to be incorrect. A stop-loss at $10.75 will provide excellent protection should the market invalidate this idea.

In order to lock in profits if the market favors our investment thesis, I believe that investors should look to sell one-third of all shares at $16.00. This threshold has historically acted as resistance and I believe that it could inhibit share price increases once again in the future. As the trend continues in our favor, I believe that a second third of shares should be sold at $20.00 per share. This price has also acted as a barrier to progress in the past and I believe that it may do so in the future. If the price is able to hit this second target, then I believe that investors should move their stop-loss up to $16.00 and should consider holding the shares until the market experiences a fundamental decline, as measured by a quarterly decrease in return on assets or return on equity. The table below shows a breakdown of this trade recommendation. This is a very favorable recommendation in that investors stand to gain $3.25 for every $1.00 that they are willing to risk on the idea. Additionally, if the trade even has a 30% chance of being correct, investors would be wise to consider purchasing American Capital.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.