I am starting to sell my American Capital, Ltd. (ACAS) shares today. ACAS showed a strong performance in book value growth for 1Q13 at 6.7% or 27% on an
annualized basis and those gains could continue. However in my view the risks have increased sufficiently to exit the position.
Reason #1 we have a nice gain, let’s not be greedy: We bought at $7.39 per share with a 38% margin of safety and the potential for appreciation of 50-60% to the estimate of intrinsic value of $11-12/share with a 1-2 year time frame. At the current price of about $14.50/share we realized a gain of about 95% well exceeding our original expectations.
We also estimated the company’s potential to reach $15-18/share in a 3-5 year time frame. The current performance indicates that is still a possibility but is seems the risks are higher and increasing. At $14.50/share that would be about 12% additional gains to the mid-range of the 3-5 year estimate of $16.50/share. This is not sufficient to continue holding the investment for the reasons discussed below.
Reason #2 the changing face of ACAS: In our thesis we purchased ACAS because it “offers a unique opportunity for non-institutional investors to invest in private equity at a deep discount to its intrinsic value.” ACAS’s private equity is in middle market companies; small to mid-size business with potential to grow faster than their larger competitors. Through the restructuring the company’s private equity assets, at fair value, declined from $5.1 billion (76% of the total assets) in 2009 to about $3.2 billion (50% of the total assets) in 1Q13.
Reason #3 increasing exposure to credit markets: The assets of American Capital Asset Management, ACAS’s asset management segment, has increased over 700% since 2010 from about 2% of the total assets to about 16% of the total assets. American Capital Asset Management’s primary holding is American Capital Agency Corp. (AGNC), a publicly traded mortgage Real Estate Investment Trust (REIT).
Mortgage REITs borrow low interest short term money to buy longer term home mortgage securities. They earn the difference between the interest rate they pay on borrowings and the interest rate they receive on the mortgage they buy (the spread). Unlike most REITs they don’t buy actual real estate, commercial office buildings or malls, they buy mortgage securities. They then use leverage to increase their profit margins. For example, AGNC is leveraged at 8.1x; they borrow $8.10 for every $1.00 of equity (that we own through ACAS) [Source]. So, although ACAS has significantly reduced its direct borrowings, it is becoming more exposed to credit markets through its asset management business.
Reason #4 interest rates will rise: The Federal Reserve Bank is using “quantitative easing” or QE to try to stimulate the U.S. economy. This loose monetary policy has resulted in historic low interest rates making short term money very inexpensive. We don’t know when interest rates will increase but we know they will. They are at historically low and unsustainably levels. When they do rise, the value of AGNC’s portfolio and earning will decline as the “spread” shrinks. For example for every 1% increase in interest rates, AGNC’s portfolio assets (the mortgages) are estimated to decline in market value by 1.6% but because of 8.1X leverage used, AGNC’s net asset value will decline 10.8% for every 1% increase in interest rates. This is per AGNC’s 1Q13 estimates [Source].
Reason #5 regulators are becoming concerned with mortgage REITs: The Wall Street Journal reported on April 19, 2013 [Source]: “A panel of top financial regulators is targeting mortgage real-estate investment trusts as a potential risk to the U.S. financial system, the latest example of Washington’s growing concern with market bubbles.
Next week, the Financial Stability Oversight Council, a panel comprising the top U.S. financial regulators, is expected to cite mortgage REITs as a source of market vulnerability in its annual report, according to people familiar with the matter, a distinction that could set the stage for stricter oversight of the industry…” The mortgage REITs assets have quadrupled to more than $400 billion since 2009 and ACAS’s AGNC is one of the fastest growing. What impact regulations may have is unknown.
Mortgage REIT fans will argue that hedging programs are in place to offset rising interest rates. AGNC has been very adept in navigating these markets. But the question is can they continually outperform the market in the face of rising interest rates. Perhaps, but my bet is not consistently, because very few if any have done it. Investing with increasing exposure to mortgage REITs, leveraged debt and financial risk are just not where I want to be.
ACAS and AGNC may do well for months or years to come but the risks are beginning to outweigh the potential remaining rewards. Besides, there are better risk adjusted returns, in my view, available elsewhere. For the reasons above I’m selling.
Disclosure: Long ACAS and will sell starting today