Buy, Sell, or Hold American Capital?

Investors in Warren Buffett's Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) know that sometimes a good investment thesis can be built on investing in a good investor.

Over time, Buffett has proven that his investing prowess is bankable -- and that's whether he's out buying shares of publicly held stocks, negotiating impressive deals on preferred stock, or buying entire companies. Similarly, the future success of the company will depend on Buffett's (and, at some point, his successor's) continued ability to make savvy investments.

The investment case is similar for the stocks of business development companies such as American Capital (Nasdaq: ACAS  ) . In short, BDCs use money raised from public equity offerings and debt to make debt and equity investments of their own, typically in small- and mid-sized companies.

Yesterday, my fellow Fool Russ Krull laid out the finer points of the strengths, weaknesses, opportunities, and threats at American Capital. Today, I thought we'd build on that base and try to figure out what investors should be doing with American Capital's stock.

Buy

  • Debt disaster averted: Things had gotten really nasty for American Capital following the recession. I mean really nasty. When the company released its annual report, it was in default on $2.3 billion in debt thanks to financial covenant violations. As a result, the company's auditors placed a "going concern" clause in the filing. For those who don't speak accountant, a "going concern" clause translates roughly to "we're not really sure this company will keep the lights on."

But that all changed late last month when the company restructured its debt. Not only did the restructuring let American Capital wriggle out some more breathing room, but it also led to the auditors removing that dreaded "going concern" clause from the audit.

  • Economic enthusiasm: The troubled times at American Capital were largely driven by the hairy recession we just experienced. Since it invests in the debt and equity of other companies, when those companies suffer, so does American Capital. But now there's the potential for American Capital to see a turnaround in its portfolio if the economy continues to improve.
  • Eye on price: It's hard to consider whether an investment is worthwhile without considering the price you're paying, and American Capital's looks bargain-basement low. As of March 31, the company had a net asset value -- NAV, or the total assets less debt and other obligations -- of $8.98 per share. Compare that to its current stock price of $5.30. Other BDCs such as Ares Capital (Nasdaq: ARCC  ) and Apollo Investment (Nasdaq: AINV  ) are currently trading at premiums to their respective NAVs.

Sell

  • Safer, but not safe: The debt restructuring was an absolute must for American Capital. However, as Russ pointed out yesterday, that restructured debt won't come cheap. And though the restructuring reduced debt by about $1 billion, the company will still carry a very substantial debt load. Prior to the restructuring, American Capital's debt-to-equity ratio was 164%. Compare that to 49% at Ares and a mere 8% at Prospect Capital (Nasdaq: PSEC  ) , another BDC.
  • Where's the dividend: Another issue Russ highlighted yesterday was the fact that American Capital doesn't pay a dividend -- which is typically a staple of any decent BDC. Ares currently yields 10.2% on a trailing basis, Apollo gives you 10.8%, Prospect is kicking out 16.7%, and even MVC Capital (NYSE: MVC  ) -- which is not really known for its dividend -- is paying 3.7%.
  • Where's the beef: Most troubling, though, is the fact that we'd be investing on the idea that the folks at American Capital are good investors. At the end of March, the company's investment portfolio was a hair over $9 billion at cost, but less than $5.7 billion at fair value. That's a pretty staggering loss of value. As a result, potential American Capital investors really have to ask themselves: "Are these investors I want to be investing in?"

Hold

  • Follow the leader: I do not blindly follow other investors -- even if their name rhymes with Barren Wuffitt -- and I don't encourage others to do it, either. Nor am I nearly as taken with John Paulson as much of the media seem to be. However, Paulson has had considerable success in recent years, so it's worth noting that Paulson & Co. has taken a near 13% stake in American Capital.

The final verdict
Investments are rarely one-size-fits-all, and American Capital is certainly no exception. I see a speculative buy opportunity here for investors who are comfortable with a bit more risk. I can't say that I'm crazy about the company over the long term unless management is able to prove it's a better investor than it currently appears, but the discount to NAV provides a distinct opportunity.

For investors who want to be in the BDC game and want either a solid underlying company, a dividend, or both, the best bet is to steer clear of American Capital and check out the other BDCs.

Do you have your own verdict on American Capital? Head down to the comments section and share your thoughts.

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BerkshireHathaway is a Motley Fool Inside Value selection. Berkshire Hathaway is a Motley Fool Stock Advisor pick. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 29, 2010, at 11:35 AM, maestro72 wrote:

    matt, i am rec'ing this article for the following sentence:

    I do not blindly follow other investors -- even if their name rhymes with Barren Wuffitt -- and I don't encourage others to do it, either.

    thanks

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