Thursday, November 6, 2008

November 2008 Stock Pick and Retail Options Explained

Okay, so you bought a few shares of one of Fleabagger's recommendations, you're down 70% and you want to know: "Why should I trust The Fleabagger Portfolio and its recommendations?"

As always, TFP has an honest answer: you and I may not know until 2010. Until then, I request that you just keep reading, and if I am a genius, we should know that in a couple of years, and I will probably start a subscription service for my faithful readers.

This is not just hedging and excuse-making. I remind you that I said from the outset that my time frame for stocks is at least 2 years, and that would be the end of May 2010 for my first pick, NDAQ. I expect this and my other picks to recover more and before the S&P, which is down more than 30% since May. (That may not be as bad as my picks, but it is an index, for crying out loud.)

This month's pick (sorry I'm late, but you have to admit: you did get a mid-month update last month) was going to be something else, but since American Capital Strategies (ACAS) went down about 40% yesterday, and is down again this morning, I couldn't pass that up. The second biggest loser in the whole U.S. stock market, the biggest loser on the Nasdaq exchange, and it is a company I track and respect, and that has already been beaten down really badly this year due to worries from the credit crunch and the deflation of almost all investment assets worldwide.

Let me disclose at the outset that I already owned an ACAS call option contract, I bought ACAS shares this morning, and I wrote (sold) a covered call on those shares.

American Capital Strategies is a Business Development Organization (BDO), which means that they lend to or buy equity (part or whole ownership, like stock) in small companies that do not have their own publicly-traded stock. Since they lend to companies that are too small to attract other sources of financing, they can command a higher interest rate than most lenders, but because they exhaustively research the companies they lend to, and the management staff of those companies, they historically have kept their default (bankruptcy) and non-performing (late-paying) percentages low. If I remember correctly, their default rate in 2006 was less than 1%, and dropped to perfect 0 in 2007. And their non-performing rate historically is in the 5-8% range (though that recently ballooned to 10% - more on that later). They command average interest rates of 11-13%, and they often take equity that is later sold at a profit or remains in the portfolio as cash-generating assets.

Among the companies they own are European Capital (a European BDO-like company that they recently announced plans to buy the remaining unowned 33% of), Mirion Technologies (a company that monitors radiation levels in nuclear power plants and other facilities, and provides comprehensive radiation safety solutions), AAMCO Transmissions (an auto repair company you may have heard of), and scores of other companies that have impressive potential or profitable free cash flow. You can see a longer (yet still not comprehensive) list of their holdings here. Follow the links to their 10Q for the full list.

Now, the reason they plummeted more than 40% yesterday is similar to the reason they'd already gone down more than 50% in the months prior. First, the economy and the expectations for the economy's future are just bad. Also, their portfolio has been marked down again and again as government-mandated accounting rules forbid them to value the assets on their balance sheet any differently from what they could reasonably expect to sell them for in today's market. Well, nobody's willing to pay much for anything in today's market, so that value is low and getting lower every quarter (3 months). When they report their earnings, they have to count reductions in the value of those assets as money they lost, even though they didn't actually lose any money yet. Of course, if something happened that forced them to sell, they would lose that money, don't doubt it.

However, if they are not forced to sell low, this money they have to say they are losing will come back to them automatically when their assets are revalued upward, either in 2009 or 2010 or whenever. If they are not forced to sell, they can keep generating cash from interest payments and wholly-owned subsidiaries like AAMCO, and wait out the economic downturn, or even keep buying distressed assets, which is what they do during the good times, and the pickin's are even better now than they've been in decades. (You can tell I'm getting excited when the sentences are 3+ lines long.) Of course, there is a risk of them being forced to sell, and that's why they were cut to an all-time low.

ACAS has institutions that lent them money. It may seem weird to you for a lender to borrow money, but that's the way it goes these days. ACAS's creditors (lenders) have a provision that allows them to take early repayment if ACAS's net asset value (NAV) drops below $4.5B - they've been steadily dropping due to those asset write-downs, and they're at about $5B. They could very easily drop below $4.5B if things continue to worsen in the economy.

Notice that their creditors would be allowed, not forced, to reclaim their investment early, if ACAS drops below $4.5B NAV. First of all, they would sacrifice interest payments if they did. Much more importantly, they would risk driving ACAS into bankruptcy. That would be really horrible for those of us who bought their stock. But that would be almost as bad for the creditors themselves, because instead of getting cash from ACAS over and over again, they'd get the diminished value of their distressed assets sold off into a market panic. It's like killing the golden goose to feed your family the drumsticks. You would if you had to, but it would be a last resort.

So it seems more likely to me that ACAS's creditors would work with ACAS to make sure those scores of companies in ACAS's portfolio stay in business and keep generating cash to benefit everyone concerned. That is, if they even have the choice, which won't be unless and until ACAS drops another 8% or so of their NAV.

Another reason for the fall yesterday is that the non-performing assets in ACAS's loan portfolio jumped from 8% to 10%. You could call that a 25% increase in the non-performing ratio. I call it unsurprising, considering the economy. Also, these assets are not in default. They have not become write-offs yet. They are merely late, so far. 40% (now 45%) off the stock price is due to more fear than actual non-performing asset concerns.

One more thing (I know this seems like a lot, but the stock did drop 45% in less than two days): ACAS used to pay a quarterly dividend of $1.05. When they were trading in the $12 range, and I thought they were going to pay the dividend, it was an annual yield of more than 30%. Well, they suspended their dividend. Some investors see this as the financial equivalent of hospice care. I already explained why I don't see it that way. They continue to invest their capital (that's what they're supposed to do), and their portfolio continues to generate profitable free cash flow. Now they need more of that cash to stay within the company for a while, and I'm willing to give them a couple of quarters to see how that pans out. At these prices, a risk-tolerant investor has a lot of upside potential to balance those risks.

Another thought on balancing risks: when you buy 100 or more shares of a stock, you can write (sell) a covered call option contract on those shares. I will explain what that means.

A call option is the right to buy stock at a given price, before or on a fixed date in the future. Each options contract is for 100 shares of the underlying stock. For example, if I buy 1 call option contract for NDAQ, and its strike price is $30, and it expires in June 2009, then I have the right to buy 100 shares of NDAQ for $30 each on any trading day up to June 19, 2009. Right now, I might expect to pay about $400 for that contract. (I do not officially recommend buying this options contract. It is used as an example.)

So if NDAQ goes up to $32 by March 2009, I could buy 100 shares for $30 each, and I'm $200 up, right? Wrong! Since I paid $400 for the contract, exercising it at $32 would put me $200 behind. Now, I could hold onto it and see if NDAQ goes up beyond $34 before June 19, or I could see if someone else thinks that and is willing to pay me more than $400 for the contract since NDAQ has already started to go up. But it's hard to say what people will be willing to pay for options contracts in the future. Bid/ask spreads make it hard to get the price you want when you're buying or selling contracts.

Put options, as opposed to call options, are the right to sell stock at a certain price on or before a fixed date in the future. (A call buys, and a put sells.) If I buy 1 put option for NDAQ and the strike price is $20, I'm hoping the price of NDAQ goes down a whole lot, so I can sell it, as a put option gives me the right to do.

However, I recently decided I like writing (selling) covered calls more than I like buying options, as a general rule. To write a covered call, you simply own at least 100 shares of a stock that has options trading activity (as almost all but the tiniest of companies have), and you sell someone else the right to buy 100 shares from you at a certain price, on or before a fixed date in the future. The effect of this is that if the stock goes down, you lose less money than you would have without selling the call. If the stock stays flat or goes up a little, you make more money than you would have just by owning it. And if the stock goes way up, you make less money than you would just by owning the stock.

In some cases (like today) you can limit your potential profit to a maximum of about 25% over the next few months. I may be young and rambunctious, but I can live with that limit. Also, the risk of loss with the stock is still there, but it's mitigated by writing the call.

I recommend buying ACAS below $7.00, and if you can afford at least 100 shares, write a DQSBU.X contract for 2 or more ($200+). Even with online broker commissions, you should be up more than 25% if ACAS stays around these levels. And if the stock drops a lot from here, buy some more. I can't guaranty that this particular stock will do well, but I can prove from history that times like these are the times that make people rich.

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