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This Week’s Sizemore Insights: The Next Enron?

Charles Sizemore
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It’s never a good sign when a company’s CFO and top accountant abruptly resign at the same time “accounting irregularities” are announced, but that’s exactly what happened at American Realty Capital Properties (ARCP) on Wednesday morning.  We’ll jump into that shortly.  But first, let’s jump to the Fed.

RIP, Quantitative Easing

Well, we all knew this day would come.  The Fed officially tapered “QE Infinity” to zero.The Fed has been preparing us for this day since May of last year, yet the markets–and particularly anything that gets a significant portion of its total return from current income–took the news in the Fed’s statement poorly.  Emerging markets also took a beating.

Why?

It had nothing to do with QE and everything to do with a subtle shift in the Fed’s language concerning the labor market.  Rather than its usual wording that saw “significant under utilization” of labor, the Fed instead said that the slack in the job market was “gradually diminishing.”

By now, I’m sure you know my view here:  Yes, it’s important to understand the Fed’s gameplan because the cost of borrowing has a major impact on stock prices. But this obsession over every tiny tweaking of the Fed’s statements–with the implication that the Fed might postpone or speed up its rate hikes by a couple months–is ridiculous.  I’ve compared it to the Church debates of the Middle Ages in which theologians would argue passionately about how many angels can dance on the head of a pin.  If you are investing even halfway sensibly and with a focus on value, it doesn’t matter if the Fed tightens in 9 months or in 12.

Yes, we need to be on the right side of the Fed’s move.  The old trader’s adage to not “fight the Fed” is good advice.  But seriously, if the viability of your investment strategy hinges on whether the Fed raising rates by a quarter of a percentage point next June rather than next September, then you’re doing it wrong.

A few weeks ago, I made my position on the Fed’s timing very clear–see “The Fed Won’t be Tightening Any Time Soon.”  To start, the Fed has already expressed concerns that raising rates too quickly will make the dollar unacceptably strong, killing exports and job growth.  And inflation is still low enough to give them a little wiggle room.  But the biggest reason to believe that rates won’t be rising much (if at all) is that the hawks screaming the loudest about rate hikes are retiring next year.

Emerging markets are rallying today, as are mortgage REITs and most other yield-sensitive investments.  My gameplan remains the same: I’m focusing on value where I see it.  And right now, that means emerging markets, mortgage REITs, and energy-related stocks.

ARCP: What’s the Story?

Yesterday, I wrote a piece about ARCP’s accounting irregularities, which can be viewed here.  Today, I’ll give you an update.

ARCP had a “damage control” press conference yesterday afternoon in which CEO David Kay said, among other things, “We don’t have bad people, we had some bad judgment.”

Well, bad judgment has consequences, and the CFO and chief accounting officer were both fired, as they should have been.  The worst part is that management admits that the accounting errors were “intentionally not corrected.”

If you love financial minutiae, feel free to read the transcript here.  But I’m happy to summarize.  The forensic accountants investigating the company found no evidence that ARCP intentionally overstated its adjusted funds from operations.  They just made a phenomenally stupid error and then, in embarassment, failed to disclose it.

So no, ARCP is not Enron.  It’s a company backed by solid real estate investments  that grew a little too fast and got sloppy with its paperwork.

What now?

I took advantage of yesterday’s slide to accumulate additional shares at prices ranging from $8.22 to $8.48 in my Dividend Growth portfolio, and we’re a little above those levels now.  But I believe that ARCP could easily deliver total returns including dividends of 50% or more in the next six months if the accounting irregularities end up being anything short of catastrophic.

Let’s take a look at the numbers.  Based on the preliminary reports, the 2014 Q1 adjusted funds from operations (“AFFO”) of $0.26 would be cut to $0.23, and the Q2 AFFO of $0.24 would be cut to $0.22. The audit committee believes that the 2013 numbers are probably accurate, though they are still investigating.

Looking at valuation, ARCP trades for about 88 cents on the dollar after rebounding from its lows yesterday.  Stripping out goodwill and intangible assets,  ARCP about 10% above the book value of its properties.  Allowing for improvements and appreciations, ARCP is probably trading within a few percent of its liquidation value.  It’s hard to see a lot of risk of long-term loss when buying a REIT at these prices.

The biggest reason I am inclined to give ARCP the benefit of the doubt, however, is that company insiders have been steadily accumulating the shares throughout 2014. Ten different insiders—including the company’s general counsel—have purchased a combined $3 million since January of this year.

That’s going to wrap up this issue.

Until next week,

Charles Sizemore

This article first appeared on Sizemore Insights as This Week’s Sizemore Insights: The Next Enron?

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