Last week, American Realty Capital Properties (ARCP) announced some accounting mistakes, where it overstated Adjusted Funds from Operations (AFFO) by 4 cents/share for the first half of 2014. The reason why the stock price declined by a third however was that there was a mistake done in the first quarter, and there was an attempt to conceal it in the second quarter. This made many investors nervous, mostly because they fear that this could be an indication of a bigger cover-up.
I have made purchases in American Realty Capital Properties on three separate occasions in 2013, after which I have mostly collected the dividends in cash to place elsewhere. The third occasion was an investment in a Roth IRA, where dividends are automatically reinvested into more American Realty Capital Properties shares. I viewed American Realty Capital Properties as a company with promise, which wanted to grow enough to gain the scale and prominence of a Realty Income (O). After my purchase however, the company grew its size very rapidly. This prompted me to reevaluate whether they are doing this for management or for shareholders. As a result of the very rapid acquisitions of companies and properties, the hefty compensation package proposals for Nicholas Schorch, as well as the warning that the above average yield provided, I was beginning to question my investment in American Realty Capital Properties.
After reviewing the press release, as well as the conference call transcript, I have identified three options for my investment in the company.
1) Sell and never look back.
Accounting issues are always a red flag. If you cannot trust the numbers, this means that you cannot properly value the business. If management produced bad numbers, this means that internal controls over financial reporting are probably very weak. Those who are selling are likely believing that the insane are running the asylum – in other words the tone at the top is bad, which has cascaded down into a rotten organization at its core. If the current accounting irregularities are just the tip of the iceberg, and there are more things uncovered, it is quite possible that share prices will fall further, the dividend will be cut, and more losses could be in store. Things can cascade down pretty quickly in a wave of investigations, credit downgrades and management would have to focus on those fires, rather than focusing on the core operations. Even if the company survives, it would be unable to grow given the fact that cost of equity is prohibitively expensive at 11%, and the cost of debt could be even higher with possible credit rating downgrades.
While accounting irregularities are bad, and the dividend could be in jeopardy, the company looks cheap relative to others. While the bad publicity somewhat justifies a discount relative to the likes of Realty Income (O), W.P Carey (WPC) and National Retail Properties (NNN), I still believe that there are real revenue streams under long dated leases with quality tenants for American Realty Capital Properties. In addition, American Realty Capital Properties is a REIT, which means that it has to pay dividends as long as it generates enough income. Therefore, even if the dividend is cut, the company could still prove to be a decent long-term holding as long as it continues sharing its cash flows with shareholders and as long as it does not uncover more irregularities. The portfolio of properties is worth something, and some dividends will be paid out. It might take a while for the integration of other properties and companies is done, and until the whole accounting mess is sorted out. If the company survives, the investor that will come out ahead will be the one who held on, and might have even reinvested dividends.
3) Add more
We all know the saying that investors should buy when there is blood on the streets. There is some blood on the American Realty Capital Properties streets. I have been contacted by a lot of scared American Realty Capital Properties shareholders, who don’t know what to do. The fact that ordinary investors and probably even top management at American Realty Capital Properties don’t know the full extent of all problems is scary. However, it could be an opportunity given the low valuation of the assets on a price to book level. The problem is that this is now not dividend growth investing, but value investing with a dose of speculation. And I do not have the guts to add to this position. But I know some are adding to American Realty Capital Properties because of the low valuation.
Overall, I am going to hold on to American Realty Capital Properties for the time being. It is less than 1% of my diversified dividend portfolio, so I can afford to do that. Even if they were to cut dividends, I would violate my sell rule and keep holding. This is because as long as the REIT doesn’t go bankrupt, as a flow through entity it will deliver dividends to shareholders. I will be able to hold through SEC Investigations, further declines in the stock price, and even a dividend cut. I might however do some tax-loss harvesting at year end. I would do this either by buying a call option, and then selling the shares in taxable accounts after 31-32 days. Alternatively, I could buy 1 more share for each share in a taxable account I already hold and then buy a protective put for the additional shares. In about 31 – 32 days I will sell the original shares and generate tax-losses.
However, I made a mistake buying American Realty Capital Properties in the first place. I violated my principles for sound investment in the first place, and now the investment genies are coming for a payback.
I invested in American Realty Capital Properties based on my gut and viewed it as a potential for becoming the next Realty Income. There are five things I look for in REITs, such as sustainable dividends, growth in FFO, ability to grow FFO further. However, the financials were not comparable, due to the rapid pace of acquisitions. I did discuss this a few weeks ago, as a warning sign that management was trying to get to be the largest triple net REIT potentially as an ego boosting exercise, rather than to maximize shareholder returns. This was a sign that things might not be what we as conservative income investors with long term holding periods expect from companies we are investing our hard earned money into. Therefore, when I purchased American Realty Capital Properties I was speculating. The relentless increase in share prices had made me a little less lenient on quality, and I ended up chasing yield. The truth is that anyone who bought American Realty Capital Properties was likely speculating, since financials included so much in new acquisitions done so rapidly, that they were difficult to rely on.
Full Disclosure; Long O, ARCP
- American Realty Capital Properties (ARCP) Dividend Stock Analysis
- Realty Income - A dependable dividend achiever for current income
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