Monday, November 3, 2014

What should I do with American Realty Capital Properties (ARCP)?

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.

My Options

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.

2) Hold

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.

Conclusion

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

Relevant Articles:

American Realty Capital Properties (ARCP) Dividend Stock Analysis
Realty Income - A dependable dividend achiever for current income
Avoid Dividend Cutters at All Costs
Five Things to Look For in a Real Estate Investment Trusts
Undervalued Dividend Stocks I purchased in the past week

19 comments:

  1. Thanks for your frank discusion of your points in regards to ARCP. As companies are made up of people, and people are prone to making silly things from time to time, so its very difficult to predict what companies are doing in their backrooms...here comes the role of diversification in handy.

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  2. Hi DGI,
    Thanks for your point of view, let me ask you something, what would you do if ARCP instead of being an 1% of your portfolio it was lets say a 5-8% of it. Still a hold?
    Thank you.

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  3. Sold and reinvested the money in Visa. Looking back, I didn't do enough analysis of ARCP before buying but simply looked at the juicy dividend versus other REITs and concluded that, even though ARCP is riskier, the dividends were sufficient compensation. High risk = high POTENTIAL reward. In this case, long term holders may still do well, but the entire house of cards could come down when the lawyers get done.

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  4. Sell ARCP only to offset profit in some other holding you wish to reduce in the current tax year. Otherwise, hold for the long term. As long as the company remains viable, it will recover. A management change is likely to follow. Add to the holding only if the steps the company takes to address its problems look reasonable.

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  5. I got in at $13 (yup, unfortunate timing), sold half of my shares at $8.80, and the rest at $9.60. With the proceeds, I bought OKE, I'm out ~30%, but I don't want to deal with this company. You are right, I was speculating with this company. I'd sold O to buy it! Live and learn.

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  6. Hey DGI,

    I'm 31-years old and like you I bought into ARCP twice during 2013-2014 in my Roth IRA and have DRIP'ed all dividends to this point (ARCP accounts for about 5% of my Roth at this time). I understood that ARCP would be volatile based on the string of acquisitions and lack of history, but like everyone else I did not see this coming (no one could). Based on David Kay's conference call, the independent audit by Ernst & Young, the fact that David Kay and other C-Level executives have bought massive amounts of shares over the last year, and the understanding that this was a one-time instance that effects AFFO by 3-4 cents I've decided to hold with the intention of buying in the near future. Their is certainly going to be some short-term pain due to litigation, FBI investigation, SEC investigation, etc. but the underlying assets are still intact and the net-lease business model is one that has proven itself over the years.

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    Replies
    1. Agreed when you grow that fast sometimes mistakes happen. Will hold until the next mistake

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  7. Greed always distorts the truth. The best of luck with your holding.

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  8. I don't own ARCP but will continue monitor and see whether it makes sense to add a small position in the future or not.

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  9. Broke your rule of investing on Facts.......IE, not gut feel...... Investing is a long learning journey. And the leaning never ends and is what makes investing fun, rewarding, and challenging.

    Baldy

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  10. I'm holding on to ARCP as well. It should recover long term.

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  11. I would sell without hesitation. I am building my portfolio to provide me (or more likely my wife after I am gone) with long term income. One of the most important elements of that is I want to invest in companies that not only pay a dividend, but have the ability to continue to grow those payments at a reasonable rate. If I were to discover that one of my companies' financial records were being manipulated for some reason, I could no longer trust that company to continue to do its job and grow my income as a part-owner. While it's very possible that the remaining management at ARCP is honest and wants to make things right, there's no way to be certain. There's far too many other good companies out there who are honestly working to earn my investments for me to waste time on one that has been proven not to be honest. Maybe a few years from now if ARCP gets its act together it will again be worthy of our trust as investors, but not today.

    TL;DR: Sell and move on.

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  12. I sold the day the fraud was announced. My portfolio's goal is to hold sleep well at night stocks that have integrity. ARCP clearly does not fit that bill and I see it as more of a gamble.

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  13. In my experience, accounting fraud never ends well.

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  14. I decided to keep my ARCP, and do tax loss harvesting on it. I understand other's concerns though. If there wasn’t such as discount between market value and what I perceive to be intrinsic value of assets, I would have sold also. Everyone should evaluate their own situation, and decide for themselves after a careful analysis what to do with their money. Just because I am doing something, doesn't mean you should do that.

    The assets are there to pay a dividend – properties under long-term leases. I believe the value of the properties exceeds the market price, and the discount is due to fears of what the true extent of issues. I am fine if the dividend is cut, as this would likely be a temporary measure. I am also fine if I see negative headlines every day – this shows me that maybe I should not be reading news every day since I am not a speculator. I plan on holding on to a company for 10 years. I try not to be too emotional about companies.

    It is quite possible that I am wrong and the accounting issues are just the tip of the iceberg, showing that company is rotten at its core. In that case the investment will be worth close to a zero in a wave of downgrades, cash problems etc.

    The more likely scenario is that dividend is cut, the company works through issues, and delivers a decent returns for someone holding and collecting cash. There will be turbulence, and volatility, but the truth is that i am willing to hold on to turbulence that is short-term in nature. Based on the REITs I have looked at, there is a high chance they bounce back eventually. I have patience.

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  15. I bought a few in December last year and let it DRIP. Bought more the day the fraud first came to light after doing the same consideration. In my mind the underlying fundamentals are still there and in the long term a huge discount on my entry point was a nice bonus. I doubt that a dividend cut will be necessary, though if there is one I doubt it will be big enough to really matter to me.

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  16. Any data to support accounting irregularities stocks?

    I wish I knew more, but one example which I knew about from a few years ago was the Diamond Foods issues in 2011-2012.

    This is anecdotal of course, but check out Diamond Foods (makers of Emerald nuts, Kettle chips, and others).

    After their accounting inquiry in the 2011-2012 timeframe, the stock dove from 70s to the teens. It's been steadily rising (although with a fair amount of volatility) from the teens into the high 20s today.

    They spent millions on accounting, legal, restructuring, etc fees, but I think they trudged along and the damage was not debilitating. Is there a parallel to ARCP? In my opinion, perhaps. The irregularity in ARCP does not seem to indicate anything besides an adjustment to Affo, and a relatively small one at that.

    You are absolutely correct, however, that it would NOT be a dividend growth purchase. It would be some mix between value and speculation if we are to hold or average down here.

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  17. I also hold a small post in ARCP. I am from Sweden and am not familiar with american rules regarding this kind of things. What kind of outcome can be expected from the lawsuits against ARCP? Is that something that small investers should join or sign up for? This investement was a good lession for me regarding risks with investments in areas where you don´t have enough knowledge and information on common practice.

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  18. Hi DGI
    Have you considered STWD as a ARCP replacement?

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