Thursday, January 15, 2015

Why I sold American Realty Capital Properties Inc. (ARCP)

Two stock sales in less than a month. What is going on around here? Have I lost my marbles?
I certainly hope not.
Although I’m a buy-and-hold investor, the occasional sale is necessary if it means making the portfolio better over the long run. Some of my past sales have turned out well, some have not. All in all, I have to make a decision with all known data at the time, and hindsight is of course 20/20.
I often say that I look at every stock in my portfolio like a fruit-bearing branch on my dividend tree. And I repeat myself because it’s true. I plan to one day live completely off of the dividend income my portfolio (the tree) provides, which will alleviate me of the need to cut down branches (sell stocks), which could possibly end up killing the tree in the long run. However, if that analogy makes sense to you, the particular stock that this article is about was like a branch that was showing signs of rot. After weeks of deliberation, I decided to cut that branch so as to limit any further damages to the rest of the tree.
I sold 280 shares of American Realty Capital Properties Inc.(ARCP) on 12/16/14 for $7.88 per share.

Overview

American Realty Capital Properties is a real estate investment trust that acquires, owns, and operates single-tenant and multi-tenant commercial real estate.

Changing Fundamentals

I discussed ARCP’s fundamentals, qualitative aspects, risks, and valuation back in October, when I decided to untimely add to my position in the REIT. I don’t regret the logic at the time, but the timing couldn’t have been worse. At any rate, I won’t rehash all of that information as, up until that date, that information is correct.
I often cite three reasons to sell a dividend growth stock:
  1. The fundamentals of the company have changed.
  2. The dividend has been eliminated/reduced or held static for more than two years.
  3. The stock has become grossly overvalued.
Unfortunately, ARCP’s fundamentals have changed rather dramatically over the last few months. I’m going to discuss a little of what has happened with this REIT, which kind of plays out like a soap opera (something I always try to avoid with companies I invest in).
First, and most importantly, the company announced in late October potentially fraudulent behavior by Brian Block, who was CFO at the time. Apparently, and unbeknownst to most of the rest of the management team (as far as we now know), adjusted funds from operations were found to be incorrect, but intentionally not corrected. Mr. Block was promptly replaced as CFO, as was Lisa McAlister, the former chief accounting officer.
So there is an audit currently underway, but the company has already announced that fiscal year 2014 numbers can not be relied upon. This is obviously a big problem because it’s impossible to value a business or trust management at all when the numbers aren’t being provided correctly. The preliminary findings were announced to believe that AFFO/share for the year was improperly inflated by about $0.04. This isn’t a big deal in itself, but the fact that the numbers were not properly corrected and presented is. However, the final results won’t be known until January.
There was also the canceled sale of Cole Capital from ARCP to RCS Capital Corp. after the latter agreed to purchase Cole Capital from the former for $700 million. Due to a breach of contract, RCS Capital Corp.agreed to pay ARCP $60 million, as well as to unwind any other business between the two companies and their subsidiaries.
Now, I had to this point decided to continue holding ARCP as the final results of the audit were supposed to be released with Q3 results. My mindset was such that a $0.04 adjustment to AFFO wasn’t detrimental to the business. ARCP still has a solid portfolio of real properties that have real tenants sending real checks which funds real dividends. The cash flow is real, which is sometimes hard to see through the fog of all the drama.
Unfortunately, ARCP then announced that they had received a waiver and extension, allowing them to delay releasing Q3 results (and the results of the audit) until January 5, 2015. Now, that’s not to say that the results will take that long. But they could. As such, this put me in a bit of a bind. If the results were much worse than expected, I’d have to continue holding ARCP through the end of the year and into 2015 before finding out. It became clear at this point that there was a possibility that I may need to unload my position in the company before the end of the year to realize any capital loss on the shares to offset some of my capital gains. Waiting until 2015 wouldn’t really help with the capital gains I’ve realized this year from a tax standpoint.
It also started to concern me that there were delays in the reporting. Perhaps just an emotional response, but I do wonder if the results are much worse than shareholders are being led to believe.
Then just yesterday, ARCP announced that Nick Schorsch, Executive Chairman and former CEO of ARCP,had stepped down. In addition, he would step down from his position in the BOD for both ARCP and Cole Capital. Mr. Schorsch is really credited with the mastermind role in putting ARCP together and fueling its tremendous growth over the last few years. Obviously, this growth has come with substantial kinks. In my view, this was to be applauded. But it gets worse.
ARCP then swiftly thereafter announced that David Kay, CEO of ARCP, and Lisa Beeson, President and COO, had both stepped down. So, if you’re following, the company has lost its CEO, president and COO, CFO, CAO, and executive chairman and former CEO over just the last few months. I’ve only been investing for almost five years now, but I’ve never seen anything like this before.
With the above announcement, ARCP also stated it had hired Morgan Stanley & Co. LLC to “to provide advice around capital structure, business strategy and capital allocation.”
And finally today, Moody’s Corporation (MCO) cut ARCP to junk status.

Investment Versus Speculation

I’m not making a call as to what happens with ARCP moving forward. Maybe the dividend is cut, maybe it isn’t. Maybe the accounting issue is truly just a $0.04 adjustment. Maybe an entirely new management team will get ARCP on the right track. Or maybe ARCP has much larger problems and the audit is discovering a rabbit hole that is deeper than some expect. I truly do not know.
What I do know, however, is that ARCP has moved from an investment to a speculation. All of the above possible outcomes are just that: speculation. I have a good idea as to where The Coca-Cola Company (KO)is going. I have a fairly good picture of where Johnson & Johnson (JNJ) might be in 10 years. But I have no idea where ARCP is going right now and where this ultimately leads.
I’m an investor, not a speculator. As such, these shares no longer belong in my portfolio.
It should be noted that I almost always relish an opportunity to buy more shares in a company after a significant pullback. Cheaper equity means my money goes further and I can buy more dividend income for the same dollar amount. But that’s assuming the company’s fundamentals haven’t changed. It’s one thing to buy shares in Coca-Cola after a 6% drop due to weak earnings, and quite another to buy shares in ARCP after a 30%+ drop because of fraudulent accounting and a clean sweep of management. Very different events. Again, there’s a difference between investing and speculation. You can certainly make some money speculating, but it’s not a game that I’d like to play or one I think I might be good at.
Now, I did highlight some of this as a potential risk back in October:
As previously mentioned, they’ve grown incredibly quickly. So there is operational risk there. It remains to be seen, because of their short history, how well they can manage their growth and portfolio.
However, I clearly didn’t anticipate anything like this. But it is now obvious that they have had troubles managing this growth. If that weren’t the case, the entire upper management team wouldn’t have exited the company in such swift fashion.
I thought this was a high-risk investment. But I felt the risk was priced in, as very little growth needed to be had in order for ARCP to be a satisfactory investment. Shares were selling at just over 11 times AFFO in early October, using the midpoint of 2014 guidance. That was a substantial discount to major peers, and really unwarranted when you look at the quality of the real estate portfolio.
Where I believe I made a mistake, however, was not requiring a lengthier track record before investing here with ARCP. I generally invest in companies with fairly substantial dividend growth records. I usually like to see at least five consecutive years of dividend increases, but prefer at least 10. Long dividend growth streaks tend to say a lot about management, the company, and the ability to profit over long periods of time through multiple economic cycles. ARCP didn’t have this rich history, but I felt the valuation, yield, and real estate portfolio quality were enough to offset this. I was wrong.
I’ve noticed some investors beating themselves up over ARCP, and I’m not quite sure that’s fair. Fraudulent accounting isn’t something that can be predicted and it’s also not something that is somehow isolated to fast-growing companies or REITs. Many major companies have been taken down over such measures, and these are things that simply cannot be foreseen. The best one can do is diversify and always try to focus on quality,which is why I’m glad that ARCP was a relatively small part of my portfolio.

Conclusion

This closes out my position in ARCP completely. My cost basis in ARCP is $3,519.91 as of right now, though that will probably be adjusted in 2015 to account for any return of capital. My total proceeds from the sale of all 280 shares of the REIT amount to $2,199.38. Factoring in total dividends of $212.34 and my loss on ARCP was 31.5%.
This is my worst investment to date, both in terms of amount of money lost and the percentage of negative return. I’ll try to take as much education from it as possible, though, again, I still stick to the belief that most of this just couldn’t have been predicted. I do admit it was a high-risk investment, though, and high-risk investments sometimes come back to bite you. That certainly happened here. Not only is the loss disappointing, but knowing that the opportunity cost was even greater pains me more.
For now, I’ll take the tax-loss against some capital gains for the year and continue to follow the ARCP story from afar. If the audit turns up that it was truly just a minor adjustment to AFFO and the business clears up dramatically, I’ll consider re-initiating a position in the future. For now, I’m happy to move on as this one stock was disproportionately sucking up my time in relation to the other 50+ stocks I’m invested in and the other 50+ I watch on a regular basis.
I will conclude with just a quick note. This is now my 10th article on stock sales for this blog (against 87 purchase articles). I’m planning on capping it there. Unless another ARCP rolls down the pike forcing my hand, I don’t plan to sell any more stocks…ever. We’ll see how that goes. I’ve mentioned before that I like the analogy between a portfolio and a bar of soap – the more you handle either, the less you’ll have in the end. Perhaps I should have just left ARCP be, but it’s moved too far over to a speculation, in my view. I hope that this is my last sale.
I usually include valuation opinions by professional analysts as a comparison, but neither Morningstar nor S&P Capital IQ rate this stock.
This sale reduces my annual dividend income by $280.00, based on the current $0.0833 monthly dividend.
I’ll update my Freedom Fund in early January to reflect this recent sale.
Full Disclosure: Long KO and JNJ.
What do you think? Is ARCP headed in the right direction? Is this more of a speculation than an investment? 

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