My High Dividend Stocks Blog

My High Dividend Stocks
This is my high dividend stocks site where I help site members find high dividend stocks with earning power and strong balance sheets.

High dividend stocks – AGNC analysis of the income account> extraordinary losses> other elements in inventory accounting

Different methods of inventory accounting can skew earnings reports.  However, the subject of this article is not applicable to AGNC.  I searched for the words “inventory”, “inventories”, “last-in”, “first-out”, and “costs of goods sold” in AGNC's 2009 annual report and most recent quarterly 10-K filing.  Those words do not appear in their SEC filings.

I decided to reprint the relevant section of Securities Analysis 2nd edition since the subject of inventory accounting is not applicable to AGNC:

Other Elements in Inventory Accounting. The student of corporate reports must familiarize himself with two permissible variations from the usual accounting practice in handling inventories. As is well known, the standard procedure consists of taking inventory at the close of the year at the lower of cost or market. The “cost of goods sold” is then found by adding purchases to the opening inventory and subtracting the closing inventory, valued as described.

Last-In, First-Out. The first variation from this method consists of taking as the cost of goods sold the actual amount paid for the most recently acquired lots. The theory behind this method is that a merchant’s selling price is related mainly to the current replacement price or the recent cost of the article sold. The point is of importance only when there are substantial changes in unit values from year to year; it cannot affect the aggregate reported profits over a long period but only the division of results from one year to another; it may be useful in reducing income tax by avoiding alternations of loss and profit due to inventory fluctuations.  

The Normal-stock or Basic-stock Inventory Method. A more radical method of minimizing fluctuations due to inventory values has been followed by a considerable number of companies for some years past. This method is based on the theory that the company must regularly carry a certain physical stock of materials and that there is no more reason to vary the value of this “normal stock” from year to year—because of market changes—than there would be to vary the value of the manufacturing plant as the price index rises or falls and to reflect this change in the year’s operations. In order to permit the base inventory to be carried at an unchanging figure, the practice is to mark it down to a very low unit price level—so low that it should never be necessary to reduce it further to get it down to current market.

High dividend stocks – AGNC analysis of the income account> extraordinary losses> reserves for inventory losses

Article_for_2010_09_08_agnc_ex

Definition for inventory: (accounting) the value of a firm's current assets including raw materials and work in progress and finished goods. Source “define: inventory” on Google.

AGNC’s current assets are mostly comprised of agency securities (over $6 billion in a $7.1 billion investment portfolio). These agency securities are toxic assets in my opinion. They will be viewed as toxic assets by AGNC’s shareholders the moment that Fannie Mae and Freddie Mac stop guaranteeing the pass-through principal and interest payments of the securitized mortgages that these agency securities are comprised of. You know they are toxic because the Federal Reserve bought over 1 trillion dollars of them from Fannie and Freddie over the course of a year ending in March 2010. The Fed buys toxic assets to bailout the largest banks.

I scanned through the most recent 10-K filing and the 2009 annual report to find out if AGNC’s management set up a reserve fund for future losses on their inventory/assets.  It turns out they haven’t set up such a reserve.  They do acknowledge the risks to their asset values under the banner of “spread risk” in the most recent 10-K filing.

Spread Risk
Our available−for−sale securities are reflected at their estimated fair value with unrealized gains and losses excluded from earnings and reported in OCI pursuant to ASC 320. As of June 30, 2010, the fair value of these securities was $7.1 billion. When the spread between the yield on our agency securities and U.S. Treasuries or swap rates widens, this could cause the value of our agency securities to decline, creating what we refer to as spread risk. The spread risk associated with our agency securities and the resulting fluctuations in fair value of these securities can occur independent of interest rates and may relate to other factors impacting the mortgage and fixed income markets such as liquidity or changes in required rates of return on different assets.

The whole ‘fair value’ accounting smells like government authorized fraud.

Be seeing you!

High dividend stocks – AGNC analysis of the income account> extraordinary losses> manufactured earnings

Today’s goal is to determine whether or not American Capital Agency Corp. (AGNC) wrote down any inventories or receivables as a charge to their surplus account since 2008.   Many companies did this during the Great Depression in order to make the next year’s income numbers look better than they really were.

“If the receivables and inventories were written down to an unduly low figure on December 31, 1932, this artificially low “cost price” would give rise to a correspondingly inflated profit in the following years.” – Securities Analysis chapter 32 section on manufactured earnings examples.

It appears to me that AGNC did not write down any inventories or receivables as a charge to surplus from 2008 to 2010.  Gains and losses in the values of its agency securities portfolio, hedges, and other assets appear on the current income statement for Q2 2010.  Therefore, I don’t think that AGNC is charging extraordinary losses to its surplus account in order to inflate its profit in the following year.  No adjustments to the income account are necessary for this category of analysis.

Be seeing you!

High dividend stocks – AGNC analysis of the income account> non-recurrent earnings> other non-recurrent items

The remaining group of non-recurrent profit items is not important enough to merit detailed discussion.  In most cases it is of minor consequence whether they appear as part of the year’s earnings or are credited to surplus where they properly belong.

AGNC did not have any non-recurrent profit items (2008-2010), so this is not applicable to AGNC.

High dividend stocks – AGNC analysis of the income account> non-recurrent earnings> profits through repurchase of senior securities at a discount

At times a substantial profit is realized by corporations through the repurchase of their own senior securities at less than par value. The inclusion of such gains in current income is certainly a misleading practice, first, because they are obviously nonrecurring and, second, because this is at best a questionable sort of profit, since it is made at the expense of the company’s own security holders.

AGNC has not issued any senior securities, so this is not applicable to AGNC.

Key definitions:
Par value - A value set as the face amount of a security, typically expressed as multiples of $100 or $1,000.  Bondholders receive par value for their bonds on maturity.  Source (www.finance.alberta.ca/business/ahstf/glossary.html)

Senior securities - Notes, bonds, debentures, or preferred stocks whose claim on earnings and assets ranks ahead of common stock. Should a company liquidate, the claims of a senior security holders ranks above those of junior security holders because the company's creditors receive recompensation before the owners.  Source (www.bluecollardollar.com/mutualglossaryq_z.html)

High dividend stocks – Analysis of AGNC income account> non-recurrent earnings> sale of marketable securities

Profits from Sale of Marketable Securities.

Most businesses do not sell marketable securities in the normal course of their business operations.  Profits realized by a business corporation from the sale of marketable securities are also of a special character and must be separated from the ordinary operating results (unless that corporation is an insurance company, bank, or investment-trust).  AGNC is a real estate investment trust so it buys and sells marketable securities in the normal course of it business operations.

The bottom line is to stay away from investing in financial securities (like AGNC) because their earning power is difficult to determine and their asset values can be very volatile.
==========
Reprint of the applicable section of the 1934 edition of Securities Analysis concerning the profit/loss from the sale of marketable securities:

Methods Used by Investment Trusts in Reporting Sale of Marketable Securities. Investment-trust statements raise special questions with respect to the treatment of profits or losses realized from the sale of securities and changes in security values. Prior to 1930 most of these companies reported profits from the sale of securities as part of their regular income, but they showed the appreciation on unsold securities in the form of a memorandum or footnote to the balance sheet. But when large losses were taken in 1930 and subsequently, they were shown in most cases not in the income account but as charges against capital, surplus, or reserves. The unrealized depreciation was still recorded by most companies in the form of an explanatory comment on the balance sheet, which continued to carry the securities owned at original cost. A minority of investment trusts reduced the carrying price of their portfolio to the market by means of charges against capital and surplus.

It may logically be contended that, since dealing in securities is an integral part of the investment-trust business, the results from sales and even the changes in portfolio values should be regarded as ordinary rather than extraordinary elements in the year’s report. Certainly a study confined to the interest and dividend receipts less expenses would prove of negligible value. If any useful results can be expected from an analysis of investment-trust exhibits, such analysis must clearly be based on the three items: investment income, profits or losses on the sale of securities and changes in market values. It is equally obvious that the gain or shrinkage, so computed, in any one year is no indication whatever of earning power in the recurrent sense. Nor can an average taken over several years have any significance for the future unless the results are first compared with some appropriate measure of general market performance. Assuming that an investment trust has done substantially better than the relevant “average,” this is of course a prima facie indication of capable management. But even here it would be difficult to distinguish confidently between superior ability and luckier guesses on the market.

The gist of this critique is twofold: (1) the over-all change in principal value is the only available measure of investment-trust performance, but (2) this measure cannot be regarded as an index of “normal earning power” in any sense analogous to the recorded earnings of a well-entrenched industrial business.

Similar Problem in the Case of Banks and Insurance Companies. A like problem is involved in analyzing the results shown by insurance companies and by banks. Public interest in insurance securities is concentrated largely upon the shares of fire insurance companies. These enterprises represent a combination of the insurance business and the investment trust business. They have available for investment their capital funds plus substantial amounts received as premiums paid in advance. Generally speaking, only a small portion of these funds is subject to legal restrictions as regards investment, and the balance is handled in much the same way as the resources of the investment trusts. The underwriting business as such has rarely proved highly profitable. Frequently it shows a deficit, which is offset, however, by interest and dividend income. The profits or losses shown on security operations, including changes in their market value, exert a predominant influence upon the public’s attitude toward fire-insurance-company stocks. The same has been true of bank stocks to a smaller, but none the less significant, degree. The tremendous over speculation in these issues during the late 1920’s was stimulated largely by the participation of the banks, directly or through affiliates, in the fabulous profits made in the securities markets.

Since 1933 banks have been required to divorce themselves from their affiliates, and their operations in securities other than government issues have been more carefully supervised and restricted. But in view of the large portion of their resources invested in bonds, substantial changes in bond prices are still likely to exert a pronounced effect upon their reported earnings.

The fact that the operations of financial institutions generally—such as investment trusts, banks and insurance companies—must necessarily reflect changes in security values makes their shares a dangerous medium for widespread public dealings. Since in these enterprises an increase in security values may be held to be part of the year’s profits, there is an inevitable tendency to regard the gains made in good times as part of the “earning power” and to value the shares accordingly. This results of course in an absurd overvaluation, to be followed by collapse and a correspondingly excessive depreciation. Such violent fluctuations are particularly harmful in the case of financial institutions because they may affect public confidence. It is true also that rampant speculation (called “investment”) in bank and insurance-company stocks leads to the ill-advised launching of new enterprises, to the unwise expansion of old ones and to a general relaxation of established standards of conservatism and even of probity.

The securities analyst, in discharging his function of investment counselor, should do his best to discourage the purchase of stocks of banking and insurance institutions by the ordinary small investor. Prior to the boom of the 1920’s such securities were owned almost exclusively by those having or commanding large financial experience and matured judgment. These qualities are needed to avoid the special danger of misjudging values in this field by reason of the dependence of their reported earnings upon fluctuations in security prices.

Herein lays also a paradoxical difficulty of the investment-trust movement. Given a proper technique of management, these organizations may well prove a logical vehicle for the placing of small investor’s funds. But considered as a marketable security dealt in by small investors, the investment-trust stock itself is a dangerously volatile instrument. Apparently this troublesome factor can be held in check only be educating or by effectively cautioning the general public on the interpretation of investment trust reports. The prospects of accomplishing this are none too bright.

Be seeing you!

High dividend stocks – Terminate Fannie Mae and Freddie Mac

I don’t like government intervention in any markets.  Fannie Mae and Freddie Mac represent massive government intrusion into the mortgage markets since the 1930s.  Without government life support they would go out of business.  The US federal government will be on life support itself in the next few years due decades of ever increasing deficit spending.  The congress will pull the life support away from Fannie and Freddie in order to save their own careers when they can no longer kick the can.  It is a question of when - not if.
So what happens to AGNC’s common stock price when that happens?  We’ll have to really scrutinize its earning statements and balance sheets to understand how exposed they are to these two GSEs.  My guess is very exposed.  We don’t have to play the game when we know it is rigged.

I think you will like this article by Michael Rozeff from www.lewrockwell.com.  I'm pretty sure it was written in late 2008 which was just after AGNC's IPO in May 2008.

Terminate Fannie Mae and Freddie Mac
by Michael S. Rozeff

I am a minority of one, or a very small number, in thinking that the failures of Fannie Mae and Freddie Mac are good news.

These two companies should not exist. No private companies should have lines of credit to the U.S. Treasury, that is, U.S. taxpayers. No private companies should be linked to a government mandate that they facilitate affordable housing by buying up mortgages. No private companies should issue debts that investors believe may have an implicit guarantee provided by taxpayers.

The only bad thing about these failures is what the Federal government may do next to keep them alive. The only bad thing is that the Federal government will probably make matters worse.

This is a golden opportunity to end these enterprises once and for all. And doing that is incredibly simple! Any Wall Street investment bank can, in short order, produce a plan to restructure these companies and charge the appropriate (high) fees for carrying out that plan. The possible ways to restructure include sales of the assets, creating subsidiaries and selling them, spinning off subsidiary companies, and breaking up the company into several companies. Fannie Mae and Freddie Mac could also put their entire companies up for sale.

Such restructurings are Wall Street’s bread and butter. The equity values of these companies have already fallen considerably. Their value in a restructuring may be quite small, but control does have a non-negligible value. The markets are already pricing the debts of these two giants at less than face value, despite the chance of an implicit guarantee or a taxpayer bailout. The debt-holders took a chance buying this paper. They should bear the consequences. Restructuring will reveal the true worth of these debt securities.

Investors in these enterprises, both debt and equity holders, should not be bailed out by the taxpayers. These two companies made bad investments by buying mortgages that have gone bad. These two companies also issued too much debt to finance these investments, which gave them very shaky financial structures. The worth of their assets is less than the worth of their liabilities, which makes them insolvent. They are not yet bankrupt. They still have the cash to service their debts. These debts are by no means worthless. About 11.6 percent of money market funds are invested in agency debt. At current prices of these debts, news of money market troubles has not surfaced. If those prices fell by 10 percent, the money market losses would be a modest 1 percent.

Any restructuring presumes what is not in evidence, which is that the Federal government has to sever completely its relationships with housing markets and specifically with Fannie Mae and Freddie Mac. There’s the rub. Congress won’t do this, unless seized by some unforeseen miracle of rationality.

There are millions of Americans who may fear the dissolution of these companies. They will wonder where they will get mortgages from. There are hundreds of columnists who share this fear. Some will pretend to hold their nose while supporting a government bailout. Some will want to maintain the government’s interference in housing markets or even expand it as a matter of public policy.

There is nothing to fear. The amount of money on the sidelines that is available for funding mortgages is tremendous. It can be coaxed into mortgages if the interest rates paid are high enough. A free market in mortgages will easily provide capital to creditworthy borrowers. But that too is the rub. The government wants to keep mortgage rates low so as to keep the housing industry going and to satisfy the voters who take out mortgages. The government does not want a free market in mortgages, and that is because neither voters nor the housing industry want a free market in housing. As long as there is a government that is empowered to interfere, the pressure to interfere will overcome the free market.

Democracy just does not work, my friends! Sooner or later, in this case 70 years later, 70 years after Fannie Mae began, the system starts to break down. Call it what you will, democratic socialism or democratic fascism or both, democracy does not work. It doesn’t work in agriculture, in the military, in the space program, in the banking system, or in any other part of an economy. Sooner or later, depending on various particulars, blowups occur.

Without the government in the picture, there is no way that Fannie Mae and Freddie Mac could ever have grown so large. Their balance sheet assets (and liabilities) total about $1.6 trillion. They have off-balance liabilities of another $3.5 trillion or so. How big is $5 trillion? The national debt of the U.S. is $9.5 trillion!

It is almost unbelievable that these two companies could have run up debts that are more than half the size of the country’s national debt. But that is inherent in the chemistry of government + housing + debt guarantees. The housing market is huge, especially over time as the housing stock accumulates. By giving Fannie Mae and Freddie Mac an advantage in issuing debt, these companies came to dominate the housing finance market. There is no better time than now to end this absurdity.

Freddie Mac faces huge losses, as much as $775,000,000. Its equity can easily be wiped out. That means bankruptcy. That is nothing to fear, either. That means that restructuring will be forced upon the company. The point is to let it happen and happen quickly and get the government out of the picture altogether.

Naturally, this has not been what the government has been doing. Instead, it has done the opposite so far. Congress has passed a bill that awaits the President’s signature or veto. There will be a deal. The bill increases mortgage loan limits drastically. Smart move, guys. Pelosi wants them even higher, $730,000 instead of $625,000.

Mr. Corruption himself, Chris Dodd, is the lead sponsor of the bill. Even as the stocks of these two companies approach $0, he reassures the public that the CEOs of Fannie Mae and Freddie Mac and Ben Bernanke tell him that they are not at risk of default. This is a bald-faced lie. Failure to face and state truths is a national addiction. The predilection to lie in the face of bad news is so ingrained that our leaders no longer can even detect the difference between what is true and what is false. They lie and they know they lie. But they also believe their lies because they believe their lies to be political necessities.

Can liars even begin to think straight about what should be done that is in the long-run interest of the American public? If they could think straight, could they summon the courage to act? Democracy encourages lies, liars, and cowardice in the face of voters and payoffs. Democracy just does not work, my friends.

Terminate Fannie Mae and Freddie Mac. Sever the relations with the government and let Wall Street, or investment bankers in San Francisco or Austin or Boston or Tallahassee do what they know best, which is restructure these companies. All the mortgages held or guaranteed by them will still be held and serviced, but by new companies and new investors. Problem solved.

July 16, 2008

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

Be seeing you!

High dividend stocks – Analysis of AGNC’s income account> non-recurrent items> profits or losses from sale of fixed assets.

Non-recurrent Items: Profits or Losses from Sale of Fixed Assets.

Profits or losses from the sale of fixed assets belong quite obviously to the category of fixed assets, and they should be excluded from the year’s result in order to gain an idea of the “indicated earning power” based on the assumed continuance of the business conditions existing then. Approved accounting practice recommends that profit on sales of capital assets be shown only as a credit to the surplus account. In numerous instances, however, such profits are reported by the company as part of its current net income, creating a distorted picture of the earnings for the period.

AGNC does not possess any fixed assets.  It has no employees or buildings because it is externally managed by American Agency Capital Management LLC.  No adjustments to earnings are required for this nonexistent item in AGNC’s earnings statements from mid-2008 to June 2010.
==========
I'm reprinting a section from the 1934 edition of Securities Analysis concerning subject of sale of fixed assets:

Examples: A glaring example of this practice is presented by the report of the Manhattan Electrical Supply Company for 1926. This showed earnings of $882,000, or $10.25 per share, which was regarded as a very favorable exhibit. But a subsequent application to list additional shares on the New York Stock Exchange revealed that out of this $882,000 reported as earned, no less than $586,700 had been realized through the sale of the company’s battery business. Hence the earnings from ordinary operations were only $295,300, or about $3.40 per share. The inclusion of this special profit in income was particularly objectionable because in the very same year the company had charged to surplus extraordinary losses amounting to $544,000. Obviously the special losses belonged to the same category as the special profits, and the two items should have been grouped together. The effect of including the one in income and charging the other to surplus was misleading in the highest degree. Still more discreditable was the failure to make any clear reference to the profit from the battery sale either in the income account itself or in the extended remarks that accompanied it in the annual report.

During 1931 the United States Steel Corporation reported “special income” of some $19,300,000, the greater part of which was due to “profit on sale of fixed property”—understood to be certain public-utility holdings in Gary, Indiana. This item was included in the year’s earnings and resulted in a final “net income” of $13,000,000. But since this credit was definitely of a nonrecurring nature, the analyst would be compelled to eliminate it from his consideration of the 1931 operating results, which would accordingly register a loss of $6,300,000 before preferred dividends. United States Steel’s accounting method in 1931 is at variance with its previous policy, as shown by its treatment of the large sums received in the form of income-tax refunds in the three preceding years. These receipts were not reported as current income but were credited directly to surplus.
==========

Be seeing you!

Fannie and Freddie

August 24th, 2010

You can listen to this article on your smart phone or computer.  This is perfect for drive time. 

We have been analyzing American Agency Capital Corp. (AGNC) for the past few articles at www.myhighdividendstocks.com .  AGNC purchases mortgage-backed securities and collateral debt obligations from Fannie Mae and Freddie Mac.  So we must understand what Fannie and Freddie are and how the make/lose money.  For those of you who don’t know – Fannie and Freddie are government sponsored enterprises.  That means they have special privileges that other corporations don’t.  They buy mortgages in the secondary market, repackage them into securitized products, and guarantee the principal and interest payments on those securitized products.  They are colossal failures and have to be subsidized by the federal government almost yearly to keep operating.  Ron Paul spoke before the House Financial Services Committee years before the housing crisis and the financial crisis.  He understands that government intervention in markets distorts the allocation of capital in those markets.  The mortgage market is no exception.  This is a concise explanation of how the markets are distorted by congress’ subsidies to Fannie and Freddie.  AGNC’s dependence on Fannie, Freddie, and Congress is a huge risk that you must understand before investing in this stock yielding 20%.

This article appeared on www.LewRockwell.com way back in September 2003

Fannie and Freddie

by Rep. Ron Paul, MD
by Rep. Ron Paul, MD

Ron Paul in the House Financial Services Committee, September 10, 2003

Mr. Chairman, thank you for holding this hearing on the Treasury Department's views regarding government sponsored enterprises (GSEs). I would also like to thank Secretaries Snow and Martinez for taking time out of their busy schedules to appear before the committee.

I hope this committee spends some time examining the special privileges provided to GSEs by the federal government. According to the Congressional Budget Office, the housing-related GSEs received $13.6 billion worth of indirect federal subsidies in fiscal year 2000 alone. Today, I will introduce the Free Housing Market Enhancement Act, which removes government subsidies from the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the National Home Loan Bank Board.

One of the major government privileges granted to GSEs is a line of credit with the United States Treasury. According to some estimates, the line of credit may be worth over $2 billion. This explicit promise by the Treasury to bail out GSEs in times of economic difficulty helps the GSEs attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital. More importantly, the line of credit is a promise on behalf of the government to engage in a huge unconstitutional and immoral income transfer from working Americans to holders of GSE debt.

The Free Housing Market Enhancement Act also repeals the explicit grant of legal authority given to the Federal Reserve to purchase GSE debt. GSEs are the only institutions besides the United States Treasury granted explicit statutory authority to monetize their debt through the Federal Reserve. This provision gives the GSEs a source of liquidity unavailable to their competitors.

The connection between the GSEs and the government helps isolate the GSE management from market discipline. This isolation from market discipline is the root cause of the recent reports of mismanagement occurring at Fannie and Freddie. After all, if Fannie and Freddie were not underwritten by the federal government, investors would demand Fannie and Freddie provide assurance that they follow accepted management and accounting practices.

Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.

No less an authority than Federal Reserve Chairman Alan Greenspan has expressed concern that government subsidies provided to GSEs make investors underestimate the risk of investing in Fannie Mae and Freddie Mac.

Mr. Chairman, I would like to once again thank the Financial Services Committee for holding this hearing. I would also like to thank Secretaries Snow and Martinez for their presence here today. I hope today's hearing sheds light on how special privileges granted to GSEs distort the housing market and endanger American taxpayers. Congress should act to remove taxpayer support from the housing GSEs before the bubble bursts and taxpayers are once again forced to bail out investors who were misled by foolish government interference in the market. I therefore hope this committee will soon stand up for American taxpayers and investors by acting on my Free Housing Market Enhancement Act.

Dr. Ron Paul is a Republican member of Congress from Texas.

High dividend stocks – Analysis of AGNC’s income account Part 1

 August 23rd, 2010

 

AGNC’s income statement must present a fair and undistorted picture of the year’s operating results if we are to use it as a basis for investing our capital.  We all still remember the lies of Enron, MCI WorldCOM, and the entire banking industry’s loan write-downs.  You can’t just trust the income statement just because they were audited.  Enron was audited by the spineless liars such as Arthur Anderson.  You may need to critically examine and adjust the numbers with respect to three important elements:

·         Nonrecurrent profits and losses

·         Operations on subsidiaries or affiliates

·         Reserves

 

Remember that our purpose of analyzing the income statements is to learn:

What are the true earnings of AGNC for the period studied (May 2008 – present)

What indications does the earnings record carry as to the future earning power of AGNC?

What elements in their earnings exhibits must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of AGNC’s shares?

 

AGNC’s management has considerable leeway in the method of treating nonrecurrent items.  Accounting procedure allows this.  Transactions applicable to past years (2008 and 2009 for AGNC) should be excluded from current 2010 income and entered as a charge or credit direct to the surplus account.  However, there are many kinds of entries that may technically be considered part of the current year’s results, but are nonetheless of a special and nonrecurrent nature.  Accounting rules permit AGNC’s management to decide whether to show these operations as part of the income or to report them as adjustments of surplus.  The following are a number of examples of entries of this type:

1.       Profit or loss on sale of fixed assets.

2.       Profit or loss on sale of marketable securities.  (This surely applies to AGNC.  We will have to examine this portion of their income statements carefully.)

3.       Discount or premium on retirement of capital obligations.

4.       Proceeds of life insurance policies (This is probably not applicable to AGNC).

5.       Tax refunds and interest thereon (We’ll check to see if they received any tax refunds and interest)

6.       Gain or loss as a result of litigation (We’ll find out if there is any).

7.       Extraordinary write-downs of inventory (Maybe).

8.       Extraordinary write-downs of receivables (I don’t think this has happened yet.  But, definately if Fannie and Freddie can’t guarantee MBS principal and interest payments to AGNC)

9.       Cost of maintaining nonoperating properties (not applicable – this happens more with manufacturing and mining)

 

Our object is to segregate all these items from the ordinary operating results of the year.  We really want to learn from the annual report and 10-K filings what AGNC’s indicated earning power is under the given set of conditions.  All these extraordinary items need to enter properly into our calculation of earning power as actually shown over a period of years in the past.  AGNC started operating its business in May 2008, so there isn’t much history for this company.  One of its competitors Annaly Capital (NLY) has been around much longer.

 

AGNC has no controlled or affiliated companies, so we don’t have to adjust reported earnings for this category of analysis.

 

Lastly, we must give critical attention to the matter of reserves for depreciation and other amortization, and reserves for future losses and other contingencies.  If the government changes the laws regarding Fannie Mae and Freddie Mac or the FED buys or sells MBSs, then AGNC can suffer huge future losses on the value of their agency securities.  We need to check this out carefully.

 

If you missed the beginning of the analysis of AGNC, then please visit www.myhighdividendstocks.com to read the last couple of posts.  I selected AGNC for high dividend stock analysis because it has a whopping 20% dividend yield.  Should you buy it, sell it, or stay away?  You’ll find out if you stick around for the next few weeks.

 

Be seeing you!