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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.

How Not to Analyze Earnings Deficits.

Analyzing earnings deficits is a tricky thing.  Many stocks earned deficits in 2009 including some high dividend stocks.  Should you only look at the deficits per share when comparing Company A to Company B, especially when both companies are selling for the same price in the market?  Of course not.

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I have been analyzing American Capital Agency Corp. (AGNC) for the last few months.  AGNC has not experienced a deficit in its short history.  The company went public in 2008 and income has been increasing every year (so far).  So the following does not apply to them.

Below is the appropriate excerpt from Benjamin Graham’s and David Dodd’s excellent book “Security Analysis”.  Apply their wisdom to your high dividend stocks that might have some earnings losses over the last five years.

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Deficits a Qualitative, Not a Quantitative Factor.  When a company reports a deficit for the year, it is customary to calculate the amount in dollars per share or in relation to interest requirements. The statistical manuals will state, for example, that in 1932 United States Steel Corporation earned its bond-interest “deficit 12.40 times” and that it showed a deficit of $11.08 per share on its common stock. It should be recognized that such figures, when taken by themselves, have no quantitative significance and that their value in forming an average may often be open to serious question.

Let us assume that Company A lost $5 per share of common in the last year and Company B lost $7 per share. Both issues sell at 25. Is this an indication of any sort that Company A stock is preferable to Company B stock? Obviously not; for assuming it were so, it would mean that the more shares there were outstanding the more valuable each share would be. If Company B issues 2 shares for 1, the loss would be reduced to $3.50 per share, and on the assumption just made, each new share would then be worth more than an old one. The same reasoning applies to bond interest. Suppose that Company A and Company B each lost $1,000,000 in 1932. Company A has $4,000,000 of 5% bonds and Company B has $10,000,000 of 5% bonds. Company A would then show interest earned “deficit 5 times” and Company B would earn its interest “deficit 2 times.”  These figures should not be construed as an indication of any kind that Company A’s bonds are less secure than Company B’s bonds. For, if so, it would mean that the smaller the bond issue the poorer its position—a manifest absurdity.

When an average is taken over a period that includes a number of deficits, some question must arise as to whether or not the resultant figure is really indicative of the earning power. For the wide variation in the individual figures must detract from the representative character of the average.  This point is of considerable importance in view of the prevalence of deficits during the depression of the 1930’s. In the case of most companies the average of the years since 1933 may now be thought more representative of indicated earning power than, say, a ten-year  average 1930–1939.

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AGNC analysis of the income account> losses of subsidiaries

You should carefully examine the consolidated earnings statements of companies that own subsidiaries and significant interest in other companies.  Some companies in the past have under reported the losses of their subsidiaries and manipulated the surplus account in nefarious ways in order to make their earnings per share look less volatile.  You should adjust the earnings of the company you are analyzing accordingly to determine their true earning power.

American Capital Agency Corp. (AGNC) is a subsidiary of American Capital Ltd (ACAS).  I’m not analyzing the parent company, so I’m not going to go through the pains of investigating American Capital. 

American Capital Agency Corp. (AGNC) owns a single wholly-owned subsidiary called American Capital Agency TRS, LLC.  I learned this from Note 1 in its most recent 10-K filing.

Here is the hierarchy:

American Capital LTD owns American Capital LLC which owns American Capital Agency Corp.

Note 1. Unaudited Interim Consolidated Financial Statements

The interim consolidated financial statements of American Capital Agency Corp. (together with its consolidated subsidiary, is referred throughout this report as the “Company”, “we”, “us” and “our”) are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10−Q and Article 10 of Regulation S−X. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates.

Our unaudited consolidated financial statements include the accounts of our wholly−owned subsidiary, American Capital Agency TRS, LLC.  Significant intercompany accounts and transactions have been eliminated. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, necessary for the fair presentation of financial statements for the interim period have been included. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year. There has been no activity in American Capital Agency TRS, LLC during the six months ended June 30, 2010 and 2009.

 

AGNC has consolidated the accounts of its subsidiary into its reported.  I don’t see any manipulation or hiding of losses by AGNC.  No adjustments to the earnings are necessary for the profits/losses of subsidiaries.

Here is the summary paragraph from the end of the section on losses of subsidiaries in the wonderful book Securities Analysis.

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To avoid leaving this point in confusion, we shall summarize our treatment by suggesting:

1.       In the first instance, subsidiary losses are to be deducted in every analysis [of the income account]

2.       If the amount involved is significant, then the analyst should investigate whether or not the losses may be subject to early termination.

3.       If the result of this examination is favorable, the analyst may consider all or part of the subsidiary’s loss as the equivalent of a nonrecurring item.

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AGNC analysis of the income account> Fictitious value placed on stock dividends received

American Capital Agency Corp. (AGNC) does not own any controlling interest in another company’s stock.  Also, it has never received any stock dividends.  Therefore, no adjustments to its earnings are necessary for fictitious value placed on stock dividends received.

Read the relevant section from Securities Analysis below to see how some other companies in the past have padded their earnings with fictitious stock dividend values.

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Fictitious Value Placed on Stock Dividends Received. From 1922 on most of the United Cigar Stores common shares were held by Tobacco Products Corporation, an enterprise controlled by the same interests. This was an important company, the market value of its shares averaging more than $100,000,000 in 1926 and 1927. The accounting practice of Tobacco Products introduced still another way of padding the income account, viz., by placing a fictitious valuation upon stock dividends received.

For the year 1926 the company’s earnings statement read as follows:

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,790,000

Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Class A dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,136,000

Balance for common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,254,000

Earned per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Market range for common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117–95

Detailed information regarding the company’s affairs during that period has never been published (the New York Stock Exchange having been unaccountably willing to list new shares on submission of an extremely sketchy exhibit). Sufficient information is available, however, to indicate that the net income was made up substantially as follows:

Rental received from lease of assets to American Tobacco Co. . . . . . . . . . . $ 2,500,000

Cash dividends on United Cigar Stores common (80% of total paid) . . . . . $ 2,950,000

Stock dividends on United Cigar Stores common

(par value $1,840,000), less expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 5,340,000

Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,790,000

It is to be noted that Tobacco Products must have valued the stock dividends received from United Cigar Stores at about three times their face value, i.e., at three times the value at which United Cigar charged them against surplus. Presumably the basis of this valuation by Tobacco Products was the market price of United Cigar Stores shares, which price was easily manipulated due to the small amount of stock not owned by Tobacco Products.

When a holding company takes into its income account stock dividends received at a higher value than that assigned them by the subsidiary that pays them, we have a particularly dangerous form of pyramiding of earnings. The New York Stock Exchange, beginning in 1929, has made stringent regulations forbidding this practice. (The point was discussed in Chap. 30.) In the case of Tobacco Products the device was especially objectionable because the stock dividend was issued in the first instance to represent a fictitious element of earnings, i.e., the appreciation of leasehold values. By unscrupulous exploitation of the holding-company mechanism these imaginary profits were effectively multiplied by three.

On a consolidated earnings basis, the report of Tobacco Products for 1926 would read as follows:

American Tobacco Co. lease income, less income tax, etc. . . . . . . . . . . . $2,100,000

80% of earnings on United Cigar Stores common . . . . . . . . . . . . . . . . . .$ 6,828,000*

$7,928,000

Class A dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 3,136,000

Balance for common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,792,000

Earned per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7.27

* Excluding leasehold appreciation.

The reported earnings for Tobacco Products common given as $11 per share are seen to have been overstated by about 50%.

It may be stated as a Wall-Street maxim that where manipulation of accounts is found, stock juggling will be found also in some form or other. Familiarity with the methods of questionable finance should assist the analyst and perhaps even the public, in detecting such practices when they are perpetrated.

AGNC analysis of the income account> morals from foregoing examples

To the best of my present knowledge AGNC has not manipulated it earnings using accounting gimmicks; therefore, you don’t need to avoid it for those reasons alone.  If this is the first post of mine that you are reading, then please type AGNC into the search box near the top of the blog.  That search will return a list of article I’ve written on AGNC.

I have a feeling that I’m not to be as forgiving to AGNC when I examine its assets.  Most of its assets are agency securities that are probably worth a lot less than AGNC claims in their 10-K filings with the SEC.

If investors would have followed the advice below they would save themselves the misery of owning Enron and MCI World Com to name just a few epic failures.
 
Here is the relevant excerpt from Securities Analysis:

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Moral Drawn from Foregoing Examples. A moral of considerable practical utility may be drawn from the United Cigar Stores example.  When an enterprise pursues questionable accounting policies, all its securities must be shunned by the investor, no matter how safe or attractive some of them may appear. This is well illustrated by United Cigar Stores Preferred, which made an exceedingly impressive statistical showing for many successive years but later narrowly escaped complete extinction.  Investors confronted with the strange bookkeeping detailed above might have reasoned that the issue was still perfectly sound, because, when the 
overstatement of earnings was corrected, the margin of safety remained more than ample. Such reasoning is fallacious. You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.

AGNC analysis of the income account> balance sheet and income tax check upon the published earnings statements

American Capital Agency Corp. (AGNC) qualifies as a real estate investment trust (REIT).  They elected to be taxed as a REIT under the unconstitutional Internal Revenue Code of 1986.  In order to avoid U.S. federal or state corporate taxes, AGNC is required by the men with guns (government) to distrubute annually 90% of their taxable income.   Therefore, we don’t need to check its income tax filings to double-check the honesty of their earnings statements.
 
Note: I wish that we could live in a voluntary society where each business could decide on its own how much of its earnings to distribute to its owners.  No businesses should be taxed.  In a truly free market some businesses would choose to distribute 90% and some would decide to distribute 30%.  Some would decide to distrubute none.  No businesses should be taxed.  Taxes take money away from the employees and owners in the form of taxes.  Individuals shouldn't be taxed either.  However, we are not free so I digress.

 

Please read the excerpt from Securities Analysis below to get an idea how to apply this action step to your own securities holdings.

 

 

Balance-sheet and Income-tax Checks upon the Published Earnings Statements. The Park and Tilford case illustrates the necessity of relating an analysis of income accounts to an examination of the appurtenant balance sheets. This is a point that cannot be stressed too strongly, in view of Wall Street’s naïve acceptance of reported income and reported earnings per share. Our example suggests also a further check upon the reliability of the published earnings statements, viz., by the amount of the federal income tax accrued. The taxable profit can be calculated fairly readily from the income-tax accrual, and this profit compared in turn with the earnings reported to stockholders. The two figures should not necessarily be the same, since the intricacies of the tax laws may give rise to a number of divergences.2 We do not suggest that any effort be made to reconcile the amounts absolutely but only that very wide differences be noted and made the subject of further inquiry.

The Park and Tilford figures analyzed from this viewpoint supply the suggestive results as shown in the table on page 436.

 

The close correspondence of the tax accrual with the reported income during the earlier period makes the later discrepancy appear the more striking. These figures eloquently cast suspicion upon the truthfulness of the reports made to the stockholders during 1927–1929, at which time considerable manipulation was apparently going on in the shares.

 

This and other examples discussed herein point strongly to the need for independent audits of corporate statements by certified public accountants. It may be suggested also that annual reports should include a detailed reconcilement of the net earnings reported to the shareholders with the 2 See Appendix Note 51, p. 787, for a brief résumé of these divergences. net income upon which the federal tax is paid. In our opinion a good deal of the information relative to minor matters that appears in registration statements and prospectuses might be dispensed with to general advantage; but if, in lieu thereof, the S.E.C. were to require such a reconcilement, the cause of security analysis would be greatly advanced.

 

 

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AGNC analysis of the income account> earnings of subsidiaries

We need to examine American Capital Agency Corp’s (AGNC) earnings statements and balance sheets to make sure there are no misleading artifices in their income account.  Today we will check to make sure they didn’t manipulate their earnings by padding their income account with some subsidiary sleight-of-hand.  This is easy since AGNC has no subsidiaries.  No adjustments are necessary.

 

Please read this excerpt from Securities Analysis on the topic and apply it to stock you own or are considering to purchase with subsidiaries.

 

 

On comparatively rare occasions, managements resort to padding their income account by including items in earnings that have no real existence.  One flagrant corporation did the following during the Great Depression:

 

“An examination of the balance sheets discloses that during these two years the item of Good-will and Trade-marks was written up successively from $1,000,000 to $1,600,000 and then to $2,000,000, and these increases deducted from the expenses for the period.

 

These figures show a reduction of $1,600,000 in net current assets in 15 months, or $1,000,000 more than the cash dividends paid. This shrinkage was concealed by a $1,000,000 write-up of Good-will and Trademarks.  No statement relating to these amazing entries was vouchsafed to the stockholders in the annual reports or to the New York Stock Exchange in subsequent listing applications. In answer to an individual inquiry, however, the company stated that these additions to Good-will and Trade-marks represented expenditures for advertising and other sales efforts to develop the business of Tintex Company, Inc., a subsidiary.

 

The charging of current advertising expense to the good-will account is inadmissible under all canons of sound accounting. To do so without any disclosure to the stockholders is still more discreditable. It is difficult to believe, moreover, that the sum of $600,000 could have been expended for this purpose by Park and Tilford in the three months between September 30 and December 31, 1929. The entry appears therefore to have included a recrediting to current income of expenditures made in a previous period, and to that extent the results for the fourth quarter of 1929 may have been flagrantly distorted. Needless to say, no accountants’ certificate accompanied the annual statements of this enterprise.”

 

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AGNC analysis of the income account> extraordinary losses> amortization of bond discount

American Capital Agency Corp. (AGNC) has not floated any bonds since it began operating in May 2008.  Therefore, no adjustments to its income account are necessary for amortization of bond discount.  You can see from their most recent quarterly 10-K filing that they have no bond liabilities.  Their biggest liabilities are repurchase agreements (6.6 billion dollars).  Repurchase agreements are not bonds.

 

The bottom line is that companies can manipulate their future earnings by charging amortization of bond discounts to their surplus instead of their income statements.

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Here is the relevant section from Securities Analysis:

 

Amortization of Bond Discount. Bonds are usually floated by corporations at a price to net the treasury less than par. The discount suffered is part of the cost of borrowing the money, i.e., part of the interest burden, and it should be amortized over the life of the bond issue by an annual charge against earnings, included with the statement of interest paid. It was formerly considered “conservative” to write off such bond discounts by a single charge against surplus, in order not to show so intangible an item among the assets on the balance sheet. More recently these write-offs against surplus have become popular for the opposite reason, viz., to eliminate future annual deductions from earnings and in that way to make the shares more “valuable.”

 

Example: Associated Gas and Electric Company charged against surplus in 1932 the sum of $5,892,000 for “debt discount and expense” written off.

 

This practice has aroused considerable criticism in recent years both from the New York Stock Exchange and from the S.E.C. As a result of these objections a number of companies have reversed their previous charge to surplus and are again charging amortization of bond discounts annually against earnings.

High dividend stocks – AGNC analysis of the income account> extraordinary losses> idle-plant expense

American Capital Agency Corp. (AGNC) does not own any plant equipment; therefore, they have no idle-plant expenses.  No adjustment to the income account is necessary for this category of analysis.  Learn more about how idle-plant expense accounting can effect earnings by reading the section below.

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The cost of carrying non-operating properties should almost always be charged against income account.  Idle-plant expenses are of a different nature than ordinary charges against income.  The idle-plant expenses should be of a temporary and therefore non-recurring type.  The company’s management can terminate the losses at any time by disposing of or abandoning the property.  If, for the time being, the company elects to spend money to carry these assets along in the expectation that future value will justify the outlay, it does not seem logical to consider these assets as equivalent to a permanent liability, i.e., as a permanent drag upon the company’s earning power, which makes the stock worth considerably less than it would be if these “assets” did not exist.

Some companies in the past had charged their idle-plant expenses to their surplus.  That relieved their reported earnings of expenditures that most companies charge against income.  They should have charged to their income account.

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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.

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