Get High Growth And High Income With This Undervalued 7.7% Yielder

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To say that the financial crisis changed the landscape of the banking industry would be a bit of an understatement.

One of the biggest dangers to capitalism was the interruption of the investment flow that technological innovators require. As the banking behemoths teetered on the verge of collapse, capital market liquidity and business lending in the traditional banking channels pretty much evaporated.

Luckily, many business development companies (BDCs) stepped up to the plate.

Basically, BDCs are simply pools of money that take investor money, lend it to businesses as some combination of debt and equity, and reward investors based on the performance of the BDC's investment portfolio.

Most of the companies that BDCs work with are what are referred to as mid-market companies: too big to be small, too small to be big. But many of these companies become bigger and often go public. That's when the true value of the equity stake the BDC takes is unlocked.

One of the more interesting names on my radar is Hercules Technology Growth Capital (Nasdaq HTGC) . With a market cap just shy of $1 billion, Hercules has set its sights on fast-growing technology and biotech businesses.

As I've said many times, I am NOT a technician. However, I don't deny the validity of certain chart patterns. Typically, a double-bottom formation can be a bullish signal. The stock has recovered an impressive 18% from that bottom after falling 23% from its high. But I'm more interested in the underlying fundamentals.

In February, S&P Dow Jones Indices said it would be removing all BDCs from its U.S. indices due to concerns regarding reporting requirements, internal fees and expenses, and certain investment restrictions. No surprise, then, that the BDC sector as a whole was knocked back some due to rebalancing and selling by shortsighted investors.

Moves like these -- that create short-term weakness in prices due to nothing more than an administrative housecleaning -- give investors a chance to get more for less... and in the case of Hercules, that's a great opportunity.

HTGC's latest quarterly earnings report was a barnburner. First-quarter earnings per share ( EPS ) came in at $0.30, handily beating expectations of $0.27. Originations (meaning loan/equity transactions) also knocked the cover off of the ball: Estimates called for $92 million, but HTGC beat that by over 20%, writing $112 million worth of new business.

Pre-payments, loans being paid off before their term ends, were also much lower than expected: pre-payments for the quarter came in at only $19 million, less than half the $39 million expected by analysts. This means that the company can maintain steady cash flow generated by interest income in order to support the 7.7% dividend yield.

In addition, the company has $230 million in cash ready to be deployed in new investments. A look at its portfolio shows HTGC knows how to put capital to good use.

The portfolio is primarily focused on information technology and life sciences. One of HTGC's most successful equity stakes have included is Merrimack Pharmaceuticals (Nasdaq: MACK ) , which has risen nearly 40% since its IPO in 2012.

Going forward, current EPS estimates call for $1.20 for 2014 and 10% growth to $1.32 in 2015. The $230 million in cash the company is looking to put to work should be the driver of that growth.

Risks to Consider: On a company specific level, the biggest risk facing HTGC involves its exposure to high-tech and biotech. Both sectors have fallen under considerable pressure so far this year, and further weakness could put pressure on the performance of the company's underlying portfolio. For the BDC sector collectively, the biggest risk always facing them is a slowdown in the larger economy.

Action to Take --> Currently, HTGC shares trade around $15.70, which is a 9% discount from their previous high. The stock has an incredibly cheap forward price-to-earnings (P/E) ratio of 12.5 and strong dividend yield of 7.7%. Based on the current valuation and high-growth portfolio, a 12- to 18-month price target of $20 is reasonable. The result would be a total return, when factoring in the dividend, of nearly 35%.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Investing Ideas , Stocks

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