Hercules Technical Growth Capital (HTGC), along with all Business Development Companies (BDCs), has had a rough start to 2014. I first talked about Hercules back in June of last year. In that piece I explained that BDCs invest in unsecured senior debt (usually floating rate loans to early stage companies) and are pass through entities (like REITs and MLPs) that pass profits on to shareholders. The fact that HGTC invested in floating rate debt while its own debt was at fixed rates made it a decent hedge against a rising interest rate environment in the future.
The stock spent the second half of 2013 adding about 30% in value and anybody who bought back then was no doubt happy with the performance at year’s end, especially having locked in a yield of over 8%. This year, however, has not been so pretty. The drop, though, has left HTGC in a place where it is looking attractive again.
In part, the decline is due to the nature of the companies that Hercules invests in and lends to. They specialize, as their name would suggest, in technology companies such as internet startups and privately held biotech firms; in other words, exactly the sectors hardest hit in the last few months. This explains part of the fall, as does the fact that interest rates have proved remarkably resilient in the face of tapering, but a large part of it is due to another problem that is specific to BDCs.
On February 24th, S&P announced that BDCs were not eligible for index inclusion due to concerns about regulation of "Acquired Fund Fees and Expenses," and in March, Russell followed suit, saying that BDCs were ineligible for index inclusion unless the SEC changed its reporting rules by this Thursday May 15th. As most BDCs are small caps, the prospect of being booted from the Russell indices has resulted in a lot of speculative short selling.
At the end of last month short interest in HGTC had almost doubled since the middle of January, to over 5 million shares, representing around 12 days to cover. Of course, as it looks almost certain that HTGC is about to be kicked out of the Russell 2000, resulting in a large amount of index fund selling, that makes perfect sense. However, in the past when fund exclusion has looked likely the “sell the rumor, buy the fact” trend has been strong. For example, following a rule change in 2012, resulting in companies with “unrelated business taxable income” being ineligible for the Russell indices, the stocks in the affected sector lost heavily in the run up to the reconstitution day, but then outperformed significantly in the month after.
This makes HTCG attractive to me again at these levels on two fronts. Firstly, I like “sell the rumor, buy the fact” plays, and secondly, I like situations where a short squeeze is a possibility. In this case, the shorts in HTGC, while significant, are unlikely to be liable to a squeeze in the near future. They are speculative in nature to some extent, but there would seem to be little doubt that the sellers they are anticipating will come.
What the large number of shorts does mean, however, is that the effects of that selling, when it actually comes, will be severely muted. That, combined with indications that the worst of the selling in the tech and biotech fields may be over, leads me to conclude that the downside for HTGC is limited.
There is some upside for the stock price, but for investors, that is not the point. It is that juicy, 8.63% yield that most appeals. After such massive gains in stocks last year, some volatility was almost inevitable this year and is likely to continue. In that environment, having something in your portfolio that gives a decent yield is a must and decent yields are hard to find.
No high yielding investment is without significant risk, though. As we have seen over the last three months, the particular areas that HGTC invests in are themselves highly volatile, and if more pressure is yet to come that will be reflected in the stock’s price. For this reason it is important to point out that neither HGTC nor any BDC is a substitute for bond holdings, but rather should be seen as a way to boost overall yield by investing a percentage of your fixed income allocation.
Market fluctuations and a very specific technical worry have brought HTGC back to a point that the value cannot be ignored. The prospect of an 8.63% yield that is, to some extent, protected against rising rates, and from an investment that has some upside and limited downside is just too good to miss.