It may be just a coincidence, but soon after a key financial
agency cautioned investors about the risks in business
development companies (BDCs), these investments lost some of the
momentum they had seen in 2010 through 2012.
#-ad_banner-#Though many these of stocks are unlikely to
deliver the sharp gains they saw in the first few years after the
Great Recession, solid values still remain among a few of
Too Much Leverage?
Back in January 2013
, the Financial Industry Regulatory Authority (FINRA) expressed
concern that these companies carried a lot more risk than
investors realized: "Fueled by the availability of low-cost
financing, BDCs run the risk of over-leveraging their relatively
Indeed, the high use of leverage turned out to be an Achilles'
heel back in 2008 as a number of BDCs' portfolio holdings began
to show signs of stress. Fearing that the BDCs would develop cash
crunches, investors fled these stocks, some of which lost 80% or
more of their value.
These days, few such concerns seem to exist. Many corporations
have either reduced debt or extended maturities at lower rates.
But the smaller, privately held companies that BDCs both lend to
and invest in continue to have real debt burdens and economic
risks -- a factor for which investors should never lose sight
The good news is that BDCs are involved with dozens or more
portfolio holdings, and any one holding rarely represents a
too-high portfolio weighting.
The other headwind for BDCs involves rising interest rates.
Not only do their stocks need to compete with investment
alternatives that are starting offer higher yields, but the BDCs'
cost of capital will surely rise in coming years. Investors are
already anticipating such a scenario, which is why some BDCs have
begun to lag the broader market.
Here's a look at how the 10 largest BDCs (by market value)
have performed since May 2013, when the Fed first laid claims to
the eventual end of the massive quantitative easing (QE) stimulus
Still, these companies offer some of the best yields on the
market, reflecting the fact that dividend growth will likely be
lacking, and some of these firms may even need to trim their
payout by 25% or more when rates rise. Even accounting for that,
the yields stand out in what it still a low-interest-rate
Let's take a close look at Prospect Capital, which has an
especially high yield. The high yield can partially be explained
by the fact that Prospect's dividend growth has been erratic. The
annual payout peaked at $1.62 a share in fiscal (June) 2009,
eventually fell to just $1.21 a share in fiscal 2011 and now
stands closer to $1.30 a share.
Looked at another way, using that $1.21 a share as a baseline
for future payouts, the yield still stands at 11.1%. Yet there
are also other factors that explain why this BDC's yield is so
First, it has a slightly greater tilt toward investments
rather than loans in portfolio companies, which adds a bit of
risk. Second, management has not been able to materially boost
the net asset value, which had been around $12.40 a share back in
fiscal 2009 and now stands at $10.73 a share.
Looking For Discounts
In effect, PSEC trades at a slight premium to tangible book
value. Is that the case with most BDCs?
Though some of these BDCs trade at a slight discount to tangible
American Capital Strategies (Nasdaq:
is the clear standout, trading more than $4 a share below book
value. The fact that this BDC chooses not to pay a dividend might
explain some of that gap.
In lieu of dividends, ACAS has been able to build its book
value at a fairly rapid pace. Tangible book value per share stood
below $9 back in 2009 and has been rising at a 15% to 20% pace
ever since. Most other BDCs see only nominal growth in per-share
book value, as most income is paid out.
Lastly, there is the issue of management expenses, which can
be alarmingly high. BDC executives often carve out separate
entities that act as a manager, paying themselves huge sums of
money in good years and bad. (As one writer on
Seeking Alpha noted
Main Street Capital (Nasdaq:
Hercules Technology Growth Capital (Nasdaq:
and American Capital Strategies get high marks for low expenses
among the BDCs profiled here.
My colleague Amy Calistri, the Chief Investment Strategist
behind StreetAuthority's premium advisory
The Daily Paycheck
, has been recommending HTGC since 2010, and she also singles out
MAIN as one of her five-star stocks.
Risks to Consider:
It's unclear whether BDCs and their relatively strong yields
are already reflecting the anticipated increase in interest
rates. They may come under further pressure as rates rise.
Action to Take -->
Recent comments from Fed Chairman Janet Yellen suggest that even
when interest rates move higher in coming years, they are likely
to remain well below the historical averages, as there remains
way too much slack in the U.S. economy. It's hard to see how
fixed-income yields will ever approach BDC yields. Then again,
some of these BDC yields could shrink as their cost of capital
increases. Still, most of these BDCs appear poised to generate
strong enough dividends to support yields above 6%. That makes
these investments still safe to buy.
American Capital Strategies appears to be the value play in
the group, while Hercules Technology Growth Capital appears to be
one of the more dynamic operators in the space. Holding both of
them in your portfolio might be a solid bookend strategy.