Is Now The Time To Buy These High-Yielders?
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 them.
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 illiquid portfolios."
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 of.
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 program.
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 high.
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 book value, American Capital Strategies (Nasdaq: ACAS ) 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 , however, Main Street Capital (Nasdaq: MAIN ) , Hercules Technology Growth Capital (Nasdaq: HTGC ) 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.
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