During most of this year I’ve been looking at a lot of high-yielding stocks for our portfolios. Last month my focus was on utilities, and now we’re shifting a bit to a very different kind of company that provides some diversity by providing income in a much different way.
Main Street Capital (NASDAQ: MAIN), a Houston-based business development company that provides financing to mid-size companies in the Southern United States, has gotten off to a brisk start in our StrataGem portfolio this month, rising 2.7% on Wednesday. It is a true micro-cap with a market cap of $229 million, yet it is an income investor’s darling with a 10% dividend yield.
Business development companies are essentially private equity funds that trade on public exchanges. They provide professional capital management to the smaller firms that they finance, and allow retail investors exposure to sophisticated transactions such as leveraged buyouts and recapitalizations.
The September StrataGem includes three other BDCs — MVC Capital (NYSE: MVC), BlackRock Kelso Capital (NASDAQ: BKCC), PennantPark Investment (NASDAQ: PNNT) — that all pay considerable dividends and share many of the MAIN’s characteristics. You’ll get to know them all before the month is out.
So how can they afford to pay double-digit dividends while blue-chips like Procter & Gamble (NYSE: PG) only yield 2.8%? Here’s the answer.
Companies that bring in revenue of $10 million to $100 million typically have a difficult time securing financing from commercial banks due to their perceived riskiness. Business development step into this breach by working directly with entrepreneurs and management to come up with “one-stop” operational and financing solutions.
In a recent transaction, Main Street purchased a 47% equity stake in Currie Technologies, an electric bike and scooter manufacturer, for $6.5 million. MAIN also invested $11 million in debt securities paying 13% interest. This combination of debt and equity reduced borrowing costs for Curie and allows MAIN to earn a substantial return on its investment, which it then pays back to its shareholders in the form of a hefty dividend.
Other recent investments of MAIN include debt/equity funding for Harrison Hydra-Gen, the largest provider of hydraulic generators to fire engine manufacturers in the United States, and PPL Motor Homes, a fast-growing retailer of used recreational vehicles.
Risk-oriented income investors want exposure to Main Street’s debt instruments, which can yield up to 13% and are vetted by professional fund managers. Three-year IBM bonds yielding 1% or 10-year treasuries with 2.5% annual interest look bland in comparison.
Business development companies are mandated by law to maintain very low leverage — total debt cannot exceed equity by more than a 3:1 ratio. By comparison, most banks have leverage of 10:1, and investment banks’ leverage can exceed 30:1. BDCs avoided most of the painful deleveraging process that resulted from the recent credit crunch and had sufficient cash reserves to make equity infusions at basement prices.
In short, it’s a paradox of regulation and custom that these seemingly dicey companies actually have lower risk profiles than their much larger peers in the banking industry.
Main Street maintains a diversified portfolio of privately-held companies that have minimal correlation to the broader debt and equity markets. The company actually increased its dividend from $1.33 in 2008 to $1.50 in 2009.
Main Street sidestepped most of the 2008 volatility and has managed to rise 40% since October 2007, vs. the -30% loss of the S&P 500 and -57% loss of the big banks in the benchmark index. Add in dividends and you are looking at an 81% return over the past 30 months. The sell-off last month presents a perfect entry point for us.
Business development companies, unlike their private equity counterparts, are transparent and subject to the reporting standards of public companies. Most BDCs revalue their portfolio every quarter with the oversight of independent valuation firms. Management is also subject to quarterly reviews of investors and analysts and must provide detailed information about distressed and non-performing assets.
Another attractive feature of business development companies is their favorable tax treatment. Like real estate investment trusts, they pay no taxes if they distribute 90% of their taxable earnings quarterly. Main Street takes this one step further and pays out a monthly dividend. So think of BDCs as REITs that own loans instead of real estate.
Investors should be excited but vigilant of Main Street’s attractive dividend yield. The firm wrote off $10 million in bad debt in the first quarter and has significant equity stakes that it must sell at market prices to cover its dividend with earnings. In a prolonged economic slowdown that depresses the value of these equity stakes could threaten the dividend. Main Street’s recent secondary offering raised $45.8 million but such actions are dilutive.
Analysts expect Main Street Capital to earn $1.30 in 2011, pricing the stock at 11.5x forward earnings. My model suggests MAIN will earn at least $1.50 in 2011 and be able to cover its dividend with earnings. This estimate, combined with a modest 12 P/E, yields an $18 price target, or 20% upside from the Wednesday close.
In sum, Main Street Capital is a new type of investment for us that offers us a high dividend yield and diversification away from the broad market. Even if the stock stagnates, you will receive 10% annually via the dividend. It’s still a good buy if you did not purchase it already.
For more ideas like this, check out Jon Markman’s Traders Advantage or Strategic Advantage advisory services.
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