A Stealth Bull Market in Financials

by Bryan Perry | September 24, 2012 7:30 am

With one scandal after another[1] this year, there’s plenty of reason to be skeptical of big finance. But I’m rooting for the little guy. There’s a lot of money going into high-yield[2] business development companies (BDCs) right now, especially because a lot of them pay out in November.

Those payouts will act as a volatility hedge with all of the fireworks coming up before the year is out: third-quarter earnings, fourth-quarter guidance, the election and the fiscal cliff — not to mention the political tension in the Middle East, China’s growth prospects and whether U.S. consumers are going to open up their pocketbooks for the holiday shopping season.

BDCs pay out 90% of earnings to shareholders[3], so they’re a great dividend play — especially in this economic climate.

A lot of these companies are concerned with the fiscal cliff, and a number of them are doing exits from their portfolios. They lend money to small- to midsize private companies, and they have equity stakes in these companies. Many BDCs are looking to unwind or sell some of these holdings before year-end to take advantage of their favorable tax status[4].

The wind is really to the back of the business development sector. So, you’re going to see a lot of big earnings from the BDCs this quarter that will show up in January when they post their numbers, and it’s a great time to catch the momentum. BDCs are in high demand because the banks still have to maintain very high capital ratios, and they’re not taking the risk on small business.

There’s also a lot of insider buying going on in BDCs. Last week, Prospect Capital (NASDAQ:PSEC[5]) had a 9.7 million share secondary offering through KeyBanc Capital Markets. This agreement provides that it can sell up to 9,750,000 shares of common stock from time to time through the sales manager, who will act as an agent for the offer and sale of such common stock.

PSEC does this for two reasons. It costs about 1% in fees to conduct this kind of at-the-market (ATM) transaction versus 5% for a spot secondary, and because it’s done piecemeal, the price of the common doesn’t get impacted as much.

As of Sept. 17, the stock was trading at $12.25 per share. On Tuesday, about 10 million shares traded and the stock fell to $11.50, indicating that KeyBanc was taking full advantage of the recent rally in the share price. According to Brian Oswald, the company’s CFO, we can expect an acceleration of exits from portfolio holdings because of the uncertainty over whether the Bush tax cuts will expire at year-end as part of the fiscal cliff.

In addition, Oswald also purchased 23,500 shares for his own account on Sept. 6 at roughly $11.70 in the open market. That tells us he’s bullish on his company’s future. As one of the premier BDCs that pays monthly, PSEC is a buy on this postsecondary dip. 

Also within the BDC sector, Fifth Street Finance (NASDAQ:FSC[6]) priced an $8.4 million share secondary offering at $10.79 per share, raising $91 million — which barely had any material effect on the shares. In fact, FSC is trading right back up to $10.94 as of Friday morning.

There have been over 25 insider buys during the past two years and no sales of stock at all. Hedge fund phenom David Einhorn and his Greenlight Capital Fund (NASDAQ:GLRE[7]) have moved up to become the third-largest holder of the company. Management is also pouring money into the company.

Again, they’re doing the same thing: They want to accelerate the number of companies they sell in the fourth quarter. That will show up as higher dividends in the next quarter. For such a good story that carries a yield of 10.6% and pays monthly, FSC is a buy.

It’s clear that institutional money is being dedicated to high-yield investing. I think this is how many fund managers who are lagging the averages will keep their jobs without chasing the high P/E performance stocks that have so much uncertainty facing them in this slack macroeconomic global outlook. I just see the money pouring into high-yield — and the spigot is all the way open.

Bryan Perry is editor of Cash Machine[8], a newsletter focused on dividends and income investing.

  1. one scandal after another: http://www.nytimes.com/2012/07/21/opinion/nocera-financial-scandal-scorecard.html
  2. going into high-yield: https://investorplace.com/2012/08/dividend-stocks-deliver-a-return-in-any-market-condition-kmp-mcd-wmt/
  3. pay out 90% of earnings to shareholders: https://investorplace.com/2012/05/bdcs-mega-dividends/
  4. their favorable tax status: http://en.wikipedia.org/wiki/Business_Development_Company#Regulation_and_tax_structure
  5. PSEC: http://studio-5.financialcontent.com/investplace/quote?Symbol=PSEC
  6. FSC: http://studio-5.financialcontent.com/investplace/quote?Symbol=FSC
  7. GLRE: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLRE
  8. Cash Machine: http://cashmachine.investorplace.com/about-bryan-perry.html

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