The Federal Reserve’s slowing approach to rate hikes is a big positive for firms that practice financial wizardry. Fed Chair Janet Yellen told The Economic Club of New York earlier this week that she considered it “appropriate for the Committee to proceed cautiously in adjusting policy.”
Translation – they’re going to keep moving slowly. Inflation isn’t yet in the picture, and until it is, the Fed can keep rates low for longer than most think. And that’s bullish for business development companies, or BDCs.
BDCs invest mostly in privately-held small to middle market companies ($10 million to $25 billion in revenues). They operate similar to private equity companies, and by rule, they’re required to pay out at least 90% of their income to shareholders.
Rising interest rates had the potential to stop the BDC party.
When these firms can’t borrow for cheap, their profitability gets slammed quickly – along with their stock prices. But as you can see, they appear to have put in a significant bottom in February:
In a rising interest rate environment, the spread between their borrowing and lending costs can be impacted in a bad way. And even fears of interest rate increases – as we’ve seen for the last 3 quarters – can crush these stocks just the same.
BDCs started sliding downward last summer on interest rate fears and got finished off when oil prices plunged. Some of these firms had loans outstanding to energy firms, and investors fretted they wouldn’t get repaid.
While these concerns might be valid, not all BDCs have high exposure to energy, making those that got swept up in the hysteria for no good reason interesting issues today.
A Conservative Powerhouse BDC at a 12% Discount
Ares Capital Corporation (ARCC) is one of the largest BDCs by market cap and holds just 3% of its entire portfolio in oil & gas investments. The firm focuses on middle market borrowers and helps them with a range of transactions like buyouts, acquisitions, financing, growth capital and others.
The company has had a long commitment to its dividend with dividend coverage averaging 121% over the past six years. The stock currently pays an impressive 10.6% dividend.
And ARCC’s earnings could even improve if interest rates rise. As a global investment firm ARCC actually benefits from a slight increase of interest rates. A LIBOR increase of 75 basis points from its current level puts the company in the place where it makes the most from the interest spread.
ARCC is one of the best run companies in the BDC space, and its stock is cheap, trading for just 88% of book value. Five management insiders agree with me that the stock is an intriguing buy – which is why they bought more than 150,000 shares for their personal accounts over the last three months.
The Value of a Good Discount
BDCs often invest in illiquid investments – but they have a listed value of their investments and update their net-asset-value (NAV) like mutual funds do on a regular basis. It shows us what we’re paying for the company with respect to its underlying investments.
It’s OK to pay more than NAV, of course. In February I recommended Main Street Capital Corporation (MAIN) even though it was trading at a 21% premium to its NAV. Shares have gained 12.5% since then.
MAIN’s a bit too popular for my tastes now – and we can do better than its 7% dividend. In fact, if we’re speculating, we can nearly double that.
13% and 14% Yields Available at a Discount
Apollo Investment Corp. (AINV) invests in middle market companies through senior loans, mezzanine investments and equity. Aviation and transportation make up 15% of its portfolio, with oil and gas holdings next at 13%.
This explains why the stock is so cheap, but it may have its energy write-offs already priced in. AINV trades at a steep 28% discount to its NAV.
Management is looking to close that discount. It just announced a new $50 million share buyback program, which would retire about 4% of current shares outstanding. The firm has maintained its dividend since its last cut (from $0.28 to $0.20 per share) in 2012 and pays 13.3% today.
If the firm is able to maintain its payout, its buyback program should provide investors with 15-20% upside.
Like AINV, Prospect Capital Corporation (PSEC) also delivers a big 14% yield. And historically, a simple contrarian strategy of buying PSEC on extreme dips on its price versus book value (a proxy for NAV) has been a profitable one. And PSEC hasn’t traded this cheap since the stock market lows in March 2009.
Senior management is interested in this strategy, too. They’ve purchased 360,000 shares of PSEC for their own accounts over the last two weeks, investing over $3.3 million of their own money in the process.
As I said on Wednesday, there are many different reasons an executive sells their company stock – ranging from divorces, college payments, new houses, or even kids who wrap their sports cars around trees. But there is only one reason that an executive puts their money on the line to buy their stock…
It’s because they believe the price is low and that it will go up.
An 8.9% Stock to Buy and Hold
I consider BDCs to be more speculations than investments. As with PSEC, you want to buy them when they’re cheap and sell them when they’re hot. These firms rely too much on financial wizardry to hold them through all market environments.
Most of my portfolio consists of solid “buy and hold” dividend plays that will perform great no matter what happens in November’s election, or even the broader stock market. These are companies benefiting from “mega trends” that will keep rolling regardless.
It’s a healthcare company that currently pays an 8.9% yield. While not quite as high as the BDCs we highlighted, this payout is very secure. It’s not a stock you’ll have to trade in and out of – it’s one that you can hold for years or decades. And reinvest the big dividends, or pocket the income.
Healthcare is big, with skilled nursing a particularly hot area. The 65+ population is set to double and 85+ will triple in the years ahead. Demand is going to keep climbing, and ironically supply is actually decreasing. We have less skilled nursing facilities today than we did in 2009!
Rising demand and falling supply have this specialty provider well positioned to grow its dividend in the years ahead. I anticipate its payout will double again over the next decade. And remember, it already pays 8.9% – so you’ll see BDC-level yields quite soon, minus the risk.
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