With the market struggling for direction as it approaches multi-year highs, value investors are finding bargain basement stocks difficult to find. Slow-growing blue chip dividend payers such as Proctor & Gamble (PG) and Coca Cola (KO) are trading at P/E levels close to or over 20. Laggards from 2011, such as financials like Bank Of America (BAC) and Wells Fargo (WFC), and homebuilders like Lennar (LEN) have had tremendous run-ups over the last year. That's not to say that these stocks are not still good investments, but if you're a true down and dirty value stock picker like I am, you would have been looking at these stocks a year ago.
So where should the value investor be looking right now? I believe that business development companies, or BDCs, are one of the most overlooked segments in today's market, and offer the value minded investor a rare combination of strong dividend income and significant capital appreciation.
Business development companies are private equity firms that invest in, provide financing for and outright acquire small start up companies, as well as investing in stressed companies as turnaround ventures. BDCs are similar to real estate investment trusts (REITs) in that they are required to distribute 90% of their taxable income as dividends to shareholders. Like the financial sector, most BDCs suffered tremendously during the 2007 - 2008 financial meltdown, and have yet to recover to anything even close to their pre-recession levels.
I've chosen to highlight my three favorite BDC stocks, one of which I own, and two that I am keeping a very close eye on. The reader should be aware, however, that there are several other BDCs out there that make very compelling investment possibilities. As always, the prospective investor should perform their own research and understand the potential risks and rewards before making any investment decisions.
American Capital, LTD
American Capital, Ltd. (ACAS) is a private equity and venture capital firm specializing in management and employee buyouts, mezzanine, acquisition, recapitalization, middle market, and growth capital investments, as well as troubled and distressed asset situations. The firm invests in manufacturing, services, and distribution companies with a special focus on the energy sectors such as exploration and mining, energy generation, transmission and distribution. It also specializes in investing in companies that provide services or products to federal, state or local governments in the information technology, human resources/benefit administration, engineering and construction, homeland security and healthcare.
American Capital is deeply undervalued, trading at $13.10 per share, with a staggeringly low P/E of 2.74. The company has recovered nicely from a near-death experience during the recession, when it was forced to eliminate its dividend, but has yet to even come close to pre-recession levels. I believe that the lack of a dividend is the reason for the ultra low valuation, as BDC investors, who typically look for dividend income, have yet to pile back in to this stock. That aside, the company has aggressively paid down debt, and has been creating tremendous shareholder value with stock buybacks, having purchased back 52.4 million shares since the third quarter of 2011. This represents just over 15% of shares outstanding, and has increased NAV by .90 cents per share. The company has stated an intention to continue buying back shares as long as share price remains below NAV, and will reinstate the dividend only when share price surpasses NAV. NAV as of Q4 2012 was $17.39 per share. This is a rare example of the correct way to conduct a stock buyback.
I am long ACAS, and also in their two externally managed, double digit dividend yielding mortgage REITS, American Capital Agency (AGNC) and American Capital Mortgage (MTGE). I believe that as the company continues paying down debt, buying back shares, and increasing their portfolio company investments, share price and NAV will slowly converge. The reinstatement of the dividend will be the catalyst that rolls in the tide of yield hungry BDC investors. This is a stock that I feel comfortable holding with a $25 long-term price target, a potential 45% gain.
data by YCharts
Prospect Capital Corp
Prospect Capital Corporation (PSEC) is a business development company that invests across all industry sectors, with a particular expertise in the energy and industrial sectors. The firm invests in oil and gas production, coal production, materials, industrials, consumer discretionary, information technology, utilities, pipeline, storage, power generation and distribution, renewable and clean energy, oilfield services, healthcare, food and beverage, education, business services, real estate, and other select sectors in the US and Canada.
Like American Capital, Prospect Capital suffered greatly during the 2007-2008 recession, and has recovered only modestly since then. Shares are trading at $11.27, with a P/E of 7.26. The company pays a monthly dividend, and is currently yielding an attractive 11.70%, with a reasonable payout ratio of 76%.
The stock has recovered after hitting a recent low of $9.60 due to a share offering in November, but I believe it still represents a great value. They also offer a huge yield that pays you to wait until it revisits its $19 pre-recession highs, a potential 40% capital gain.
data by YCharts
Technology Investment Capital Corp
The third BDC stock on my watch list is Technology Investment Capital Corp (TICC). TICC Capital is business development company that operates as a closed-end, non-diversified management investment company. The firm primarily invests in debt and/or equity securities of technology-related companies that operate in the computer software, Internet, IT infrastructure and services, media, telecommunications and telecommunications equipment, semiconductors, hardware, technology-enabled services, semiconductor capital equipment, medical device technology, diversified technology, and networking systems sectors.
Like both ACAS and PSEC, TICC Capital has yet to fully recover from the recession, and is trading at very low valuation. Shares are trading at $10.64, with a P/E of 6.27. The company offers a solid 10.9% dividend yield on a very sustainable 65% payout ratio. This is yet another compelling value play that offers a dividend yield that pays you to wait for share prices to its $17 pre recession levels, an approximate 40% potential gain.
data by YCharts
Business development companies stocks are the financials and homebuilders for 2013, beaten up and overlooked stocks that offer something for both the long term value and income investor. In addition to the three companies I've highlighted here, investors may also want to look at other, equally attractive high yielding BDC stocks, such as Main Street Capital (MAIN), Triangle Capital (TCAP), Solar Capital (SLRC) and Apollo Investment Corp (AINV). All offer tremendous value possibilities along with healthy dividend yields, as well as their own potential risks. I believe in Benjamin Graham's market weighing machine, and with BDC stocks sitting at the light end of the scale, they offer the potential for a very prosperous 2013 and beyond.
Disclosure: I am long ACAS.
Additional disclosure: I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. It is up to investors to make the correct decision after necessary research. Investing includes risks, including loss of principal.