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This article compares three business development companies (BDCs): Medley Capital Corporation (MCC), MCG Capital Corporation (MCGC) and Fifth Street Finance Corp. (FSC). BDCs are a great way to access the small to midsized corporate lending market and earn healthy dividends. This market is still overlooked by most banks, creating an opportunity for these companies that are required to distribute at least 90% of taxable income as dividends to investors and pay little to no corporate tax. For the last few years I have been closely following 30 BDCs looking for well-managed, consistent, profitable, and diversified companies.

These are the five general criteria that I use to evaluate BDCs:

  • Profitability
  • Risk
  • Payout
  • Valuation
  • Analyst Opinions

A well-managed BDC will have Net Investment Income that matches distribution paid to shareholders. If they are paying too much there is a risk of dividend cuts. Earnings growth and profitability can be difficult to determine because BDCs often issue new shares to raise capital since most distribute 98% of income. I try to normalize EPS assuming they deploy capital consistent with past practices as well as consider analyst earnings expectations.

Many of the typical market risks are involved with investing in BDCs but depending on the portfolio credit quality, industry diversification, concentration, etc. they may be able to outperform the overall market in a recession. In addition to portfolio composition I look at market cap, volatility and leverage ratios, institutional ownership, interest coverage and performance during down markets.

Dividend yields for BDCs currently average 9% or higher. Again, my primary concern is if the company can sustain current distribution levels. Beyond the highest yield I look at dividend growth and consistency.

The metrics I use for relative valuation are mostly based on earnings and book value. With earnings I try to look one to two years out to factor in growth. Also with Net Asset Value I look at recent historical NAV growth rates.

Analyst opinions are important as gauge but seem to be more of a lagging indicator. I use various sources like Thompson, First Call, Fidelity, Dividend Channel, Motley Fool and Zacks.

Here is an oversimplified chart evaluating these three stocks among my universe of 30 BDCs, giving them a relative score between 0 and 10 (10 being the best). In reality I use different weightings for each criterion. In future articles I will add the new companies to this chart as well as update info.

ProfitRiskPayoutValuationAnalystTotal
MCC8774834
FSC4855325
MCGC004217

Medley Capital Corporation became public in early 2011 and has consistently grown quarterly net investment income along with its dividend. MCC has a relatively diversified portfolio in consumer & retail, healthcare, energy, financial services, industrial, manufacturing, natural resources, real estate and transportation. Dividend yield is currently 9.7% and has grown 71% since September 2011. They have been actively raising capital through equity and debt offerings as well as increasing borrowing facilities to grow the portfolio. On February 6th they will release their latest financial results and are projected to cover their $0.36 per share dividend. Keep in mind they have added new shares without the full benefit of their capital deployed so I expect future increases in dividends as earnings permit. This stock is currently trading above NAV but the P/E and PEG ratios are relatively low especially if you annualize the most recent quarter EPS and is recommended by most analyst, as well as myself, so I consider MCC one of 'The Good' BDCs.

MCG Capital Corporation is a BDC that I love to hate. The company has been through a painful transition from an equity investor in concentrated industries to senior debt holder in more diversified companies and suffered multiple write downs of book value. Over the past two years quarterly revenues have declined 50%, net investment income is down 70%, and dividends were cut twice. It's projected to make $0.07 this quarter, not enough to cover the $0.125 dividend. MCGC has high volatility and leverage ratios, poor past performance in down markets, and low interest coverage due to its high debt and declining income. The dividend yield is 11% but will most likely be cut again. The stock is currently trading below its NAV probably because of continued write downs and distributions in excess of income. P/E ratios are the highest in the industry and most analysts consider MCGC a sell but there is potential for a turnaround. They have recently announced various management and board member changes, realigned the portfolio, and have significant cash reserves to rebuild the portfolio, reduce leverage, and/or continue to repurchase shares. I think this stock is overvalued and consider it one of 'The Bad' BDCs.

Fifth Street Finance Corp. is one of the larger BDCs with a market cap close to a billion but not as diversified as other BDCs with 70% of its portfolio in healthcare, consumer products, and technology. Profitability is hard to determine since they issue new shares a couple times a year diluting the EPS. Revenues have not seen significant growth (around 5%) over the last five consecutive quarters yet the number of shares has grown 26%. However, they announced a new quarterly origination record for the December quarter and analyst are projecting a sharp rise in revenues over the coming quarters. On February 6th they will release their latest financial results with projected EPS of $0.27 just short of covering their $0.29 dividend. FSC currently has a dividend yield of 10.8% and has cut distributions in the past. This stock is also trading above NAV with average P/E and PEG ratios. The analyst are a less enthusiastic about this stock and like me are probably waiting to see upcoming earning releases with revenue growth resulting from recent deployments of capital making it a 'Maybe'.

In my next article I will cover Prospect Capital Corporation (PSEC), Gladstone Capital (GLAD) and Technology Investment Capital Corp. (TICC).

Source: 3 Business Development Companies: The Good, The Bad, And The Maybe? Part 1