This article is a follow up to "A BDC Investment Philosophy And 4 Portfolios," where I discussed what BDCs are and why I see them as good investments as well as four different approaches to investing in BDCs, including the 'Value and Growth' portfolio. The BDC sector can be volatile, but this portfolio attempts to find undervalued investments with an annual dividend yield of over 10% and the potential for capital gains and special dividends. Currently, the top five investments for a value and growth BDC mix are TCP Capital (TCPC), THL Credit (TCRD), Prospect Capital (PSEC), Medley Capital (MCC) and TICC Capital (TICC). Out of the 25 BDCs that I follow, I will pick five for each portfolio type (with the exception of the general portfolio) along with recommended weightings. The four types of portfolios that I will cover are:
The Value and Growth Portfolio
This portfolio is for investors who want to participate in capital gains from undervalued BDCs and will most likely have the highest turnover and needs more attention than the other portfolio types. This is for investors looking for capital appreciation in the long and short term, while willing to take on a little more risk and most likely these BDCs will have higher yields. I consider many things when assessing valuation levels, including net asset value ("NAV") and EPS multiples as well as growth rates and projected earnings. I also take into account the risk ranking, and I believe there is a strong correlation between investors' perception of risk and the valuation multiples they pay. I use 'total return' to evaluate performance, taking into account dividend yield plus long-term capital appreciation. NAV growth per share (or at least NAV stability) is an important indicator for many reasons, including the demonstration of growth or preservation of investors' capital through appreciation of assets and/or the reduction of liabilities. BDCs are usually priced based on NAV multiples, so a growing NAV per share usually leads to incremental capital gains for investors.
The key considerations for this portfolio were:
- Valuation multiples (NAV, P/E, PEG)
- Dividend yield and coverage
- Dividend growth history
- NAV per share growth or stability
Again, this portfolio will most likely contain many of the same BDCs as the High-Yield portfolio due to increased yields from being undervalued. The following allocations for the value and growth BDC portfolio are used for the remainder of the information in this article, and all metrics are weighted accordingly.
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Other BDCs Considered
While trying to come up with this portfolio there were other companies that I considered. Main Street Capital (MAIN) has the highest NAV per share growth among dividend paying BDCs but also has some of the highest multiples giving it one of the lowest yields. American Capital (ACAS) does not pay a dividend but has the highest NAV per share growth that has been slowing as discussed in "American Capital: Is It Time To Get Out?" and shown in the chart below:
Ares Capital (ARCC) has a 9% yield with 3% dividend growth and decent NAV per share growth but it is not as underpriced as the other BDCs in the portfolio. Fifth Street Finance (FSC) has a high-yield at 11% but very low dividend growth and slightly declining NAV per share.
These are the five general criteria I use to evaluate BDCs followed by my most recent BDC ranking table. I have included the Value & Growth, Risk Averse and High-Yield portfolios in the chart indicating how a portfolio with my recommended weightings would compare to the other BDCs.
- Profitability (EPS to cover dividends, NAV and EPS growth)
- Risk (rate sensitivity, diversification, portfolio quality, volatility)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (NAV, P/E, PEG)
As you can see the value and growth portfolio has a higher ranking for valuation and payout compared to the average BDC.
When evaluating BDCs, it is important to understand if the dividends are sustainable, ideally through net investment income ("NII") and special dividends covered by realized capital gains. All of these BDCs have recently been raising capital through debt and equity offerings, making it difficult to normalize EPS to get a run rate of expected NII per share. In many cases, there are timing differences between the capital raised from issuing shares and the amount of income received from deploying that capital. The table below shows the current dividends and projected EPS for the calendar Q4 2013 for each BDC:
It is also important to watch for NAV stability to indicate if the value per share is stable after paying its dividends. Historically, all of these BDCs have had NAV per share growth or stability.
In a recent series of articles, I took an in-depth look at the relative risk levels of each BDC. Specifically, I looked at portfolio credit quality, investment asset classes, diversification, non-accrual rates, portfolio yield, fixed/variable rate loans, leverage, interest rate sensitivity, volatility ratios, market capitalization, insider ownership and trends, institutional ownership and trends, and management/operational history for each BDC. The following chart shows the most recent relative risk ranking with a weighted average rank of 6.9 for this portfolio (a rank of 10 implies the least amount of risk).
Recently, the Fed's comments pushed up the yield on the 10-year Treasury note to the highest level in almost two years. In my article "BDC Risk Profiles: Part 6 - Interest Rate Sensitivity" I focused on the interest rate sensitivity for BDCs considering fixed vs. variable rate investments compared to the amounts borrowed to fund those investments. This portfolio has a weighted average 66% of debt investments with variable rates, higher than the average BDC with 61%, and a below average debt-to-equity ratio of 0.53.
I believe that most BDCs will benefit from rising interest rates given the high amounts of variable rate investments and fixed-rate borrowings. These BDCs have been increasing their amount of floating rate loans, especially TCPC as discussed in "BDC Risk Profiles For Q2: Part 3" and on the last earnings call, the CFO stated "it's been a very deliberate strategy to shift to floating rate. On our call just three months ago I think we were asked why we were doing that and we noted that after 30 years of falling rates at some point we thought they were more likely to go up down and we just thought it was worth giving up some rate to position and floating rate."
This portfolio has a higher than average dividend yield at 10.3% compared to the current average of 9.2% but this does not take into account the 'total return' which includes its regular dividend growth, NAV per share growth, and special dividends. All of the BDCs in this portfolio have a history of growing dividends and TCPC and TCRD have paid out special dividends that should be considered when comparing overall yields. The charts below show that these BDCs have a history of higher dividend growth with higher yields and NAV per share growth or stability compared to the others:
PSEC and TICC have longer operating histories than TCPC, TCRD and MCC, but I believe this provides for a good balance especially when considering the potential for growth.
Analysts have relatively higher opinions for most of these BDCs with the exception of PSEC and TICC with average expectations and target prices for the group are around 8% higher than current levels, indicating potential upside in stock prices.
Below is a table using my relative risk rankings to categorize each BDC into valuation levels and appropriate multiples of NAV, LTM EPS and 2013 EPS:
Currently the average NAV per share multiple is 1.08 (excluding ACAS as an outlier) and P/E multiple is 10.9 using LTM EPS (with the exception PSEC which I normalized for impacts from the Gas Solutions sale). The 'standard deviation' statistically measures the variation of pricing compared to the average, with 68% of BDCs priced within one standard deviation from the average or between 0.94 and 1.22 times NAV per share and between 9.2 and 12.7 times LTM EPS. Ideally, each BDC would be priced along a valuation curve with investors paying a premium for favorable risk to reward ratios. The chart below attempts to price each BDC based on risk levels using the current averages and standard deviation of multiples.
As you can see the five BDCs included in this portfolio are undervalued by an average of 17% using this methodology.
This is a solid portfolio for investors that are concerned with valuation and growth taking into account:
- Potentially undervalued by an average of 17%
- Average dividend yield of over 10% with adequate coverage from NII
- Average dividend growth history of over 10% annually
- NAV growth or stability
This portfolio might require a higher amount of turnover and reinvestment as prices change relative to each other, and as interest rates rise many of these investors will sell baskets of high yielding stocks regardless of the underlying fundamentals. This should be seen as an opportunity to buy for the long term. In my weekly newsletter I track the performance of the 25 BDCs that I follow and currently they are on an upswing as seen in the chart below. The next Fed statement is September 18th and usually signals a top of some kind but it obviously depends on the statement itself.
Investors should only use this information as a starting point for due diligence. See the following for more information: