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 'General Optimal' portfolio. The BDC sector can be volatile but this portfolio attempts to find the 'best of breed' companies and their counterparts to create balance.
Obviously each investor has different needs, so there is no optimal portfolio that 'fits all,' but I believe there are BDCs that offer higher returns for the amount of risk as well as potentially being underpriced. This portfolio is for the investor seeking the optimal balance between risk and reward with a higher than average total returns. Many of these BDCs can be volatile individually but as a group tend to perform with the market. The number of BDCs will change as opportunities present themselves. For now I have come up with eight that I believe are among the best in the industry as well as provide for a solid BDC profile for investors looking for sustainable yields, lower risk and volatility, and to participate in capital gains from undervaluation or net asset value ("NAV") per share growth.
This portfolio will focus on 'total return' as discussed in "Triangle Capital: Is It Priced For Total Return?" and take into account expected NAV and dividend growth as well as the current dividend yield to come up with the overall expected return for each BDC.
Currently, the BDCs that I consider to be the best for a general optimal portfolio are TCP Capital (TCPC), Prospect Capital (PSEC), THL Credit (TCRD), Main Street Capital (MAIN), Ares Capital (ARCC), Triangle Capital (TCAP), Medley Capital (MCC) and Golub Capital BDC (GBDC). 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:
I consider investing in BDCs as an investment in the overall market with risk levels similar to other equity investments. I do not consider BDCs as simply a financial sector investment but take into account the sector diversity of each portfolio. Each investor has different needs and allocations but I believe that BDCs deserve a large portion of the overall stock allocation. BDCs can be volatile and affected by interest rates in the short term but I believe they will benefit from rising rates given the high amounts of variable rate investments and fixed-rate borrowings.
The chart below shows the performance of this portfolio over the last three months compared to the S&P 500 but keep in mind that this portfolio will change every quarter or as needed.
The General BDC Portfolio
This portfolio is for investors who want predictable and stable dividends while participating in potential market gains and will most likely have quarterly turnover. The key considerations are:
- Optimal risk to reward ratio
- Total return
- Dividend yield and coverage
- Valuation multiples (NAV, P/E, PEG)
- Dividend growth history
- NAV per share growth or stability
The following allocations for the general 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. Fifth Street Finance (FSC) is currently the smallest component in the high-yield portfolio but recently announced an offering of 15.5 million shares and is not projected to cover dividends this year. TICC Capital (TICC) is a component of both the high-yield and value & growth portfolios but is considered riskier than the other BDCs in this portfolio. PennantPark Floating Rate Capital (PFLT) is a component in the risk averse portfolio but does not have enough NAV per share growth or dividend coverage. American Capital (ACAS) is undervalued and 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:
These are the five general criteria I use to evaluate BDCs followed by my most recent BDC ranking table. I have included the four portfolios in the chart indicating how a portfolio with my recommended weightings would compare to the other BDCs.
- Profitability (dividend coverage, NAV and EPS growth)
- Risk (portfolio quality, rate sensitivity, diversification, volatility)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (NAV, P/E, PEG)
As you can see the general optimal portfolio has a higher ranking for profit than the other portfolios implying that this portfolio has a higher coverage of dividends and NAV per share and earnings growth. It also has a higher risk ranking (implying lower risk) than the others with the exception of the risk averse portfolio. However it has lower payout and valuation ranking than some of the others due to lower risk and paying higher multiples for that reduced risk.
Keep in mind that the 'total' rank is a simple average of the categories and does not imply that it is 'the best'. Each investor should rank the categories appropriate to investment needs. This portfolio is not the best in any one category but attempts to find balance while taking into account favorable risk to reward imbalances.
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. Most 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:
Ultimately, these companies should be able to sufficiently cover dividends with NII. PSEC announced the following: "We intend to continue earning net investment income that covers and provides the opportunity to increase our dividends. Our objective is to increase net investment income and dividends over time by expanding prudent leverage, increasing our mix of higher yielding originations, and from time to time making accretive acquisitions."
Recently MCC issued 6,900,000 shares, which includes the full exercise of the underwriters` option, at a public offering price of $13.00 per share that was accretive to its NAV per share of $12.65 but increased the amount of shares by 20%. MCC is one of the newer BDCs and is still in a growth phase but historically has covered dividends.
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 (discussed later) especially both MAIN and TCAP with the highest growth rates among dividend paying BDCs which is why they trade at higher multiple than average.
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 7.3 for this portfolio (a rank of 10 implies the least amount of risk).
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 62% of debt investments with variable rates and a below average debt-to-equity ratio of 0.57.
I believe that most BDCs will benefit from rising interest rates given the high amounts 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."
As discussed earlier I consider BDCs as an investment in a variety of sectors and look at the type of businesses contained in the underlying portfolios. Using the weightings of each BDC in this portfolio, the breakdown by sector would be very diversified as shown in the chart below:
This portfolio has a lower than average dividend yield at 8.9% 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. Most of the BDCs in this portfolio have a history of growing dividends and MAIN, TCPC, TCRD, and ARCC have paid out special dividends that should be considered when comparing overall yields.
On the most recent earnings call, the CEO of MAIN explained: "During the course of our last conference call, I referenced our spillover taxable income of over $40 million at March 31. As of June 30, we estimate that our spillover taxable income is $46 million. In order to reduce this amount, stay in compliance with a regulated investment company tax rules and reduce the 4% federal excise tax payable on the spillover amount that carries over into 2014, we expect to ask our board later this year to declare our next semiannual supplemental dividend of at least $0.20 a share payable on or around year end. We continue to expect that we will pay semiannual supplemental dividends going forward for the next few years in addition to our regular monthly dividends."
The charts below show that most of these BDCs have a history of higher dividend growth and NAV per share growth or stability compared to the others:
PSEC and ARCC have longer operating histories than the others, but I believe this provides for a good balance especially when considering the potential for growth.
Analysts have much higher opinions for most of these BDCs with the exception of PSEC with average expectations but recently they have started to improve as predicted in my "Prospect Capital: Time To Buy?" article and shown in the chart below:
Target prices by analysts for these BDCs range from 1% higher for TCAP which already trades at higher multiples and 15% higher for MCC which is clearly undervalued most likely due to continued share offerings.
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:
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Currently the average NAV per share multiple is 1.07 (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 0.93 and 1.21 times NAV per share and between 9.1 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 most of the BDCs included in this portfolio are undervalued using this methodology. However as discussed earlier both MAIN and TCAP are priced higher than the others most likely due to superior NAV per share growth, excellent history of dividend coverage and dividend growth. Investors tend to pay higher prices for consistency and higher growth rates.
This is a solid portfolio for investors that are willing to take on the general risk of owning stocks but want a 9% yield that is sustainable and growing. This portfolio will require a certain amount of turnover, most likely on a quarterly basis after results are reported. I will continue to provide updates as needed with suggested weightings for each BDC.
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. Recently the Fed statements have signaled 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: