Business Development Companies (BDCs) offer investors the opportunity to obtain attractive dividend yields with reasonable transparency and low leverage. BDCs have statutory limits on leverage(debt cannot be more than 1 times net book value) and are required to pay out 90% of earnings as dividends as a condition of the favorable tax treatment provided in the Code (BDCs in compliance are generally not required to pay any corporate income taxes). A disadvantage is that BDC dividends are generally taxed as ordinary income(making BDCs ideal investments for IRAs or other tax sheltered accounts).
BDCs generally invest in equity and debt instruments issued by small and mid-sized companies. In the recent financial crisis, BDCs had to write down the value of many of their holdings; in some cases, this led to leverage issues or disputes with lenders. Some BDCs reduced or omitted dividends. The "hangover" from that debacle is still with us as some BDCs are still experiencing asset write downs and investor revulsion still arises whenever a financial scare reverberates through the market. In short, although all of us on this website are "seeking alpha," many of the BDCs are experiencing lots of "beta." The last few weeks have driven down the stocks of many BDCs and some very attractive bargains are opening up.
This article features three BDCs trading well below book value. In each situation there is reason to be optimistic that write downs are very unlikely to take book value to levels equal to current market cap. In each case, I list the symbol, Friday's closing price, the price to book value, and the current dividend yield.
1. MCG Capital (MCGC)(3.96)(.62)(17.2%)
This is one of my favorite investments at this time - partly because I bought some at 85 cents a share back in 2009. MCGC has had a rough time - especially due to one investment which has been a kind of albatross around its neck. It has written down its investment in Broadview (a CLEC - competitive local exchange carrier) some $74 million in the last 9 months. Last quarter, the write down was $25 million. These write downs hammered MCGC's earnings and led to weak quarterly numbers. MCGC has been engaged in an aggressive effort to transform itself from an investor in equity holdings like Broadview to more of a conventional BDC investing in senior debt securities. The fair value of its current holdings includes some 65% senior secured debt. Broadview is still in bad shape; MCGC's quarterly report identifies problems Broadview may have in rolling over debt. The good news is that MCGC is almost at the end of the tunnel in terms of writing down the book value of its Broadview stake - at the end of the latest quarter MCGC's Broadview position was valued at $29 million. This means that there may be one more big $25 million or so write down of the Broadview position but that, after that, there will be nothing left to write down. Like a household finishing up with tuition payments, MCGC is positioned to move forward with much better earnings and much more stable book value very soon. I do not believe the current valuation takes this unique situation into account.
2. American Capital (ACAS)(6.54)(.55)(0)
This is probably the cheapest BDC in terms of price to book value ratio. ACAS is not currently paying a dividend but has used some cash to buy back stock earlier this Fall. This stock has taken an enormous hit since the summer and is dirt cheap at this price. Part of the problem has been that a large hedge fund investor unloaded an enormous amount of stock. In addition, there have been some write downs - especially of positions with European exposure. But ACAS has very low leverage and a diversified asset base. It also manages a large agency mortgage REIT and earns management fees based on the REIT's asset value; money has generally been flowing into this sector the last couple of years because of the attractive yields that can be achieved. ACAS should get back above 10 when financial markets settle down and it resumes a dividend (probably late in 2012 or early 2013).
3. Gladstone Investment (GAIN)(6.83)(.72)(8.4%)
GAIN is a conservatively managed BDC with very low leverage. There has been some tendency to overweight mezzanine debt but the current market valuation presumes a level of write offs which is unrealistic. I have never quite understood why this BDC does not "get more respect" in the market. It did run into problems in 2008 and 2009 with a lender but those problems are long since gone. This stock should be trading between 8 and 9 dollars a share.
Each of these stocks will jump around a lot in a "risk on/risk off" dominated market and I cannot promise a Christmas present from any of these. But in the intermediate to long run, buying a dollar's worth of assets at discounts of between 28 and 45 per cent will pay off handsomely.