Desperately Seeking Yield Through Equities Redux: Part 1 - BDCs

by: Philip Mause

In the summer of 2011, I wrote the "Desperately Seeking Yield" series of articles starting with this article on Business Development Companies (BDCs). I thought it a good idea to bring things up to date for several reasons.

First of all, the migration of yield-hungry investors into yield-oriented equities continues. This is a true migration because there have been a number of IPOs and many of the entities in the sector involved have actually engaged in secondary offerings of additional stock so it is really a case of more net investment money moving in this direction. I periodically read a comment to the effect that the Federal Reserve is "robbing" savers by holding interest rates low and forcing savers into miniscule returns. I had lunch with a wealthy friend who said that he really had to have at least $74 million to retire because he could only earn .25% pre-tax on his money. There is really no excuse for this. There are readily available strategies for generating high single-digit and even low double-digit returns with reasonable risk. Investors have woken up to this and have pushed prices up to reflect the value of dividends. I believe that the stock market is even beginning to trade more and more on a dividend-yield basis and to resemble the bond market and I have tried to explain how this works here.

A second concern is that investors are still confused about some of these strategies. The dividend stocks dealt with in the original series and in this update vary enormously. In some cases, dividends are taxed as ordinary income. In other cases, tax consequences can arise even if no dividends are paid. Some of the companies tend to increase dividends over time; others do not. It is very misleading to compare BDCs, REITs, MLPs, electric utilities, and tobacco companies using the same metrics but it is done all the time. It is very important for investors to have an understanding of what they are buying and a basic understanding of the different types of yield oriented equities is essential.

Thirdly, I thought it would be interesting to see how these companies have done over time. In June 2011, when I started the original series, we were just about to go through the first "debt ceiling" scare. We have had periodic squalls over potentially higher interest rates, eurozone defaults, fiscal cliffs and other potentially nasty events. This has created some interesting buying opportunities and is also giving us the beginnings of a "long-term" perspective on some of these classes of investments.

The first piece dealt with BDCs. Reviewing briefly, BDCs are generally regulated investment companies (RICs) which are exempt from corporate taxes but must pay out 90% of their income as dividends. The dividends are, in turn, taxed as ordinary income to the shareholders. BDCs generally own debt instruments in which the debtor is a small or middle sized business entity; however, some BDCs hold equity positions in these entities. The debt holdings make BDCs behave somewhat similarly to closed end bond funds (with which they are sometimes confused). They are, therefore, a very logical early step in the "risk on" direction for a bond investor.

There are some important caveats: BDCs inherently have a high "pay out ratio" (dividends as a percentage of income) and therefore dividends are a bit unstable and are not necessarily going to increase over time. BDCs are limited in the leverage they can use to a 1 to 1 debt/equity ratio. When investments decline in value, they can bump up against this limit and this can require the liquidation of assets. During the Panic of 2008, BDCs took a beating because of bad loans, pressure from lenders and general investor angst. There were some outstanding bargains in early 2009 but unfortunately the easy money has been made. On the other hand, a diverse portfolio of BDCs has a place in an income oriented portfolio. I have written an entire series of articles, starting with this one, just on BDCs and it provides much more detail.

This piece features Hercules Technology (NASDAQ:HTGC), NGP Capital (NGPC), PennantPark Investment (NASDAQ:PNNT), Fifth Street Investment (FSC), and Gladstone Investment (NASDAQ:GAIN). In each case, I am providing the price on June 10, 2011, Friday's closing price, the current yield, the current price to book ratio and the current leverage (debt as a percent of total assets). Prices are based on Yahoo Financial; the other data is based on calculations derived from recent SEC filings.

Price 6/10/11 Price 3/1/13 Yield PB Leverage
HTGC $10.77 $12.64 7.6% 1.29 34%
NGPC $7.73 $7.09 9.0% .73 30%
PNNT $11.68 $11.77 9.5% 1.13 38%
FSC $11.55 $10.71 10.7% 1.08 36%
GAIN $7.20 $7.49 8% .82 23%

A few notes. PNNT could have been bought as low as $8.57 in October 2011 and FSC went for $8.53 in the mini-panic of August 2011. It makes sense for investors to keep a list of these stocks handy and watch what happens when the market dips. The group as a whole is slightly up but investors do not generally buy these stocks for appreciation. The yields have been relatively solid throughout the sector and that is attracting more and more investor interest. A number of BDCs have issued more stock and there have been a bunch of new BDCs doing IPOs and coming into the market.

HTGC tends to have a tech orientation and can take some equity in its portfolio companies. It had a secondary last Fall at $10.82, so an investor here is paying a premium over that price. NGPC is focused on energy (primarily oil and gas) and has had some rough spots with some losing investments. I still like it because of the discount to book but it has had a nasty slide since the first article. PNNT has had a good record of containing loan losses; it was active prior to the Crash but weathered the storm relatively well. FSC had a secondary last Fall at $10.79 so that the current price reflects a discount. It has been active primarily post-Crash and so does not have the ticking time bombs that were put in place prior to 2008. GAIN has been a favorite of mine for a while because of its discount to book value but it is on the small side and thus would benefit from growth (due to the potential to reduce costs as a percentage of revenue).

It is interesting that these stocks have been reasonably stable in value despite repeated speculation that higher interest rates would hurt the sector. A certain amount of the lending done by the sector is floating rate and loans tend to be of short duration so that higher interest rates are not the end of the world for these stocks. These matters vary from company to company and can be readily checked on quarterly financials. An additional benefit of the sector is a high level of transparency. An investor can generally develop a reasonable understanding of the assets held by a BDC without undue effort.

An interesting final point. One BDC outperformed all of the above. American Capital (NASDAQ:ACAS) was trading at $9.03 on June 10, 2011; it closed Friday at $14.01, which beats the above (even taking dividends into account). ACAS is a BDC, which is not paying dividends and I think that explains why it has been undervalued. It dipped in price in October 2011 to $6.36 due to the forced liquidation of large hedge fund position in the stock. This gave investors a very nice entry point. When ACAS resumes paying dividends, I expect it to pop up significantly.

Disclosure: I am long HTGC, PNNT, NGPC, FSC, GAIN, ACAS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.