Desperately Seeking Yield Through Equities: Part 1 - BDCs

by: Philip Mause

>> Go to Part 2


Fixed income yields are increasingly meager and investors often hesitate to increase yields by buying longer duration fixed income securities because the long awaited increase in interest rates will (if and when it comes) would drive down the prices of those securities dramatically. Thus, we see fixed income investors huddled under the shelter of short term Treasuries, even though the 2 year Treasury yield is .44% and the 5 year is 1.63%. These are pre-tax yields and it is clear that a number of investors in these securities will see the real value of their portfolios slowly evaporate before their eyes with even limited inflation.

The equity markets offer opportunities to obtain higher yields with some degree of inflation protection. For example, the dividend on the Dow Jones Utility Average is 4.18% - considerably higher than it was in 2007 when interest rates were much higher. And there was not a quarter throughout the panic in which the aggregate dividend payment level of the Dow Jones Utility Average went down.

In addition, equity dividends are generally (but not always) taxed at lower rates than interest payments. In addition, some equities (BDCs, REITs, MLPs) offer much higher yields than utilities. Finally, certain large cap companies with stable businesses seem to have persistently high dividend yields. This series will explore the various categories of equities attractive to yield hunters and will set forth some of the peculiar issues and problems associated with each category.

While an investor must exercise care and be aware of the problems associated with each group of stocks and while my distaste for Treasuries does not reach the Nassim Taleb ("every single human being" should short Treasuries) level, I am firmly of the belief that investments in select equities providing attractive yields will outperform almost all fixed income investments from here.

Some Important Considerations

I often see lists of high yielding stocks or stocks with low price earnings ratios which include a mix of Business Development Companies(BDCs), Mortgage Real Estate Investment Trusts (REITs), electric utilities, and tobacco companies. It is important to understand that some of the stocks which produce high yields have special characteristics that make the application of traditional stock valuation metrics problematic.

The most important factor is that BDCs and REITs are subject to special tax and regulatory rules. They are sometimes called "flow through entities" because they typically do not pay tax on income and flow income through to stockholders who, in turn, are generally obligated to pay ordinary income tax on the dividends. (In some cases, some dividend income may be taxed as capital gains or not taxed as all and treated as a return of capital - investors receive tax information at the end of the year clarifying this.)

A series of law review articles could be written on this topic and I am oversimplifying but it is vitally important for investors to have a working understanding of this system. Regulations require that a high proportion (90%) of income be passed through to shareholders promptly as dividends. This tax and regulatory arrangement is important to bear in mind for several reasons.

  1. Investor Tax Liability - As a shareholder, you will generally have to pay ordinary income tax on dividends. Some dividends will be treated as capital gains or as a return of capital but generally dividends will be taxed as ordinary income. Of course, this tends to make these investments attractive for tax advantaged accounts like IRAs.
  2. Higher After Tax Earnings - Two companies, identical in every other respect, one of which is a REIT or BDC and the other of which is a normally taxed company, will have different after tax earnings because the normally taxed company will have to pay taxes which will reduce after tax earnings.
  3. High Dividend Pay Out Ratio - The percentage of earnings paid out as dividends will be high for REITs and BDCs which are required to pay 90% of their earnings as dividends; this should result in a pay out ratio of at least 90%. The pay out ratio for the Dow 30 is now about 33%.
  4. Dividend Volatility - Paying out 90 percent of earnings means that earnings dips will likely lead to dividend dips while normally taxed companies paying out 33 percent of earnings as dividends can continue paying dividends at current levels even if earnings decline. With REITs and BDCs, an investor should be aware that nobody is promising him that the dividend will continuously increase at a nice steady pace until the end of time.
  5. Secondary Offerings - Since 90% of earnings go out the door as dividends, very little in the way of earnings can be retained. As a result, BDCs and REITs usually grow by periodically engaging in secondary offerings of stock.
  6. Limited Potential for Growth - Because earnings are quickly dispatched as dividends, the potential to reinvest earnings and grow the business is limited. A growing BDC or REIT will almost always be engaged in secondary offerings which will create dilution and also limit the potential for appreciation in the stock. There have been some cases of BDCs and REITs whose prices were driven way down below fair value and an investor who "bought at the bottom" made out handsomely. In addition some equity REITs can attain substantial price appreciation in a rising real estate market. But, as a general matter, you are not very likely to find many true growth stocks in this area.
  7. Domestic Orientation - For a variety of reasons virtually all of the stocks that will be dealt with in this series (with one very important exception) are much more focused on and dependent upon the US economy than equities in general. I feel that this is a substantial disadvantage as these stocks are not in a position to benefit from a declining dollar or from greater economic growth in overseas markets.

Business Development Companies (BDCs)

I have written quite a bit about BDCs on this website. They are generally registered investment companies (RICs) and have the characteristics of flow-through companies described above. There is also a statutory limit on leverage at the 2 to 1 level (total assets can be no more than twice the value of net equity).

The sector went through a rough patch in 2008-09 but has bounced back strongly. Recent declines in the stock market have created some attractive opportunities in this sector. Asset mix can vary - some BDCs invest in equity, but most concentrate on loans to small and mid-size businesses.

Some BDCs also run CLOs. A number of BDCs have started taking SBIC loans which permit a bit more leverage in some cases. Most of the loans BDCs make are short term so they are working their way out of the default problems created by the Panic and a higher and higher percentage of assets consists of loans made since the onset of the crisis which generally means that the loans reflect considerable risk aversion. The market that BDCs serve is huge and the BDC universe is still tiny (I believe total market cap of all BDCs is considerably less than $20 billion) so there is potential for growth and for demand to continue to draw supply into the market at favorable terms. The recent pullback has created some attractive opportunities in this sector.

For instance:

A. Hercules Technology (NASDAQ:HTGC) - This BDC (yielding 8.5%) has an excellent track record on loan performance and also frequently gets an "equity kicker" when it advances money so that it is in a position to benefit from appreciation in the stock of companies it lends to. Apparently, it didn't get a piece of Facebook but, as it is located in Silicon Valley, it is in a position to pursue opportunities in the tech sector.

B. NGP Capital (NGPC) - A stock which I believe has been persistently underpriced and is trading at a 27% discount to book value, NGPC yields 9.3%. It concentrates on providing financing for the energy sector and often takes a royalty or other energy interest in a transaction. There are signs of boom in the oil and gas business and NGPC should be well positioned to benefit.

C. PennantPark Investment (NASDAQ:PNNT) - PNNT yields 9.2% and has a high percentage of loans made during the period of enhanced diligence, a strong loan performance record and the opportunity to increase earnings by modestly increasing leverage.

D. Fifth Street Investment (FSC) - FSC yields 11.1% and has a solid record of loan performance. Management has attained excellent performance and FSC appears to have a very strong mix of assets as well as the opportunity to increase earnings with some additional leverage. I am somewhat concerned about paying a price significantly above book value but, in this case, I think it is merited.

E Gladstone Investment (NASDAQ:GAIN) - This BDC had lender problems but they are now resolved. It currently yields 7.5% so that an investor will be paid to wait for the price to trade up and close out the 20% discount to book value.

Disclosure: I am long HTGC, NGPC, PNNT, FSC, GAIN.