This is an excerpt from a blog published earlier today: Stocks, Bonds & Politics: Bought 1 Extremely High Risk Sandridge Energy 8.75% Senior Bond Maturing 1/15/2020 at 65/Added 50 FSC at $7.86/Bought 50 TCRD at $11.38 Regular IRA
In this post, I explain how I am coping with the freefall in BDC prices by focusing on just one small 50 share purchase of Fifth Street Finance (FSC).
BDC stocks appear to have made a collective decision a few weeks ago to jump off a cliff.
The market price declines have taken many of the externally managed BDCs to historically high discounts to net asset value per share.
The price declines in the better internally managed ones, including Maintstreet (NYSE:MAIN) and Triangle Capital (NYSE:TCAP), have significantly narrowed their premiums to net asset value per share before rallying some on 12/17/14.
In comments here at SeekingAlpha, I have tried to answer what appears to be a simple question: Why is this happening now and is it rational?
The answer to that question can not be determined with certainty, but an attempt needs to be made anyway since the assessment will impact what I need to do now.
One answer involves temporary market factors that will dissipate soon. The other involves a future forecast that would be consistent with those price declines.
I am inclined to believe that most of the decline is due to the following temporary market factors:
1. Tax loss selling, which is now being aggravated by
2. Panic selling (a common human personality trait ingrained in our genes to run from actual or perceived danger)
3. Just remove the pain and I will feel better
4. Forced selling due to margin calls as price declines in a number of income security categories fell in tandem (e.g. MLPs, BDCs, bond closed end funds, BDCs, and energy stocks)
The other explanation for the persistent decline has longer term implications.
BDCs lend money at high interest rates to leveraged borrowers. A 10% to 15% interest rate does not mix well with deflation and/or recessions. A lot of other costs, besides interest expenses, are sticky including employee wages and benefits.
Imagine being in a spot where the demand for your product declines even after a price cut, while your lender is waiting for that monthly 13% interest payment on a loan.
I am not inclined-yet-to accept that kind of problematic economic scenario in the U.S. within a reasonably foreseeable time frame. The weight of the economic evidence is that the economy is regaining its sea legs and will improve in 2015 compared to this year. GDP growth and job creation are accelerating after all.
In my trading system for externally managed BDCs, I try to capture a total return in excess of the dividend yield. In other words, I do not want unrealized losses in the shares to offset, in whole or in part, the return generated by the dividend.
Over the years, I have found that accomplishing that goal is easier said than done with externally managed BDC stocks. I can improve my chances in realizing that goal by buying when the market price is lower than the net asset value per share and to consider selling when there is a price spurt over net asset value. A 10%+ premium to net asset value per share for an externally managed BDC has become almost an automatic sell.
Under this trading system for externally managed BDCs, I have to do my buying when the price craters, which has happened recently. I do not know now how far the price correction will go, so I am chopping orders into small pieces and spacing them out over time.
The answer to my earlier question may be forthcoming after the end of this year. It would be an ominous sign for prices to continue their descent after year end.
Added 50 FSC at $7.86 (see Disclaimer): I have small positions in this BDC in two IRAs and in a taxable account. This buy was made in a taxable account to generate cash flow for reinvestment in other securities and to reduce my average cost to $9.04 per share, with just a 150 share position.
Snapshot of Trade:
Security Description: Fifth Street Finance is a business development corporation (hereinafter BDC) that invests primarily in small and mid-sized private companies, primarily in connection with investments made by private equity sponsors.
Website: Individual Investor | Fifth Street
Fifth Street Finance Profile Page at Reuters
Fifth Street Finance Key Developments Page at Reuters
The portfolio is weighted in secured loans:
A description of the FSC's investments can be found starting at page 90 of its recently filed 10-K.
The oil and gas sector exposure appears to be relatively light at 3.71% as of 9/30/14 and is described as "oil & gas equipment services" rather than a loan to a production company. (page 55) That exposure is to three companies and two of them are in the "process of sold for a fairly substantial multiple". Page 4 Earnings Call Transcript | Seeking Alpha
One of the comments to that SA transcript reproduces some comments, both negative and hopeful, about FSC from the BDC Reporter that are worth reading.
This BDC has what is called an ATM program where KeyBank capital markets can sell FSC's stock in the open market. In a Prospectus filed 12/9/14, FSC mentions that it sold through its ATM program 841,456 shares of stock between 8/22/14 and 9/30/14 at an average price per share of $9.86 or $8.3M The $100M authorization under the ATM program is consequently reduced to $91.7+M. There is a statement in the prospectus that the sale's price can not be "less than the net asset value per share of our common stock at the time of such sale" (page S-10).
After the share price finally worked its way back over $10 per share, FSC Interactive Chart, FSC announced after the close on 7/10/14 that it was going to sell stock, one of the well known and perpetually annoying risks associated with BDCs. Fifth Street Finance Corp. Commences Public Offering of Common Stock FSC priced 13.25M shares at $9.95 per share to the public. There was the usual over allotment option granted to the underwriters. Fifth Street Finance Corp. Prices Public Offering of Common Stock
When looking at a stock offering, it is important to keep in mind that the $9.95 per share offering price to the public is not what FSC receives per share. The underwriters bought the stock at $9.81. FSC also incurred about 2 cents per share in expenses relating to the offering. So the net proceeds after the underwriting discount and FSC's expenses was about $9.79 per share. The net asset value per share was $9.71 as of 6/30/14.
Other stock offerings since December 2012 are detailed at page 71:
This BDC has sold two exchange traded baby bonds with a $25 par values: Fifth Street Finance Corp. 6.125% Senior Notes due 2028 (FSCFL); Fifth Street Finance Corp. 5.875% Senior Notes due 2024 (FSCE)
This is a link to a press release discussing one large recent investment: Metalogix Acquisition by Permira Funds
Dividend History: Fifth Street Finance raised its monthly dividend from .0833 per share to $.0917 effective with the September 2014 distribution.
FSC has cut its monthly rate twice since the 2010 4th quarter. The first cut was a small decline from $.11 to $.1066. The next cut was to $.0958 in January 2012 and then to $.0833. Fifth Street Finance Dividend History
I would not call the increase to $.0917 a dividend raise. When the dividend is increased to over $.11 per month, the rate from November 2010, then that increase will be a raise. The last increase just restored some of the previous cuts.
Assuming a continuation of the current monthly rate and a total cost per share of $7.86, the dividend yield is about 14%.
When the ten year Treasury is yielding just over 2%, a 14% yield obviously carries a lot of risk. The problem with BDCs is how to harvest the yield without giving some or all of it back in share losses.
Recent Earnings Report: For the Q/E 9/30/14, FSC reported $.25 of net investment income per share. The weighted average yield on FSC's income producing investments was 11.1% with the cash component of that yield making up 9.9%. At fair value, 79% of FSC's portfolio consisted of senior secured loans.
An article discussing this report is authored by Scott Kennedy and published earlier this month at Seeking Alpha.
Rationale: There is only one reason to invest in this company. In today's abnormally low interest rate environment, a prudent saver has no real options for generating a satisfactory real rate of return without taking risks. I could buy a 10 year treasury yielding slightly over 2%. Before taxes and inflation, it will take about 35 years for money to double at a 2% rate. Estimate Compound Interest Investing at a 2% rate of return is in my opinion a huge risk for most investors to take, since it enhances the risk that assets will not grow sufficiently to meet expenses.
So, I have no choice but to take risks. I would prefer to avoid companies like FSC altogether.
I can suffer a loss in the shares that generate a 14% yield and still receive an acceptable real rate of return, particularly with inflation trending down.
The discount to the last reported net asset value per share of $9.64 is historically abnormal at 18.46+% based on the purchase price of $7.86. That historically high discount at least suggests a reasonable possibility of price appreciation to more normal levels, assuming the market price decline is primarily due to temporary factors.
Management has stated that it will not sell stock below net asset value per share, which is a positive.
Risks: The risks are substantial, as one would expect for a 14% yield.
1. Net Asset Value Per Share Destruction: Most of the time, the market price for an externally managed BDC will hug net asset value per share within a few percent either higher or lower. If the external managers are destroying net asset value over time, the market price will be declining too.
What is FSC's long term record? Fortunately, this BDC had an IPO in 2008 rather than in 2006 with the investments made just in time for the Near Depression.
6/30/08: $13.2 per share (page 5 10-Q)
6/30/09: $11.95 per share (page 5 10-Q)
6/30/10: $10.43 per share (")
6/30/14 $ 9.71 per share (page 3 10-Q
9/30/14: $ 9.64 Fifth Street Finance
Does that history show a trend yet, or is the decline some kind of aberration that will not repeat itself in the future?
2. Unsatisfactory Long Term Total Returns: The Longrundata calculator goes back to 6/12/2008 for FSC and will reinvest the dividends to buy more shares. Starting then and calculating the total return through 12/16/2014, FSC has produced only a 4.56% annualized total return, significantly below its average dividend yield. Calculator That poor annualized total return highlights an issue. An investor should not become mesmerized by the dividend yield when the long term total return performance screams trade.
3. Serial Stock Issuer: Stock offerings cost money and raise significantly less per share after the underwriting discount and the BDC's expenses relating to the offering than the public price per share. The continuous offering of shares whenever the price creeps above net asset value per share has a tendency to cap price gains to small premiums.
If there is a prolonged period where stock can not be sold above NAV per share, the coffers will not be replenished after loan losses, and net assets producing income will decline. The company would also lose the asset value accretion due to stock offerings where the proceeds to the BDC per share exceed the then existing book value per share.
4. The dividend is not safe or secure. The dividend history proves this point. In case anyone needs to be reminded, the next recession will provide a refresher course about the sustainability of the payouts.
5. Dividends Drain Cash: To maintain its tax status, the BDC must pay 90%+ of its taxable net income to its shareholders. The avoidance of double taxation increases the amount available for distribution, but the dark side to that high dividend is that funds are not being retained to grow the business.
6 The company discusses the abundant risks incident to its operations, including conflict issues inherent in the external management arrangement, starting at page 24 of its recently filed annual report, FSC 10-K F/Y Ending 09/30/2014
7. The significant costs of external management are also a major negative. Net expenses for the year rose to $151.4M from $106.7M for the prior fiscal year.
How did net asset value increase between 9/30/13 and 9/30/14?
Page 47-FSC 10-K
9/30/14: $9.64 Net Asset Value Per Share
9/30/13: $9.85 Net Asset Value Per Share
What can you say about that? In a generally favorable economic environment, net asset value per share decreased by $.21 per share as expenses rose $44.7M. Are FSC's external managers justifying their pay packages? Each investor can answer that question for themselves. I view the answer as both obvious and certain.
8. The chart looks awful: FSC Interactive Stock Chart
I believe that it is important to have a handle on the downside risks.
When I look at the preceding summary, one rational and understandable response is just to say no. Another, which I follow, is to recognize those downside risks and then try to adapt.
Future Buys and Sells: I will consider averaging down at a lower price. I will consider selling shares when the market price exceeds net asset value per share or possibly as soon as I have a net profit in the shares after harvesting dividends. My preference is to harvest 1 to 2 years and then escape with a profit on the shares while I still have one.
Closing Price 12/17/14: FSC: $7.92 +0.10 (+1.28%)
The next ex dividend date is 1/13/15. FSC
Disclosure: The author is long FSC.
Disclaimer: I am not a financial advisor but simply an individual investor who has been managing my own money since I was a teenager. In this post, I am acting solely as a financial journalist focusing on my own investments. The information contained in this post is not intended to be a complete description or summary of all available data relevant to making an investment decision. Instead, I am merely expressing some of the reasons underlying the purchase or sell of securities. Nothing in this post is intended to constitute investment or legal advice or a recommendation to buy or to sell. All investors need to perform their own due diligence before making any financial decision which requires at a minimum reading original source material available at the SEC and elsewhere. Each investor needs to assess a potential investment taking into account their personal risk tolerances, goals and situational risks. I can only make that kind of assessment for myself and family members.