Identifying Business Development Corporations Worth Keeping Vs. Those To Avoid Right Now - Part V: Market Cap Smaller Than $100 Million

| About: Harvest Capital (HCAP)

Summary

After examining the effects of higher rates/yields periods on mortgage and equity REITs, it's time to do the same drill with BDCs.

Unlike equity REITs that have shown (almost across the board) negative effects, BDCs suppose to react more favorably to periods of increasing rates/yields.

This analysis should provide a good indication regarding the resilience of different types of BDCs to higher rates/yields - a very probable theme for 2017.

Each article in this five-part series will focus on a smaller sub-group within the BDCs segment, based on market cap.

This article is focusing on BDCs with market caps smaller than $100 million.

Background / This Time Is Different!

How many times have you heard the commonly used "this time is different" claim? I guess that many times.

Retrospectively, when you look back, how many times has the "this time is different" turned out to be a bad, self-convincing, excuse, at best? I presume that close to a 100%.

Well, I'm not sure about the market (no, I'm just kidding - I'm pretty sure that this time will be no different, just like in previous times), but this article is going to be different.

After writing that "Higher Rates Are Upon Us (Whether We Like It Or Not...)" as well as about "The Importance of an Appropriate Yield and Floating Rates"...

After writing that "BDCs Are Better Positioned Than REITs" as well as about "Risk Management And The Market Timing Myth"...

... I've decided to leave this fifth (and final) part of the BDCs series clean of verbal analysis and strictly dedicate the entire space to the numerical analysis. However, it doesn't mean that this article isn't going to be long - rather that you won't need to scroll down to the variable sections right away.

Last month, I started a series of articles that solely focuses on the resilience and performances of certain yield-starving instruments during periods of rising rates and yields.

The series started with an analysis of mortgage REITs (REM, MORL, MORT), "mREITs" hereinafter. In total, 40 names across 4 different types of mREITs (Commercial, Residential, Hybrid/Special and Traditional/Agency) have been part of this analysis.

From mREITs, I moved to equity REITs (VNQ, IYR, ICF, RWR, SCHH, XLRE), "eREITs" hereinafter. In total, 146 names across 13 different eREITs' sub-groups have been part of this analysis:

Part I: Residential eREITs

Part II: Data-center and storage eREITs

Part III: Small-cap (*) hospitality eREITs

Part IV: Large-cap (**) hospitality eREITs

Part V: Large-cap (**) healthcare eREITs

Part VI: Small-cap (*) healthcare eREITs

Part VII: Industrial eREITs

Part VIII: Triple-Net Lease eREITs

Part IX: Small-cap (*) Malls and Shopping Center eREITs

Part X: Large-cap (**) Malls and Shopping Center eREITs

Part XI: Specialized Commodities-Related and Housing eREITs

Part XII: Government-Related & Infrastructure eREITs

Part XIII: Specialized Diversified/Hybrid and Leisure eREITs

(*) Small-cap = Below $3 billion market cap

(**) Large-cap = Above $3 billion market cap

It's now time to move to the third segment of yield-starving instruments: Business Development Corporations (BDCS, BDCL, BIZD, BDCZ, LBDC), "BDCs" hereinafter. Unlike mREITs and eREITs, the BDCs coverage is being cut into five pieces based on market caps of the publicly traded BDCs. The 56 names spread out across 5 different categories, solely based on their market caps:

Methodology

In total, we now have 5 categories of BDCs (sorted according to order of publication):

  1. Market cap greater than $1 billion (11 names): ACAS, AINV, ARCC, CODI*, FSIC, GBDC, HTGC, MAIN, NMFC, PSEC, TSLX
  2. Market cap greater than $300 million and up to $1 billion (13 names): BKCC, FDUS, ECC*, FSC, GSBD, MCC, PFLT, PNNT, SLRC, TCAP, TCPC, TCRD, TICC
  3. Market cap greater than $200 million and up to $300 million (11 names): CPTA, CSWC, FSFR, GAIN, GLAD, MRCC, NEWT, OXLC, SUNS, TPVG, WHF
  4. Market cap greater than $100 million and up to $200 million (12names): ABDC, ACSF, CMFN, GARS, GECC**, GSVC*, HRZN, KCAP, MVC, OFS, SAR, SCM
  5. Market cap smaller than $100 million (9 names): EQS, FULL**, HCAP, MFIN, OHAI, RAND, SVVC, TINY, XRDC

*While technically this is not a BDC, the company operates similarly to few/many BDCs, distributes a steady dividend periodically and keeps the dividend yield in line with levels that most BDCs pay out.

**Acquired the assets of Full Circle Capital and began trading as Great Elm Capital in November 2016

Over the past five years, we have witnessed three periods of rising rates/yields:

  • Period I: 4/26/2013 - 12/27/2013
  • Period II: 1/30/2015 - 7/3/2015
  • Period III: 7/8/2016 - 12/15/2016

For each type/classification of BDCs, there are three charts that show the performance of the relevant companies (belonging to the sub-group) during the three periods - three charts per group, one chart per period.

Then, the average return for each group during each period was calculated in three different ways:

  • Average based on all the observations (of all the companies that were publicly traded) during the period.
  • Average that excludes the best and worst observations that were recorded during the period.
  • Median or average of the median (if it comprises two observations).

By excluding the best and worst, we "soften" the "bumps" that may occur due to specific/extreme news/events that may have affected a certain company. In other words, we avoid temporary "noise."

After receiving three different averages, I calculated an equal-weighted average for all three averages. By doing so, I believe the data is more reliable and less affected by temporary specific news, events or returns that one or two companies may have gone through the examined period.

Bear in mind that this is a relative drill - an attempt to point out at specific types and names of BDCs that perform more or less favorably during periods of higher rates/yields. Therefore, more than an accurate mathematical-scientific result, I'm mostly interested in presenting the trends and the different performances of various types of BDCs. That way, we will be able to draw better conclusions regarding each sub-group's relative strength compared to other sub-groups within the BDC segment.

Comparisons

Before presenting the charts for the specific BDC sub-group that this article is focused on, it's worthwhile to take a closer look at how the main - best comparable ETFs have performed during the three periods (of higher rates/yields) that we examine:

  • Equities: The SPDR S&P 500 Trust ETF (SPY)
  • High Yield: iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG)
  • mREITs: iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM)
  • eREITs: Vanguard REIT Index ETF

Here are the charts showing how the main BDCs' ETFs (NYSEARCA:AND) - and other relevant benchmarks - performed while the US Treasury 10-Year and 30-Year yields (UST, TLT, TLH, PST, TBF, TBT) rose:

Period I: 4/26/2013 - 12/27/2013

Interestingly, not only did BDCs outperform both types of REITs, they also managed to deliver a very nice positive return of ~7.5%. It's worthwhile noticing that HYG, which also posted a positive return, albeit small, are more closely correlated to the HY space rather to their yield-starving counterparts - eREITs and mREITs.

The first examined period's results definitely strengthen the perception that rising rates/yields are actually beneficial for BDCs. Let's see how things look during the second period of rising rates/yields:

Period II: 1/30/2015 - 7/3/2015

Once again, we see a very similar picture: While both eREITs (mostly) and mREITs struggle, BDCs managed to end the second examined period with a positive return of ~2.1%, not too far away from the ~1% performance of HYG (though more than doubling it). The second period revalidates what we've experienced during the first period. So far so good, but will the third period reaffirm these interim conclusions?

Period III: 7/8/2016 - 12/15/2016

Ladies and gentlemen, we have a "full house!" Three periods, three positive total returns, three decisive results of clear outperformance. With its circa 11% return, the BDC segment proves it's not only resilient but actually benefits from periods of rising rates/yields.

Looking at the three periods of rising rates/yields, the performance of BDCs (7.5%, 2.1%, 10.7%) is miles ahead that of mREITs (-16.9%, -3.36%, 4.78%) and, especially, eREITs (-9%, -10.6%, -8.72%).

As a matter of fact, the combined ~20.3% return of BDCs during the three periods of higher rates/yields is much better than the combined performance of the HYG, and it's not too far from the combined return posted by the SPY.

Clearly, this should come as no surprise to anyone who tracks and understands BDCs. I have written a couple of times about the relationship between rates/yields to BDCs' prices. The bottom line here is that these two are positively correlated, and the former is beneficial for the latter.

Now, knowing that BDCs are able to perform during periods of increasing rates/yields, the question that remains is: Can we identify specific BDCs, names or sub-groups, that perform better than others during periods of rising rates/yields?

Specific BDCs - Charts and Analysis

Within the BDC segment, the sub-group that this article is focusing on is BDCs with market-caps smaller than $100 million ("BDCwMC<100M")

Chart 1: BDCwMC<100M, 4/26/2013 - 12/27/2013

Please note the following:

(*) Full Circle Capital (FULL) announced a merger with Great Elm Capital in June 2016. The FULL symbol traded until November 3rd 2016. The new merged company started to trade in January 2017 under the symbol GECC. The performances in this analysis are, therefore, those of FULL although they are being presented under the symbol of GECC.

  • Average including all observations: 2.77%
  • Average excluding best and worst observations: 2.21%
  • Median: 3.91%
  • Average performance of all three averages: 2.96%

Perhaps not surprisingly, BDCs with market caps that are smaller than $100M didn't perform as well as any of their larger-size siblings. during this very same period, other sub-groups perform much better:

BDCs with market caps... Performance
Greater than $1B 13.11%
Between $300M to $1B 7.98%
Between $200M to $300M 9.74%
Between $100M to $200M 5.47%

The 2.96% isn't too impressive even in annualized terms as it comes to only 4.44%, much less than what the BDCS or BIZB, not to mention the SPY, delivered during that period of time.

OHAI outperformed with 24.48% while EQS underperformed with -15.6%. Those were the only two observations that ended up with double-digit total returns.

As a reference, here are the total returns that three close-end funds ("CEFs") within the same category of market-caps (<$100M) - that operate in a similar manner to BDCs, i.e. fixed-income, yield-starving, regular (dividend) payouts - have delivered during the exact same period:

Much worse, if this is of any consolation...

Chart 2: BDCwMC<100M, 1/30/2015 - 7/3/2015

Please note the following:

(*) Full Circle Capital (FULL) announced a merger with Great Elm Capital in June 2016. The FULL symbol traded until November 3rd 2016. The new-merged company started to trade in January 2017 under the symbol GECC. The performances in this analysis are, therefore, those of FULL although they are being presented under the symbol of GECC.

  • Average including all observations: 2.25%
  • Average excluding best and worst observations: 0.15%
  • Median: -3.22%
  • Average performance of all three averages: -0.27%

Things don't improve for BDCs with market-caps smaller than $100M. Here is how BDCs with larger market-caps performed, on average, during the same period of rising rates/yields:

BDCs with market caps... Performance
Greater than $1B 2.59%
Between $300M to $1B 8.14%
Between $200M to $300M 9.27%
Between $100M to $200M 6.91%

Once again, it's OHAI that is the clear outperformer with a circa 30% total return. On the other side of the spectrum, FULL's 12.8% was the worst-recorded total return during this period.

During the second examined period we had two other names posting double-digit total returns, one on each side: On the positive side it was HCAP (19.22%) that joined OHAI while on the negative side it was TINY (-10.1%) that joined FULL. TINY and FULL make an investor a BIG FOOL during this period.

Here is how the reference CEFs performed during the same period:

With an average return of -0.73% the CEFs were only a tad lower than the BDCwMC<100M overall average performance.

Chart 3: BDCwMC<100M, 7/8/2016 - 12/15/2016

Please note the following:

(*) Full Circle Capital (FULL) announced a merger with Great Elm Capital in June 2016. The FULL symbol traded until November 3rd 2016. The new-merged company started to trade in January 2017 under the symbol GECC. The performances in this analysis are, therefore, those of FULL although they are being presented under the symbol of GECC.

Although not presented in the above chart, the flat performance of FULL during the third examined period (till and including 11/3/16) is included in the below calculations. During that period FULL didn't pay (what used to be monthly) dividends. (The last distribution was paid in March 2016.)

  • Average including all observations: -8.88%
  • Average excluding best and worst observations: -6.08%
  • Median: -5.35%
  • Average performance of all three averages: -6.77%

Remember the "this time is different" claim? Remember that in most (perhaps all) cases this claim is nothing but a self-convincing excuse? Here is a live example to it. If it didn't work/perform before - it won't start working/performing now. This time is no different!

BDCwMC<100M didn't perform well during the first examined period. They performed even worse during the second examined period. There are no miracles and the third examined period was no different.

Not only did BDCwMC<100M not perform well during the third examined period - they really stank! Even when we exclude MFIN's -53.1% horrible performance - things don't look good.

Here is how BDCs with larger market-caps performed, on average, during the same period of rising rates/yields:

BDCs with market caps... Performance
Greater than $1B 11.12%
Between $300M to $1B 9.57%
Between $200M to $300M 16.25%
Between $100M to $200M 5.11%

There was quite a big divergence among BDCwMC<100M during the third examined period. On one hand, we had two names - EQS and HCAP - recording positive double-digit total returns. On the other hand, we had four names - MFIN OHAI, TINY and RAND - recording negative double-digit total returns.

Here is how the reference CEFs performed during the same period:

For the third time in a row, the CEFs delivered a negative total return, unsurprisingly taking into consideration the rising rates/yields environment. Nonetheless, for the first time they've outperformed the BDCwMC<100M. This only tells you how awful did BDCwMC<100M perform during that period.

BDCwMC<100M - Main Results and Findings

First of all, let's put the data we have gathered from the above charts into a table:

There are a few immediate results that catch the eye regarding BDCwMC<100M performance during periods of increasing rates/yields:

  1. Even if "great things come in small packages," the packages can't be too small. The smallest BDCs delivered the smallest returns. As a matter of fact, it wasn't even a tiny positive return but rather a poor-negative one. Simply put, BDCs with market caps smaller than $100 don't deliver.
  2. For the first time in this series, half of the BDCwMC<100M's 24 observations ended up with negative total returns. Say no more. Seven out the twelve negative observations were in the double-digit range.
  3. Four of the eight BDCwMC<100M names finished this analysis with negative total returns, on average: MFIN (-17.12%), TINY (-12.75%), FULL (-5.24%) and RAND (-4.17%). MFIN's -53.3% disastrous performance was a combination of very poor results and a massive 80% dividend cut. TINY was the only name within the BDCwMC<100M sub-group to post a negative return during each and every examined quarter.
  4. Nonetheless, with the bad/negative there's also some good/positive and names succeeded in recording positive double-digit total returns, on average: HCAP (18.64%) and OHAI (10.04%). While HCAP did so in a very consistent way, OHAI was very volatile, posting a >24% move (either direction) during each and every of the examined three periods.
  5. HCAP wasn't the only consistent name within this sub-group. XRDC also managed to post a positive total return during all periods of rising rates/yields.
  6. Surprisingly (taking into consideration the poor performance of the sub-group as a whole), TINY was the only name to post negative total return during all periods of rising rates/yields. Tiny indeed. FULL escaped from entering this list only thanks to a flat third period.
  7. Bottom line: HCAP and XRDC are the winners; MFIN and TINY are the losers. Here is how it looks (for these names) from a total return perspective since the US elections:HCAP Total Return Price Chart
    Hardly ever are there miracles and hardly ever is there a coincidence. The winners delivered 38.51% (on average) in ~100 days while the losers delivered -20.42% (on average) during the same period. Surely, this is, i.e. could have been, one of the best long-short pair-trades ever!

Bottom Line

The bottom line is very easy and very clear:

  • Over the past few months, I've explained a couple of times why I believe that mREITs are better positioned than eREITs. Over the last couple of months, I've also written many times that BDCs are better positioned than REITs. If you haven't understood why I say so and where I'm coming from - this article clarifies the matter and clears the way. BDCs are not risk-free instruments, not at all, but it's important to know which hand to play when; 2017 seems like the right time to play the BDCs hand.
  • Over the past few months, I've explained a couple of times why I believe that many eREITs are overvalued. Although most BDCs trade at or near their 52-week highs, it's safe to say that (unlike eREITs) BDCs are not overvalued. The growing economy, positive sentiment and near-term possible legislation create an almost perfect setup for BDCs to keep flourishing. Although BDCs aren't immune to losses, especially if the market as a whole goes through a correction, they still offer an attractive risk/reward profile.
  • BDCs with market caps smaller than $100 performed poorly during periods of rising rates/yields. This sub-group is, by far, the worst among the segment and it's no wonder that these names have such a tiny market-cap. Unsurprisingly, none of the names in this sub-group found a place in my A-Team.
  • Nevertheless, even within this very disappointing group we found two names that may join the higher-ranked categories if they continue to perform as decent as they did. Bear in mind though that the smaller, the riskier. Extra cautiousness is surely warranted when it comes to these micro-cap BDCs.

One should always be mindful of changes in the landscape that may change the attractiveness of a certain investment/instrument. Nonetheless, as it looks now, there won't be many "wrong-doers" among the BDCs segment during periods of rising rates/yields.

I intend to write (hopefully next week) a summary of this series in order to draw final conclusions. Meanwhile, we already found out that BDCs are for real! It's better to stick to the larger caps but even within the small caps we can find diamonds and pearls.

Bear with me, Do your own due diligence, Create wealth and Stay tuned!

Disclosure: I am/we are long ARCC, GAIN, HTGC, NEWT, PSEC, NMFC, PNNT, TCPC, ABDC, AINV, MRCC, TPVG, TBT.

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.

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