Main Street Capital: Neutral Until Yields Go Higher

Summary

• Main Street Capital is very sensitive to interest rates, and the Fed has started cutting rates to fight the COVID-19 impact. The cuts will erode the company’s profitability.
• The company has assumed that the COVID-19 virus will not have a significant impact on its 2020 earnings, and this assumption is not holding good.
• I am neutral on the stock for now. However, this is a very efficient company that can be considered by dividend investors after the economy stabilizes.
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A big business starts small. - Richard Branson

The business prospects of Main Street Capital (NYSE:MAIN) are interlinked with the fortunes of the lower middle market. It is an efficiently managed company that has been paying monthly dividends since 2013. The company is so committed to its shareholders that it didn't reduce dividend payouts during the 2008-09 recession. It gets access to favorable opportunities in the capital markets because Standard & Poor's has assigned it a BBB/Stable rating, which is considered strong.

Though all seems good, the company has made an important assumption in its Q4 2019 earnings call on Feb 27, 2020, and that assumption may not hold good the way events are shaping up. My rating is neutral; however, you can consider buying it when its dividend yield spikes.

Here are the reasons why:

MAIN vs S&P 500 vs MDY

Image Source: Seeking Alpha

MAIN, the S&P 500 (SP500), and the SPDR S&P MidCap 400 ETF (MDY) have delivered flat returns since 2019. I have selected MDY because it is representative of the middle market sector.

MDY paid $5.04 dividend (at 1.52% yield) in 2019, and MAIN has paid $2.46 dividend (at 6.6% yield) in 2019.

MAIN is way better than MDY from the dividend yield point of view, but we still must compare it with its peers.

MAIN - Peer Comparison

MAIN faces competition from Ares Capital (ARCC), Golub Capital BDC (GBDC), and Apollo Investment (AINV).

Image Source: Seeking Alpha

MAIN stands out as an investment that has delivered gains to its long-term shareholders (five years and above) both from the valuation and dividend perspectives. MAIN also has the lowest dividend yield (6.6%) amongst its peers, and that's because it is fancied by investors.

However, the entire peer group has underperformed from a valuation perspective and looks set to underperform some more because the markets are reacting badly to the COVID-19 virus.

The COVID-19 Assumption that Went Wrong

At the Q4 2019 earnings call, MAIN's management team was hopeful that the COVID-19 impact wouldn't be significant. It felt that in the worst-case scenario, it would impact only the heavy electronics industry.

Well, it's not even a week since the earnings call and we have seen how COVID-19 has shaken global economies. No one knows how it's going to end, but the one certain thing is that it will spook people, lead to self-quarantines, and restrict consumer spend in the near future. No one even knows to what extent demand will revive when there is clarity on the epidemic.

All U.S. companies will be impacted in the near term, including MAIN's clients. Goldman Sachs (GS) estimates that public companies will post a flat growth in 2020. How far down the virus will take us, no one knows.

Interest Rate Disadvantage

The interest rate on 73% of MAIN's outstanding debt obligations is fixed. 74% of MAIN's debt investments are made at floating interest rates.

When rates increase, MAIN's net earnings rise, and vice versa. The COVID-19 impact will make Fed cut rates - this is a given. Wall Street estimates the rates will fall to zero.

A 100 BPS cut in rates translates to a loss of $8.7 million ($0.14 per share) to MAIN. This is another negative that shareholders have to live with.

The Verdict

MAIN faces disruption in 2020 mainly by the COVID-19 black swan. The Fed's rate cut of 0.5% announced yesterday and its forthcoming rate cuts will reduce the company's profitability. Plus, any adverse economic impact on the companies operating in the lower middle market sector will impact its portfolio quality.

Once things clear up, the company should be back where it belongs, but no analyst can estimate when things will return to normal. In the near term, consumer spending will take a knock, dragging down business.

MAIN is a dividend stock and therefore dividend chasers should wait for the yield to become more attractive - perhaps 8-10% - and then start adding the stock.

Till the yield becomes compelling, I'm neutral on MAIN.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

This writing is for informational purposes only and Lead-Lag Publishing, LLC undertakes no obligation to update this article even if the opinions expressed change. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services in any jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Lead-Lag Publishing, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

Comments

[KMR holder]

I just published a blog post in this maybe not "best in breed" BDC

seekingalpha.com/...

[ijeff]

"MAIN is a dividend stock and therefore dividend chasers should wait for the yield to become more attractive - perhaps 8-10% - and then start adding the stock."

Here we are at 11-12%. Anybody adding besides me?

[KMR holder]

@ijeff

I'm not adding but I opened a very small position in MAIN at $23.50 yesterday and have already lost more than 12.5% in 26 hours. It'll take
about 12 monthly dividends and two specials to make me whole if the price doesn't rise. I'd consider doubling my position in MAIN if the price drops below $19, but it will still be less than 0.5% of the size of my position in OCSL.

I can't imagine the pain of those who invested above $40 to capture the secure dividends paid by this "best of breed" BDC. They may need to wait a decade to get even.

No matter how secure the distributions of a company may be, the price that investors pay to stake their claim on that cash flow must be reasonable.

[Daniel.Cluley]

I bought 50 shares this morning at $19.60.

Will buy more if it drops lower this Friday when I get paid.

[KMR holder]

@Daniel Cluley

My buy of MAIN was insignificant in size. I more than tripled my position in OCSL since mid-January. My average cost is now $4.79 not counting dividends and trading profits in the name since May 2018.

[livelaughlikelove]

@Jim_Purzickis: I'll admit that I have posted some dumb comments, but calling this author "inexperienced" and a "clown" are emotional responses. He is a CFA who does research. Look at ARCC, FDUS, PSEC, GAIN, MAIN and other BDCs recently; they are all hitting or near 52-week lows, and the carnage might not stop. Take this man seriously, Jim. You & I are smarter than including "name calling" tactics with our opinions. I promise that my derogatory remarks on Seeking Alpha will have stopped March 11, 2020. I might disagree with a contributor, but it will be respectfully.

[james1337]

Thanks for the article; agree that it's not the best time to buy BDCs in general. How do you compare MAIN vs GAIN btw?

[livelaughlikelove]

The Federal Reserve's action cutting interest rates shows no faith in the U.S. economy. Interest rates should be determined by the so-called "free market". A virus is not slowed down by anything the Federal Reserve does. The real clowns are politicians who think rates should be cut more to compete with other countries. I'm not selling MAIN or GAIN. I have stocks that I follow, and each one is lower than my "buy" prices. What am I doing? Dividend reinvesting them while waiting for better add-on prices. The term "long" for me means having investments for more than one year. Also, I bought more toilet paper a few days ago at Walmart, as I was running low on that item.

[MrFireby2023]

I bought both MAIN & MDY on Feb. 28th. I like the monthly dividends offered by MAIN and I got it at a very attractive price during that day’s rout. MDY was purchased simply as a trading position. It was trading over 350/share in mid February. It’ll return to that level once this ridiculous corona panic subsides.

[Pablo]

My take away is BUY MAIN when it swoons.

[Brucejfern]

MAIN's premium has always been too rich for me. Chose TSLX in 2015 for that reason and bought more TSLX last MON in pre-market because their premium to NAV much less and best of breed like MAIN and TSLX almost always sell at significant premiums to NAV.

The author does not understand that best of breed BDCs have undistributed earnings that can be called upon to cover for possible shortfalls to keep dividend stability. If you a long only holder of better and best of breed BDCs then we have all taken a huge hit to our capital but the issue is the quality and maintenance of dividends. The BDCs I own have undistributed earnings that can be called upon.

This Corona virus like viruses before it will pass and the world's market reaction is at panic levels.

A reminder that between AUG 2008 and MAR 2009 we saw the ugliest market in our lifetimes with the S&P finally reaching 666 (the devil's number) before we hit bottom in early MAR 2009. That was a financial panic and it does not appear we will have the same credit panic as that period. Some companies may not be able to refinance their debt at desirable levels because the companies are trying to refinance during a period where risk is being redefined. But the systematic collapse of the financial system in 2008 and 2009 was quickly and fully discounted and by MAR 2009 we didn't know then this was the beginning of a great bull market.

Investors always have the choice of succumbing to the fear and panic or hold through. That assume you are not on margin. If on margin you better get out before you lose everything but those of us who are income investors have to decide whether this virus has the capacity to bring down the world economy. I have a hard time believing that having been through that great financial crisis in 2008/09 and will stand and hope the markets of the world are overreacting.

[toh192]

60% premium to NAV is more than absurd and they don’t have undistributed earnings that isn’t factored into NAV. Sure they can issue shares and take 40% in fees and still have it accretive to grow NAV — for now, nobody’s noticed management is sucking the premium into their wallets.

[Lance kaminsky]

what's the premium to nav now that stock price went down a lot past 2 week?

[KMR holder]

With all the new shares issued at premium prices Main's NAV has increased 5.8% over the last 4 quarters according to cefdata.com. Without all that free money raised through their ATM, I wonder what Main's NAV would be. Over the same period these are the BDCs with the greatest increases in NAV. Not all of them have been diluting their shareholders equity through the issuance of new shares.

SAR 19.59%
HTGC 14.82%
OCSL 14.64%
TSLX 12.37%
WHF 12.34%
BBDC 11.95%
NEWT 11.73%
HRZN 11.07%
ARCC 10.93%
OCSI 10.92%
GBDC 10.69%
NMFC 10.61%
GLAD 10.57%

The owners of any of these shares have seen the value of the assets that back their shares grow by at least 10%.

[excenter]

Wait, been paying dividends since 2013 but didn't reduce them in 2008-2009? wut?

[Fero.]

MAIN's divs are good enough compared to the yield on bonds. I'll be adding on the way down.

[Lance kaminsky]

This article seems like it was cut off but there was no keep next to the article saying premium. Do you realize their dividends have grown every year?

[KMR holder]

@Michael A. Gayed, CFA

Do you think that the market recognized as far back as 9 months ago the cost differential that would occur do to the level of fixed rate debt? That seems not to be very likely to me. When comparing Main's price performance with your listed peers, do you think that investors are simply less willing to provide so high a premium to NAV for its share price.

Generally the more one pays to own an asset, the higher the risk in the price. Could it be that investors feel that owning MAIN shares at an 80% premium to book is too risky and during unsettled economic conditions even more risky?

Your recommendation that investors should buy after a spike in yield would certainly occur if the stock price dropped much closer to NAV. I believe that outcome will come sooner than interest rates rising quickly.

[Jim_Purzickis]

Your statements/thesis is making the assumption that the USA is in full Covid pandemic mode with domestic supply shocks. This is not currently the case. If we are headed there, MAIN and every other US company will be impacted. The one thing MAIN enjoys is a quality premium over its sector with superior management and low non-accruals. We can quibble about where MAIN's price ends up trading but I will buy it now and on the way down while collecting that nice monthly distribution. BDCs are sensitive to declining economic growth, so a buying opportunity is presenting itself. Despite this, you expect a 'melt-up' in US equities but remain neutral on a top-flight BDC like MAIN which tends to outperform on upside market moves. Not very well thought out. Party

LONG MAIN (and GAIN)

[Jim_Purzickis]

Even if the Fed drops rates to 0% and the 10 year is at 40bp, I'm sure investors will have no interest in 6.5%+ yielding MAIN. This author is a clown.

[Jeff from SD]

I tried to find continuity with this article. Found none. So I must agree that the author was "clowning around."

[Jim_Purzickis]

@Jeff from SD author looks pretty inexperienced but it's all good.

[MLian]

Did you forget about two specials MAIN pays and gradually planning to transfer to the monthly dividends?