- We speak with PendragonY, contributing author to High Dividend Opportunities, about the BDC sector.
- He discusses why the team focuses on income over total return as a mindset.
- He also shares a few BDCs that are well positioned for a downturn or which are even benefiting from this environment.
Editors' Note: This is the transcript of the video we posted last Saturday. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the video as well as a combined podcast featuring two other interviews along with this one, embedded below, if you need any clarification. We hope you enjoy.
Daniel Shvartsman: I’m Daniel Shvartsman, Director of the Seeking Alpha Marketplace. We’re doing another Coronavirus-Themed Roundtable. I’m joined today by John Yesford, who writes as PendragonY, a contributing author to High Dividend Opportunities, a leading service for income investors and retirees, focused on high-yield opportunities.
Listen and subscribe to the Marketplace Roundtable on these podcast platforms:
The conversation with John runs from 24:00-49:00 on the above podcast.
So, John, good morning. How are you?
John Yesford: Pretty good. How are you doing, Daniel?
DS: I’m doing well. I’m doing well. So we wanted to talk – we’re going to talk about BDCs today, business development companies corporations, but the place I wanted to start is something we emailed about. And obviously, you’re part of a High Dividend Opportunities leading service. And you talked about how you and the group, in general, is focused on income and income growth over total return. I wanted to get unpack that, because it’s – I know, it’s not uncommon to focus on that. But I’m – it’s also not obvious. So why is that your focus in a time like this?
JY: Well, there’s a lot of ways to make money in the stock market. Maine, [ph] I like to focus on something that I can actually predict. And it particularly on the short-term, stock prices aren’t really very predictable. They go all over the place.
And as we saw last month and even to some extent this month, they can plunge out of nowhere, something bad happens and boom. Whereas with dividends, they’re far more predictable. You can look at the metrics of the company, you can see how much cash they’re earning, you can see what their sales are. And from that, you can get a good idea of where the dividends are going to go.
The other thing is, dividends are basically determined by both how the companies are operating and the Board of Directors, just basically a handful of people. You can look at it for share prices. They, too, are driven by the same metrics that drive dividends. But it’s thousands, ten thousands, even millions of people that are making the decision about where the share price goes. Predicting where all those guys are going to go is a lot harder than the half a dozen to a couple of dozen people on the Board of Directors.
And the Board of Directors are going to almost always make far more logical decisions than the markets, the market panics. One thing that all saying kind of I like is that, one thing you can depend on the market is that it will always overreact.
JY: Good news will send stock down, stock prices up far more than they should and bad news will knock stick share prices down far more than they should. And then the littlest bit of, once you knock them down in the littlest bit of information, send them soaring, again. So that kind of gyration tends to make it very hard to plan.
The last thing you want to do is be in a position where you need cash. And the markets decided that, “Hey, your portfolio is down 30%. So go ahead.” So perhaps dividends, that money is coming in whether it’s – no matter what the price of the stock is. It gives me a much more predictable and reliable stream of income that you don’t necessarily get from relying on capital gains. It’s a bit less, but it’s more reliable. So I like the predictability.
DS: Well, and so I suppose you talked about income and income growth when we were emailing. Income growth, usually, as you said, is driven by the same metrics that drive share prices in the long-term, but the markets are weighing machine eventually earnings, cash flow, et cetera is what most stock price is higher. And so you could also argue that it’s a simpler way to focus on that?
DS: Question to you is that, that all holds except when a dividend gets cut or frozen or whatever else. So what are you doing? There are some sectors, for example, that are getting hit, energy, obviously, but even mortgage REITs and what’s going on there or whatever. So how are you – what are you doing to try to manage the risk of a dividend cut or – I saw today, Southwest Airlines (LUV) suspended their repurchases dividend and they raised shares today, so..
JY: Okay. Yes, the airlines are going to be suspending dividends just because they have to. They – they’re so cash flow for right now that they need to conserve, yes. So they’re not going to be paying dividends, I would.
JY: …the price that Southwest cut it. Basically, well, one of the things that we do – we look at is we look at the liquidity of the company to see if they have plenty of cash to continue paying the dividends and see how the current operations might be impacted and reduced their cash flow.
One company that we really like, EPR Properties (EPR). They invest in movie theaters – they rent out basically movie theaters and their other big client is Topgolf. Both of those – all those things are closed right now. But they also have in cash that they’re sitting on over a year’s worth of revenue in cash.
So they can continue paying their dividend. They can buy up new buildings and properties at low prices, because everybody is all freaked that nobody is going to go to the movies, again, which they will in six months people will be packed in the movie theaters.
The other thing that we do is we’ve started moving up the capital stack by investing in preferred stocks, baby bonds and even regular bonds. A couple of weeks ago, in particular, there was a big huge search for liquidity and people were just selling everything that wasn’t nailed down. And so we managed to alert to our members a bunch of stocks, preferred shares and baby bonds that were just selling at with ridiculously low prices and absurd levels.
JY: A couple of weeks ago, it was just ludicrous level of stuff.
DS: Right. I was looking at – the last interview I did was with somebody focused on high-yield debt, specifically, and we were talking about and I looked at some of the preferred shares and even baby bonds trading at 50% of par that have, like a lot of the market have come back up to about 75% of par, or 80% of where they were before. But yes, there’s a – there is that overreaction, underreaction cycle there, isn’t there?
JY: Yes. That’s – but I mean, that’s basically what – you keep looking at the same thing you do. You look at what are their prospects for generating income in the company in their operations and how much cash and whatever then – how well covered is the dividend.
DS: With a stock like EPR, or a REIT and it’s exposed to social activity, essentially, in groups, and so that’s obviously like airlines in the spotlight right now. Do you – you’re counting on the dependable income, but do you have a stance on – what do you think of the argument that maybe it would be better to not pay a dividend and conserve cash to get their, and if they’ve already done something, please correct me if I’m wrong?
JY: EPR is still paying their dividend. There is definitely – we have looked at holding some companies that have suspended their dividend, because we think they'll work out and that right now the price is just absurdly low. So we realize that we’re going to take in the short-term, maybe a little bit of a hit income. But down the road, they’ll come back and we’ll have them at a really great price generating lots of cash for us.
IVR is a ticker that comes to mind. They suspended their dividend and the common and the preferred shares and recommended people pick up the preferred shares. And I believe that one has actually already resumed just paying their dividends. They basically suspended them for about a week. So we basically scooped him up at like, ludicrously low prices and now get a nice dividend off.
DS: So – and so that – that’s an example of a mortgage REIT, I don’t remember the full name of the company, but…
JY: Yes, Invesco or something that I’m particularly…
DS: I thought it was [Multiple Speakers]
JY: …I don’t know their full names.
DS: Yes. So – but so I – so we were going to talk about BDCs.
DS: And what I think is interesting, first of all, they’re a source of – there are quite a few baby bonds from the BDC sector. So exchange-listed bonds.
DS: But also what’s interesting to me about BDCs, I used to follow it quite closely. I used to have positions in a couple of them. They’re really exposed to small businesses, which would seem, especially in the spotlight, and maybe not all of them, but the ones I’m familiar with, I suppose small businesses, so they’re in the spotlight of the – or under the glare of the shutdown period right now. And there’s always been the case that the net asset value is a little bit opaque, because you’re counting on the company to value the portfolio correctly. So how do you think about the sector in this climate?
JY: We like BDCs. We have – well, we had four, we were recommending to our members. Now we’re down to three. We decided one of them was a little bit too precarious. But what we look at is, we look at how much cash and cash flow do they have in the liquidity? So that’s what, what we focused on. What we really, really like is Newtek (NEWT) business services. They make a lot of their money off of is basically giving out administration loans, which stimulus packages have dumped a whole bunch of money.
So, just in April, they wind up about over $750 million in those loans, which they make a lot of money off of. What they end up doing is, they get the money from the SBA. They make the loan. Then they sell the loan – then they sell the guaranteed portion of the loan from anywhere from 106% to 120% of the face value.
And then basically, they service the remaining portion. And that’s where basically, their capital and risk is. With the stimulus packages that have gone out, SBA loans now are guaranteed 100%. So that $750 million that they’ve just basically turned around into a big fat profit. So we really like that.
DS: They essentially are passed through for that $750 million that they look, they pass along to businesses. They then farm out the loan, so that it’s not a balance sheet risk for them. And they’re just, they just have to deal with whatever servicing, which is all margin is how you’re describing it. Is that right?
JY: Pretty much. Yes. So I mean, they have other business lines that they do, because it’s – they’re kind of a unique in the BDC realm. In that they own a whole bunch of companies that provide services to all their other portfolio companies. So, to some extent, some of that business might be negatively impacted, because business you’re not using any services.
But one of the things that they do provide for their portfolio companies as they do provide work services and Internet access. So that should – so with people working at home and they should – that should always continue to be paying. But, again, the SBA loans is like the biggest portion of their revenue. And they basically just give them a big – nice big check.
DS: It’s interesting, I didn’t think about that part of the process there and those are the words. Are the SBA loans the same as the PPP loans as far as just to maintain payroll? Because there’s the aspect of the CARES Act, where you’re just getting money essentially to keep people on staff. Are these the same sorts of laws, or they…?
JY: They, I believe, are doing PPP loans as well. But they – this is an existing loan program that basically the Fed has just dumped a bunch of more money into.
DS: Got it. Okay.
JY: …to keep small businesses afloat – help keep small businesses afloat.
DS: Got it. Okay. So you’ve mentioned Newtek, any other BDCs you want to discuss?
JY: Well, we also like Ares Capital (ARCC). We’ve looked at them and they’ve got enough cash and cash flow that they should be – they made it through the late – The Great Recession. They had about a 20% dividend cut. They made up within about a year.
So we’re thinking they should do fine. There might be a cut, but we figured that the income will come back. They’ve navigated this. They’ve been around their amendment company, because they’re externally managed, has been around for 30 years or something like that. So they’ve gone through multiple recessions, so we’re not particularly worried about them and they have the liquidity.
One I personally like is Main Capital (MAIN), that’s like I’ve written on Main dozen times. It’s the first BDC I ever got involved in. It’s one of the best-run BDCs out there, in my opinion. For HDO, it’s – until very recently, the yield has been too low. We like to – in HDO, we pretty much don’t recommend stocks with yield below 6%. And until recently Main didn’t quite hit that. Now it’s 10%. And honestly, that’s a steel.
And the only thing that we expect from Main is that, they’re probably their June special dividend probably won’t happen, because that usually comes from basically capital – realized capital gains from that – from most parts. So with this environment, that’s probably not going to happen. And even they usually announce right around in now and haven’t said anything about it, we triggered that that’s because they’re not going to give it.
DS: With BDCs, it seems – I was trying to think about this before the call and then as you’re listening – listened to you as well. The – there’s not a ton of cost in the structure, right? There’s just whatever management fees and then whatever interest they’re paying for their own debt, right?
JY: Right. Then they have only a few employees for the most part.
DS: Right. So is it – do you – I’m just thinking about valuation down the line. If – Newtek is an interesting case, because as you said, they’re really exposed to the SBA loans and maybe those and then they – I don’t understand – I don’t know the full balance sheet, sort of what you’re saying they’re farming those loans out.
But the, let’s say, that portfolio companies struggle, is that a risk at all with any of these companies where, let’s say, portfolios companies struggle, net asset value gets dropped and then that has effects on whether it’s maintaining the dividend, because they’ve – that – I don’t know, is that something that…
JY: Well, that’s why we – that’s why, in part, we like. That’s one of the reasons why we like ARCC so much. They got lucky. They had just sold off a big investment just before everything crashed, so they had the cash all sitting and ready. And one of the things that BDCs do that are different from CEFs is, BDCs actually take an active role in helping their portfolio companies operate and manage.
So they give guidance. They find them. If they need some product, they help find – they help their companies to find it. So the experience that these companies had working through bad times before, I don’t know plus for them. Again, too, that’s why we looked at liquidity. Some portfolio company gets into trouble. We’re looking for the BDC to come use some of their cash, I’ll prop that up and put them over at the bad part.
And that’s why, I mean, we did a – I’m not sure if we – if this has yet gone out to the public site yet. But we did, for our members, we did analyze the levels of all our BDCs recommended. And that’s why Monroe Capital (MRCC) was our fourth one. And we decided to move that from basically a top buy to okay, hold that and as soon as the price comes up a bit.
So mainly because they had the lowest amount of liquidity. And a number of these companies also what they did, they drew down on their lines of credit. A lot of people all got all nervous when companies on their lines of credit. But it was actually a smart move on anybody’s management’s part, because they’re counting on that money in the line of credit being there when they need it. But given current circumstances, the bank might decide what line of credits cut in half.
DS: Right, right.
JY: So if they take the money and add it all in cash, the bank can’t say no, you can’t have that.
DS: …forsaking the situation like this.
JY: Yes. And that’s – I mean, and that’s one of the things that we like to see is we like to see management being proactive for stuff. I mean, if we can see that there might be a problem, we expect management to already have been acting on.
DS: Right. Good point. It’s – what’s interesting to me about BDCs is that, they’re sort of a – they’re your general investing process on a micro level. You know what I mean? Because you’re investing in companies that are that investing on. And so you get a different view of the economy. You get a different view of the world and you’ve tried it, you’re – it’s very easy to put yourself in the shoes of the management team, because that’s sort of what you’re doing yourself as an investor is deciding where to allocate your money?
JY: Yes, yes. And that’s one of the things why for both CES and BDCs, a lot of people like oh, I only buy if they’re trading below now. And it’s like, I don’t see it that way. I see that management, especially in BDCs, should be adding something. Oh, I want to own them when they’re trading above now. I certainly don’t mind buying them if they dip below that.
JY: But it’s kind of like, the idea of BDC for me is, like every time I have cash and I want to buy it, the share price drops below NAV and I buy some.
JY: But otherwise, it’s trading above NAV, because one of the things that Main does is that, that makes it such – it helps make its performance so outstanding is that, since it’s trading at a premium NAV, it’s regularly selling more shares in order buy more assets than the underlying shares currently are supported by.
So it’s – it has this steadily increasing NAV, which is fairly unique, I won’t say unique, it’s rare in BDCs, because basically BDCs is their biggest investments are loans, which get paid off. They’re constantly fighting to maintain that. Whereas Main, it’s almost a straight line up.
In fact, every time I write an article about Main, they have a slide there in their presentation and they basically give it and you see that, there’s the upward trending NAV, there’s an upward trending net investment income. So this is why you’re buy Main, because it does this all the time.
DS: Right. Yes, that’s why they are the most popular, I would say, BDC at least among Seeking Alpha it seems the most, the leading company in the sector.
JY: Yes, I don’t know. Some people seem to like Prospect Capital (PSEC) a lot for some reason.
DS: I would say, Prospect Capital is the more controversial BDC, based on their observations over the years, never had a position either of those two, but Prospect has always been in the crosshairs of vigorous discussion on the site?
JY: Yes. Well, I’ve written a few companies that I’ve regularly written articles about why you shouldn’t buy it. Because for the most part I – what I found on Seeking Alpha is, what’s most – what tends to be most popular is articles of telling people why they should buy a company. Articles telling people why they shouldn’t buy isn't popular, except for Prospect Capital.
DS: Yes. Yes, there’s a, I, it’s been a while since I worked, but those comments streams tend to be pretty – a lot of personal insights and grievances or successes I shared in…
JY: Yes. I get people that are like, “Oh, this is a great company. What are you talking about?" to? "Oh, yes, right on, this is a horrible company, the managers are all thieves.”
DS: Yes. Yes, it’s an interesting company, but okay. Well, John, thank you so much for your time today that – again, I was speaking with John Yesford, who writes his PendragonY on seekingalpha.com. He is a contributing author to High Dividend Opportunities, a leading service for income investors and retirees. You can find the service on his profile page or by going to seekingalpha.com/marketplace.
John, any disclosures before we wrap up? Any positions in any of the companies you mentioned?
JY: I own all the companies mentioned except for Prospect Capital.
DS: Okay. Fair enough. Okay. Very good.
JY: Okay. Sure.
DS: All right. Thank you so much, John.
JY: Well, thank you.
This article was written by
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. I have no business relationship with any company whose stock is mentioned in this article.
PendragonY is long EPR, NEWT, ARCC, MRCC, and MAIN. Daniel Shvartsman has no positions in any stocks mentioned. Nothing on this video should be taken as investment advice.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given that any particular security, portfolio, transaction or investment strategy is suitable for any specific person. The author is not advising you personally concerning the nature, potential, value or suitability of any particular security or other matter. You alone are solely responsible for determining whether any investment, security or strategy, or any product or service, is appropriate or suitable for you based on your investment objectives and personal and financial situation. The author is an employee of Seeking Alpha. Any views or opinions expressed herein may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank.