After the current dip in this business development company's ("BDC") valuation, Hercules Capital, Inc. (NYSE:HTGC) provides exceptional value. Following last week's stock market sell-off, which pushed major stock indices into bear market territory, this BDC's stock is currently trading at a significantly lower premium to book value than in the past.
In a rising interest rate environment, large floating rate exposure signals income upside. I liked Hercules Capital before, but now I like it much more.
Investors have been chasing the yields generated by real estate investment trusts and business development companies in recent years. It was not uncommon for high-quality BDCs such as Hercules Capital or Main Street Capital (MAIN) to trade at significant premiums to book value, with stock yields of barely 6-7%. But, as recession fears mount and inflation soars, a sell-off has occurred, placing high-quality income options like Hercules Capital back on the radar.
Hercules Capital has built an emphasis on providing equity and debt financing for growth firms, distinguishing this BDC from others that focus on industries with steady revenues and cash flows.
Hercules Capital's investment portfolio, which is significantly weighted toward debt investments, particularly excludes investments in volatile industries with low profits predictability, such as oil and gas or mining. Hercules Capital, rather, focuses on high-quality debt investments, mainly in the growth sector.
Hercules Capital had made $2.39 billion in loan investments in 97 firms as of March 31, 2022. Furthermore, the business development firm invested in 76 enterprises. The entire value of the investments, including equity and warrants, was $198.1 million.
As previously stated, debt investments comprise the majority of Hercules Capital's investment portfolio (92.2% to be exact). Only about 6.2% are stock investments, while the remaining 1.5% are warrant positions. The portfolio is focused on floating rate investments, as seen below: 94.7% of all assets are floating rate, with only 5.3% of investments having fixed loan rates.
The fact that their loan rates reset higher if interest rates rise is a major element of variable rate loans. Because the central bank has indicated that it will hike interest rates rapidly to combat inflation in 2022, the floating rate feature in Hercules Capital's portfolio is an appealing bonus for investors concerned about rising consumer costs. The inclusion of floating rate debt protects the BDC from inflation while also providing upside in portfolio earnings, as I shall discuss later.
As the central bank fulfills its vow to combat inflation, Hercules Capital's floating rate debt is an important asset for shareholders. Higher interest rates, and hence higher lending rates in Hercules Capital's portfolio, are expected to boost portfolio earnings.
Hercules Capital makes money by lending money to investing firms. The BDC's net interest margin in 1Q-22 was 8.9%, a 1.1 percentage point decrease from the previous quarter. Over the last three years, the median net interest margin was around 10%. Net interest margins must be high in order for the BDC to pay its dividend.
The effective yield on Hercules Capital stock is higher than the headline yield of 9.7%. In order to disperse extra profits to shareholders, Hercules Capital declared supplemental dividends of $0.60 per share in February. The BDC stated at the time that it will pay four quarterly special dividends of $0.15 per share, in addition to the usual quarterly payout of $0.33 per share.
Based purely on the regular dividend of $0.33 per share, Hercules Capital's stock has a dividend yield of 9.7%. Hercules Capital's forward stock yield is higher than that, however: 11.8% and it is made up of four regular payments of $0.33 per share plus two special dividends of $0.15 per share.
The forward yield assumes that Hercules Capital will maintain a regular quarterly dividend of $0.33 per share and special dividends will cease to be paid after the BDC's $0.60 per share in excess earnings have been distributed.
In May, investors liquidated business development businesses, notably Hercules Capital, as they were increasingly concerned about probable book value losses and weaker portfolio earnings in a recessionary climate.
Hercules Capital's stock is now trading at a 26% premium to book, which is much lower than the BDC's long-term average. The decrease in the book value multiple indicates that Hercules Capital's stock and yield are now undervalued.
Hercules Capital's investment performance is determined by the economy's overall direction. A recession is likely to have an impact on Hercules Capital's portfolio performance, which means that the value of the BDC's debt and equity investments may drop. Such write-downs may result in book value losses, resulting in an even lower book value multiple.
The stock of Hercules Capital is a steal. Aside from a substantially reduced book value multiple that investors pay for the BDC's portfolio income, the dividend yield has recently skyrocketed to nearly 10%. When two additional special dividends are considered, the effective dividend yield becomes even higher.
Hercules Capital deserves to be sold at a higher premium to book value, and the market may currently be driven by excessive fear of a recession. I'm happy to double back on Hercules Capital as long as the market is concerned about a recession, inflation, and the prospect of stagflation.
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Disclosure: I/we have a beneficial long position in the shares of HTGC either through stock ownership, options, or other derivatives. 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.