Capital Southwest: Price Dislocation Spells Opportunity

Summary

• CSWC is a well-run BDC with a highly fragmented and less competitive lower middle market focus.
• It continues to demonstrate improving operating leverage and is growing its dividend.
• It's currently attractively valued and trading at a discount compared to its internally-managed peers.
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Andrii Yalanskyi

Having read many reader comments on BDCs, I get the sense that Price to NAV is an important measure of valuation for this segment. While I believe this is a relevant metric for externally-managed BDCs, well-run internally managed BDCs are simply more efficient, and is efficiency translates into earnings power.

This brings me to Capital Southwest (NASDAQ:CSWC), which remains attractively valued compared to its internally managed peers. In this article, I highlight its fundamentals, and show why this stock is a sound pick for high income, so let's get started.

Why CSWC?

Capital Southwest is one of just a handful of internally-managed BDCs and is based in Dallas, Texas. It carries an investment portfolio with a $1.1 billion fair value that's well-diversified across 78 investments. CSWC has a very solid track record of returning value to its shareholders. As shown below, CSWC has created substantial value primarily through a combination of regular and special dividends.

CSWC Value Creation (Investor Presentation)

At the same time, management has transitioned the portfolio towards a safer profile. This is reflected by the increase in first lien debt investments, rising from 86% of the debt portfolio to 94% at present, with the remaining 6% comprised of also relatively safe second lien secured debt.

Notably, CSWC is focused on the highly fragmented and less competitive lower middle market, and the investments are spread across everyday industries, with media/marketing, business services, consumer products & services, and healthcare comprising its top sectors, representing nearly half of portfolio fair value.

Meanwhile, CSWC continues to see healthy deal activity amidst market volatility, with $85 million worth of new committed credit investments during its second fiscal quarter (ended Sep. 30). It also carries a robust weighted average yield of 10.6% on debt investments, and non-accruals remain low, representing just 0.9% of the investment portfolio at fair value. Importantly, CSWC paid a regular $0.50 dividend in the month of September, which was well covered by the $0.54 NII per share generated in that quarter.

Also encouraging, CSWC continues to realize operating leverage, as its percentage of operating expenses to total assets continues to trend down. As shown below, this ratio now sits at 2.0%.

CSWC Operating Leverage (Investor Presentation)

Looking forward, it appears that management is confident about the future, as it raised the regular quarterly dividend to $0.52. This should be supported by rising rates, as 98% of CSWC's investment debt is based on floating rate. It also maintains sound leverage, with a regulatory debt to equity ratio of 1.11x, sitting well below the 2.0x statutory threshold.

Notably, about half of CSWC's debt liabilities are fixed rate unsecured bonds and its earliest debt maturity isn't until 2026. Management also remarked on low refinancing activity in a rising rate environment, which benefits CSWC, and the health of the deal pipeline during the recent conference call:

The market for acquisition capital continues to be active. Not surprisingly, we have also seen a slowdown in refinancing activity. As a result, we would expect continued solid net portfolio growth in the near term. The activity in our investment pipeline is strong in terms of both volume and breadth of deal sources. We are pleased with the strong market position our team has established in the lower middle market as a premier debt and equity capital partner as evidenced by the broad array of relationships across the country, from which our team is sourcing quality opportunities.

Turning to valuation, I find CSWC to be attractively valued at a PE of just 8.5, sitting well below that of other well-run internally-managed peers. This is reflected by Main Street Capital's (MAIN) PE of 12.0, and Hercules Capital's (HTGC) PE of 9.9. Given CSWC's track record and operating efficiency improvements, I would expect for it to trade at a PE of 11x. Analysts have a consensus Buy rating on CSWC with an average price target of $22.14.

Investor Takeaway

CSWC is a well-run BDC with an impressive track record of returning value to shareholders through regular and special dividends. It maintains a strong portfolio, carries healthy yields on its investments, and has solid operating leverage. Meanwhile, it trades at a meaningful discount compared to other peers, making it an attractive buy for income investors.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CSWC 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.

I am not an investment advisor. This article is for informational purposes and does not constitute as financial advice. Readers are encouraged and expected to perform due diligence and draw their own conclusions prior to making any investment decisions.

Comments

[Retire2020]

SA shows CSWC has a p/b of 1.1. Is that cheap for bdc?

[Bekster]

@Retire2020

Not all BDC's are created equal.

P/B of 1.1 is pretty cheap for a BDC like CSWC.

[Retire2020]

@Bekster Thanks.

[Raj Mehta]

I’ve been long $CSWC in my IRA since 2020. Sadly, down 12%. But I am patient. My average cost basis is 20.54. Hoping for further recovery in price.

[birder]

I have a moderate position in CSWC which I have held for a few years. Most is in my IRA accounts since the dividends are 100% taxable.

[The Dividend Collectuh]

One of my favorite stocks in my portfolio. Long CSWC

[jeffgr]

Thanks for a really great article.

[Gen Alpha]

@jeffrg you're welcome. I'm glad you enjoyed it.

[stompers54]

Long in Roth. I own due to internal management structure which I believe over time is a competitive advantage and track record. CWSC has increased the dividend and in recent years has paid supplemental dividends as well. The trading range has been huge but now much closer to the lower end for those considering entry level.

[Gen Alpha]

@stompers54 well put. Roth is an excellent place for this income stock.

[KMR holder]

Maybe internally managed BDCs deserve a premium to NAV, but I'm pretty sure that one of the reasons why some well run internally managed BDCs have not done as well for their investors is that investors have paid more to own them. What ever benefit they earn from lower management expenses can be offset by investors paying too much to own their shares.

Five year total return since December 1st, 2017:

CSWC 13.55% per year
ARCC 13.71% per year
OCSL 17.41% per year

CSWC has outperformed MAIN by a lot over those same five years. MAIN has returned to its investors 6.48% per year. Investors' returns have been less than the distribution yield.

[lateralgs]

@KMR holder

All true. But as always, what matters most is what each individual investor has paid for the shares they own, and when they bought them. Without considering the effect of distributions, our cost for our MAIN shares is around $27/sh average. So our returns and effective yield on expended capital in MAIN are very substantially above the tracked paper returns everybody looks at. Price paid matters a lot…as you already know, of course.

[KMR holder]

@lateralgs
My problem with thinking like that is the lost opportunities you had in continuing to own MAIN at such high prices over time. There have been times at which you could have sold your MAIN shares, paid capital gains taxes and then reinvested in less expensive BDCs like ARCC and doubled your returns. In a tax deferred account you could have done even better as there would have been no tax drag at all.
It isn't what you paid that makes your profits. It is buying cheaply and selling when expensive.

[lateralgs]

@KMR holder

How do you know I have not sold shares? In fact, I have. I take profits…and losses in the case of taxable accounts…strategically. And how do you know whether I hold MAIN or any other investment in a tax deferred or taxable account? I own my largest dividend/regular income payers in IRAs, mostly Roth. Those include large positions in things like JEPI, JEPQ, DIVO, MAIN, ARCC, CSWC, CGBD and other holdings. Some of these I also own in taxable accounts after the Roth accounts are maxed-out.

[Cristian Chierici]

Nice article (Thank You).
My only concern about CSWC are their DIVIDEND COVERAGE and their OPERATING CASH FLOW that seems to be not enough to cover their debt position.
Someone read these factors differently from me..?

[Gen Alpha]

@Cristian Chierici thank you. NII is the standard measurement for dividend coverage capacity.

[Cristian Chierici]

@Gen Alpha Thank You very much for Your explanation..! Now things are clear. Another question for You: from the comments i don't understand IF the dividend IS OR NOT a ROC. Can You clarify this too, please?

[Dr. LouX]

I have been adding CSWC on dips.

[Gen Alpha]

@Dr. LouX we’ve been fortunate to have had plenty of dips.

[Dr. LouX]

@Gen Alpha Yes. I have bought some CSWC a bit too soon so my cost basis is approximately flat, but the dividend more than makes up for that.

[Eileen Dover]

@Dr. LouX Me too, holding on for those dividends.

[petergo007]

thank you for the article!

May I kindly ask you please if it is correct that the distributions are mainly Return of Capital (ROC)

NRA investors enjoy owning shares that distribute dividends as ROC.

kindest thanks

cheers

[lateralgs]

@petergo007

This is the second time I have seen someone post that CSWC’s distributions are (or may be) primarily ROC. In fact, 100% of the distributions paid in 2021 were classified as ordinary dividends. In 2020, approximately 91% of the distributions were ordinary dividends and the remainder were qualified dividends. In 2019, approximately 52% of the distributions were long term capital gains, 41% were ordinary dividends, and 7% were qualified.

If Capital Southwest is now distributing primarily ROC in 2022, that would be a significant change.
www.capitalsouthwest.com/...
www.capitalsouthwest.com/...

[Income4ever aka Cyclenut]

@lateralgs
Very odd that the Roc thing keeps popping up...
ROC IS A DOUBLE EDGE SWORD

[lateralgs]

@Income4ever aka Cyclenut

Yeah. Rumors travel fast.

And correct on the ROC observation. My wife has owned units of an MLP for around 15 years now. I despise K-1 forms so refuse to own MLPs myself. But the great majority of the admittedly high distribution is classified as ROC. So over time her effective basis in the units for tax purposes has shrunk significantly. That’s great for current year tax considerations, but you face a potential giant capital gain and tax if you liquidate much later. It’s virtually all cap gain. So for sure that MLP will get sent to some heirs at some point, and my wife will just start taking the distributions as cash to spend in the meantime.

Cheers…

[Manydoglady]

I finally jumped into this one a couple of weeks ago after watching it almost all year, likely first inspired by one of your articles. Big dips never coincided with available capital, but the stars have aligned to establish my base position before the next ex-date. Thanks!

[Gen Alpha]

@Manydoglady you’re welcome and good luck!

[elliot_mllr]

After owning CSWC in my tax qualified accounts for several years I have now added CSWC share to my currently taxable accounts as well because of the factors outlined in the above article.
Elliot Miller

[Gen Alpha]

@elliot_mllr I have it in both as well. Good investing to you.

[57seagull]

@elliot_mllr Me too. Great minds think alike.

[Income4ever aka Cyclenut]

One of the oldest , since 1960s and definitely one of the best..
They have a JV partnership with MAIN and they have top shelf shareholders aligned friendly management.
Long Cswc looking to add on dips -$17.75

[Gen Alpha]

@Income4ever aka Cyclenut well put, thanks for adding.