BDCs are often seen as big risks. Here’s why that should no longer be the case.
Business Development Companies (BDCs) such as Ares Capital (NASDAQ: ARCC), Gladstone Investment Corporation (NASDAQ: GAIN), Horizon Capital Corporation (NASDAQ: HRZN), and Triangle Capital (NASDAQ: TCAP) should have significant upside with the American economy continuing its steady recovery from The Great Recession.
Created by Congress, BDCs invest in small- and mid-sized companies. Ninety percent of their income must be paid to shareholders in order to qualify for special tax considerations. This feature makes BDCs very attractive to income investors, as some have yields in the double digits.
The improving American economy makes BDCs appealing to all investors.
BDCs perform very well when the economy is growing, as small- and mid-sized businesses fare better. Conversely, when there are dire economic conditions, small-and mid-size companies struggle to grow. Large firms have the resources to endure adverse economic times that small- and mid-size entities simply do not.
Investors should feel positive about those BDCs that survived The Great Recession for a variety of reasons.
If their investment portfolios made it through terrible economic times, they can make it through anything. It’s a tribute to the management of the company in assembling those investment holdings that held up under bear market conditions. For those that were able to maintain their dividend payments, it is even more a tribute to how solid the investments are and how strong the management team is for the BDC.
As it is when you invest in any asset class, thorough due diligence is required for BDCs.
Much of the quality of the portfolio of investments should come from the diversity of the assets. As a timely example, six months ago any asset related to oil and natural gas looked promising. Over the last six months, however, United States Oil (NYSE: USO), a major exchange traded fund for oil, has fallen more than 50%.
During that same period, United States Natural Gas (NYSE: UNG), a major exchange traded fund for natural gas, has dropped more than 34%. Investors should look for a BDC to have diverse holdings so that the portfolio, and the share price, both hold up under any economic conditions.
The table below features a number of BDCs that made it through The Great Recession and maintained generous dividend yields with strong earnings growth projected:
|Earnings-per-share this year
|Projected average earnings-per-share for the next five Years
|Gladstone Investment Corporation
|Horizon Capital Corp.
Source: Finviz; *a short float of 5% is considered to be troubling for a publicly traded company.
Analysts expect each of these five BDCs to experience solid growth over the next five years. Furthermore, the miniscule short floats reveal that few investors think that the share prices of any of these BDCs are going to fall. This short factor is noteworthy, especially in light of the fact that renowned hedge fund billionaire David Einhorn achieved a great deal of prominence in shorting Allied Capital, a leading BDC that eventually collapsed. Einhorn prospered from that position; and wrote about it in, “Fooling Some of the People All of the Time: A Long Short Story.”
Due to the success of people like Einhorn, many have scrutinized the holding of BDCs due to the potential for large profits in shorting the stock, a la Allied Capital.
That the short positions are so modest for Ares Capital, Gladstone Investment Corporation, Horizon Capital Corp., and Triangle Capital is a very bullish sign for investors. Coupled with the high dividend yields and the forecast for growing earnings, the outlook for a substantial total return is compelling.
With the American economy in much better shape, investors should no longer fear BDCs.
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