The Business Development Companies (BDCs) have retreated from their highs, after a strong rally over the past year, and particularly since the general election and renewed small business optimism. That they have not retreated more—given valuations (with many trading well above NAVs), higher interest rates, and a string of dividend cuts among more marginal BDCs—is due to the juicy yields.
Given the strong rally over the past year and the fact that the group is trading at two-year highs, we are not chasing the stocks here, but are holding.
Mixed period, with mostly good news, but equity raise dragging
Gladstone Capital Corp. (GLAD:NASDAQ, 9.01, yield 9.3%) has had a mixed recent period. Investment income is up, as is new investment activity following an equity raise in October, and the yield on investments has inched up to 11.3%, while expenses are down. The debt-to-equity ratio has improved and the company has plenty of dry powder, partly because of the equity raise and partly because of recent repayments.
The bad news is that the NAV declined again, in the most recent period because of net losses on investments and the stock offering, which was done at a discount to NAV. But the NAV has declined on an annual basis every year but one since 2007.
The company is earning its dividend, just, and that with a waiver of some fees by the advisor. The dividend has stayed static since 2009 (and that following a 50% cut in the dividend). We do not believe the dividend is at risk right now, but the company needs to see an improving NAV and an increase in the dividend to justify the high valuations. Right now, the stock is trading close to its high since 2010. We will hold—9.3% is nice—but hold off buying.
Less activity, but NAV increases
Gladstone Investment Corp. (GAIN:NASDAQ, 8.81, 8.5%), Gladstone Capital's sister company that makes more junior loans with more equity investments equally has had a mixed performance. Investment income is up, and debt declined, but expenses are up. GAIN has also been slow making new investments, with only two new investments over the past year, which management attributes to its discipline in not overpaying. Unlike GLAD, GAIN's NAV increased in the most recent period, continuing its generally upward trend in NAV. GAIN is also barely earning its dividend.
At 8.5%, its yield is near the low end of its recent range, while the price-to-NAV and the stock price are close to its post 2008-highs. Given the valuation, we will hold.
Cushion on dividend payments
Ares Capital Corp. (ARCC:NASDAQ, 17.37, 8.8%) is by far larger than the two Gladstone companies, with a current market cap of $7.4 billion, and because of its size, it tends to invest in the upper middle market where yields are lower. Its portfolio yield has declined to 9.3% (compared with 12.7% for Gladstone Investment, which investments in far smaller companies).
Ares has had a good recent period, with its earnings up and continuing to cover the dividend distribution. Indeed, it currently has about 80 cents per share of undistributed income carried forward, a healthy cushion to meet any shortfall or pay another bonus dividend as it has done a few times since it last increased its regular quarterly payment in mid-2012. On the negative side, non-accruals have increased over the past year while leverage has inched up, though both are still at reasonable levels. Ares has one of the top "economic returns" (NAV increase plus dividends) over the years of any externally managed BDC, yet its valuation remains near the low end. This is partly because of the acquisition of American Capital.
ACAS acquisition gives room to grow
Ares Capital calls 2017 a year of transition, beginning with the acquisition of American Capital. The purchase is modestly deleveraging, since ACAS has no debt, but it also reduces the yield on assets, given ACAS's lower-yielding portfolio including high equity allocation. Ares intends to rotate out of the lower-yielding portion of ACAS's portfolio.
Ares has received a waiver from the SEC allowing it to co-invest with other funds in the Ares family. This will be a positive for Ares Capital, expanding the universe of investments available to it.
Trading just above book value with the dividend towards the low-end of its recent history, but covering it dividend with a good cushion, Ares is a good buy for a long-term investor new to the sector looking for income—nothing shabby about 8.8%—though I suspect we'll see better opportunities at some point.
Adrian Day, London-born and a graduate of the London School of Economics, heads the money management firm Adrian Day Asset Management, where he manages discretionary accounts in both global and resource areas. Day is also sub-adviser to the EuroPacific Gold Fund (EPGFX). His latest book is "Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks."
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1) Adrian Day: I, or members of my immediate household or family, own shares of the following companies mentioned in this article: Gladstone Investment and Ares Capital. I personally am, or members of my immediate household or family are, paid by the following companies mentioned in this article: None. My company has a financial relationship with the following companies mentioned in this article: None. Funds controlled by Adrian Day Asset Management hold shares of the following companies mentioned in this article: Gladstone Capital, Gladstone Investment and Ares Capital. I determined which companies would be included in this article based on my research and understanding of the sector.
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