The Business Development Company sector has dropped from its highs, partly on realization as quarterly financials came out that the sector was ahead of itself, and also following dividend cuts at a couple of BDCs. Our holdings have avoided that fate, but all have had meaningful news. All are off their highs in varying degrees; one is a strong buy.
A "miss" on income sends stock lower
Ares Capital Corp. (ARCC:NASDAQ, 16.28, 9.3%) fell sharply after missing estimates for Net Investment Income (NII), which came in at 32 cents, well below the dividend of 38 cents. This shortfall was due to lower-than-expected fee income (because of fewer new investments), as well as from the impact of the great number of shares outstanding from the acquisition of American Capital.
Though Ares has the capital, and a strong backlog of potential deals, it chose to close fewer because of the high valuations, hence the shortfall on fee income. Credit quality remains good and stable, with non-accruals at just under 3% (at cost). NAV inched up.
Overall, in our view, the "bad" part of the financial report was understandable, while the fundamentals remain good. While we are not expecting any dramatic increase in income in the coming quarter or two, the potential for gains is strong, given the opportunities presented by the American Capital portfolio. ACAS brought $1.1 billion in assets with average yields of 6.7%, so we expect Ares to sell down these high-quality assets and move into higher yielding opportunities. Such moves would also generate origination fees which would help to offset the remaining lower-yielding assets on a quarterly basis.
That Ares chose not to buy more so far this year is a sign of their discipline, we think. I suspect that had the company been more aggressive to achieve NII that covered the dividend, the market would have rewarded it; opting not to chase high valuations and yields is a positive for the long term.
Trading at just under NAV—below its post credit crisis average—and yielding almost 9.4%--above its average, though below its highs—makes it attractive. Earning over 9%
from a solid company with a strong balance and stable NAV is not so bad! At its lowest price of the year, Ares is a buy for more conservative or income-oriented investors.
Mixed results yet valuation stays high
Gladstone Capital Corp. (GLAD:NASDAQ, 9.77, 8.6%) also reported earnings, and it was another mixed bag. It made three new investments made this year, a good rate of investing. And it has low leverage, with room to continue making new investments without the need to raise fresh capital.
However, the Net Asset Value slipped again, down three cents to $8.33. The fall in the NAV is slowing; NAV was $9.51 at the end of 2015, and $12 in 2010, so this has been a long-term steady trend.
And, though the 21 cents quarterly dividend was covered by net operating income, that it only because the advisor once again waived part of its fee, this quarter 6 cents, which is meaningful.
Lastly, the stock's valuation is hardly a bargain, with price-to-NAV at 1.17, the highest since the credit crisis; with the 8.6% yield, the lowest since 2011. However, GLAD can continue to make investments to boost income without raising more equity (a concern with a BDC selling at nearly 1.2 x NAV). And the 8.6% dividend is probably secure, with growing income, and the advisor demonstrating a willingness to continue to waive the fee. Thus, we are holding for now.
Share raise pushes stock down
Gladstone Investment Corp. (GAIN:NASDAQ, 9.11, 8.4%) has not reported financials yet, but announced a share offering earlier this week of 2.1 million shares at $9.38, well below the $9.70 plus at which it was trading prior to the announcement. As always, the stock fell immediately to the price of the offering and beyond.
GAIN makes more equity investments than most BDCs, giving it more gains potential. The dividend is covered (though again with some fee waivers) and the stock is trading at 0.92 x NAV. Though we like GAIN and its potential, and the valuation is hardly stretched, nonetheless the valuations are close to recent extremes for the stock (that is, high price-to-NAV and low yield). So we are holding, but not yet buying again.
Given that the underwriters have a 30-day option to buy additional shares, the stock will likely remain under pressure; at least, it is unlikely to move above the offering price until the 30 days is over.
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: Ares Capital, Gladstone Investment. 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: Ares Capital, Gladstone Capital and Gladstone Investment. I determined which companies would be included in this article based on my research and understanding of the sector.
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