Business development companies (BDCs) have been hit particularly hard, on concerns that small businesses to which they lend will not be able to repay loans. That concern is legitimate. The stocks have fallen far more than the broad market, several large ones down 60% over the past month, compared with 32% for S&P. BDCs themselves are leveraged; lending used to be limited to twice assets, but recently the restriction was loosened. Most BDCs, however, have kept their leverage under control, far below what is permitted, with many still well below the old 2-to-1 limit.
We do expect to see many portfolio companies of the BDCs unable to repay loans, some perhaps going out of business. However, many BDCs have strong balance sheets and will be able to assist their portfolio companies, if they see fit. Many also have collateral on their loans, which may not see 100 cents on the dollar, will help. Our two holdings has spillover income to be distributed, so could—again, should they choose—continue to pay their current dividends for a few quarters, even if they see a sharp decline in income for that period. And lastly, at present valuations there is a thick cushion; even if book value was cut in half, and the dividend likewise, the valuations would still be on historical norm for the respective companies.
The largest and one of the strongest BDCs can continue to pay
Ares Capital Corp. (ARCC:NASDAQ) (10.39) is the largest of the publicly traded BDCs and one of the more conservative. In recent months, it had been cautious in new lending even ahead of the coronavirus. Core income remains above the dividend and the company has spillover income of around $0.95 per share, equivalent to nearly 70% of next year's dividend. Its total debt is just under half the fair value of investments.
The stock traded above $18/share for virtually all of the past year. At the current price, the stock is trading at just less than 0.6x earnings, about 0.6x book value and yielding 15.98%. Now, there will be some defaults no doubt in the economic downturn that lies ahead, and the leverage will compound the effect. But will earnings be cut so that the yield is cut in half, to 8% (still a healthy yield in the current environment)? I don't think so.
Buy Ares Capital. But in this volatile market it is essential to be very disciplined with prices. I doubt if Friday's price will be the bottom. In this market, also, we would trim stocks on strong rallies, looking to buy more on another drop, thus accumulating a position in a strong company with a high yield, but always reducing your cost basis.
Gladstone has strong backlog of income
Gladstone Investment Corp. (GAIN: NASDAQ) (7.72) similarly has fallen considerably, has low valuation, income exceeding the dividend, and a backlog of undistributed income. Unlike most BDCs, Gladstone looks for both dividend income in its loans and for capital gains from the equity kickers it generally gets with its investments. It aims for 70–75% of its investments to be in loans, the rest in equity. It pays two separate dividends, a steady monthly dividend from its loan income—recently boosted to $0.07 per month—plus it pays bonus dividends funded from capital gains. These have added $0.21 over the past year, for a total yield at today's price of over 13%.
Net investment income—$0.23 in the latest quarter—is exceeding distributions, and the company currently has$1.76 per share in undistributed net income, equal to the regular monthly dividend for more than two years. This provides a cushion against a dividend cut.
There is ongoing insider buying, both as the stock price appreciated over the last year, and as it collapsed in the last two weeks. This is a strong vote of confidence.
Low valuations gives cushion
Down from north of $15 at year-end, and over $11.50 for most of the past year, Gladstone is down sharply over the past month. The current yield, including the anticipated semi-annual additional distributions, is 13.4%. The stock is trading at 0.6x book, with a price to free cash flow of less than 3x. So again, Gladstone has a pretty good cushion to survive some damaging news at its portfolio companies.
Buy Gladstone, but again be very disciplined with limit in these volatile markets, and if there is a strong short-term rally, trim holdings so you can add more if it drops again.
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."[NLINSERT]
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