Too often, income investors are forced to choose between dividend yields and growth. Fast-growing companies rarely pay dividends, since they need their cash for business expansion. Those with generous yields are usually either mature, out-of-favor companies or slow-growth utilities and telecoms. For the most part, these are companies that have put their double-digit growth years behind them.
Fortunately, there is a little-known asset class that can provide investors with steady income and high growth. Wall Street isn't interested in this small sector, because it represents only $21 billion in market value, but it can lead to exceptional profit opportunities for those willing to do the research.
Business development companies, or BDCs for short, came about in 1980 as a form of publicly-traded private equity firms. BDCs are similar to real-estate investment trusts (REITs) in their pass-through tax structure. To qualify as a BDC (and thus avoid corporate income taxes), the company is required to pay out the majority of its income to shareholders. As a result, BDC dividend yields are high, typically ranging from 6% to 11%.
Growth rates are often above-average as well because a BDC acts similar to a venture capital firm, lending money to mid-sized companies at interest rates higher than banks can charge. In addition, BDCs often take an equity stake in the borrower. BDCs are prospering right now because many banks are still reluctant to lend, so smaller companies are seeking investment capital. The middle market for corporate lending is especially underserved by banks, and BDCs are stepping in to fill that void and reap the profits. [My colleague Andy Obermueller, editor of Game-Changing Stocks, has been singing the praises of BDCs for months now. His special research report "Everything You Need to Know about BDCs," is one of the most popular pieces of research StreetAuthority has put out all year.]
Here are three BDCs that are combining rich yields with high double-digit income growth...
1. Prospect Capital Corp. (Nasdaq: PSEC)
Prospect Capital was founded 24 years ago, initially specializing in loans to the energy industry. After acquiring Patriot Capital in 2009, the company broadened its focus to include more sectors, with a particular expertise in the energy and industrial sectors. Prospect typically invests between $10 million and $250 million in companies with sales up to $500 million, but it also co-invests in larger deals.
In fiscal 2012 ended in June, Prospect doubled its net investment income to $186.7 million from one year ago. Earnings grew by 48% to $1.63 per share from $1.10 per share in the year-ago period. The company made $1.12 billion of new investments during the year, while earning a 13.6% annualized yield on its portfolio. The year-end portfolio consisted of 82 investments valued at $2.1 billion, which makes Prospect one of the nation's largest BDCs.
Since its IPO eight years ago, Prospect has grown its dividend by 60%. It managed to do so while consistently generating enough income to cover rising dividend payments. Dividends are paid monthly at a $1.22 annualized rate for a yield of about 10%.
2. Fifth Street Finance Corp. (Nasdaq: FSC)
Fifth Street invests in small to mid-sized companies with annual revenue of $25 million to $250 million. This company has a good quality portfolio with first-lien loans -- the safest debt to hold -- representing 69% of investments. Since its IPO four years ago, Fifth Street has grown its portfolio from 24 companies representing $274 million of investments to 76 companies, or $1.2 billion of investments. That's an impressive three-fold portfolio growth in just four years.
The company's net investment income, the key driver of dividend growth, improved 33% in this year's June quarter to $21.9 million from a year earlier. Earnings rose 8% to 27 cents per share from the year-ago period. The portfolio generated a yield of roughly 12%. The company's growing deal pipeline points to a potentially record December quarter loan volume, according to company executives. The company has also raised $91 million through a stock offering last month to help fund this anticipated growth.
Fifth Street has paid $5.44 in cumulative dividends per share since going public in 2008 and nearly doubled the annual dividend rate. The company makes monthly payments, for a yield of almost 11%. An investor who purchased shares early in 2009 would have accumulated returns exceeding 87%, which is considerably higher than the S&P 500 return of 55%.
3. THL Credit (Nasdaq: TCRD)
THL Credit is a newcomer to the BDC sector, as it went public in 2010. This company invests in middle-market businesses with annual revenue between $25 million and $500 million. In just two years, THL Credit has expanded its portfolio from 13 companies totaling $153.5 million to investments to 30 companies and a $330 million investment portfolio. That's a doubling of the size of the portfolio in less than two years.
During the June quarter, THL Credit earned an average yield of 14% on its investments. In addition, the company recently closed $86 million in financing, which will be used to capture new lending opportunities. The company's net investment income climbed 30% in the three months ended June 30 to $6.5 million from a year earlier. Earnings improved 28% to 32 cents per share. Analysts say this company will deliver at least 24% earnings growth this year and with growth averaging 28% in each of the next five years.
THL Credit paid a 29-cent dividend per share as well as a special 5-cent dividend per share during the March quarter, and hiked the quarterly dividend 10% after the close of the June quarter to 32 cents per share. The annualized $1.28 dividend rate yields about 9%. Since initiating payments in 2010, the dividend has grown more than five-fold.
Risks to Consider: BDCs seldom disclose much information about the companies in which they invest, making it difficult to assess risk. Evaluation comes mostly from the company's track record. A rule of thumb I use to help mitigate this risk is to avoid investing in BDCs that can't cover dividends from net investment income.
Action to Take --> My top pick for risk-adverse investors is Prospect Capital, because of the company's long track record and consistently strong coverage of the dividend. More aggressive investors may prefer THL Credit, which is starting from a smaller asset base and is likely to deliver faster income growth. Fifth Street has the highest yield of the three, which should attract yield-hungry investors.