When income investors set out to find high yields, they're lucky to find a stock yielding 6%, maybe 7%. Anything more is usually in dubious territory. This is because a higher yield is often backed by a stock that has dropped precipitously for one reason or another, and usually a dangerously high dividend payout ratio, meaning the company is paying out nearly all of its earnings as dividends.
What happens next is all too easy to see. A dividend they thought they had secured.
But that's not always the case.
All you have to do is know where to look.
In fact, I've found one stock that offers an incredible 14%. It's a special type of company that's using this low interest rate environment to its advantage. Where many mid-sized businesses are struggling right now, it's sitting in the cat bird seat. Not many companies can say that right now. Even better for investors -- the stock pays dividends monthly. If you buy this stock, you won't have to wait every three months to compound your money or collect a nice, fat paycheck. [It's exactly the type of stock my friend Amy Calistri holds in her Daily Paycheck newsletter portfolio.]
How Fifth Street (and other BDCs) work
BDCs turn a profit by borrowing money at low rates and in turn lending at a higher rate to small businesses with trouble securing traditional financing. Although there are only a handful of these companies, and they're not widely followed by Wall Street, BDCs are unique in generating the outsized returns while providing the transparency and liquidity of a stock. Best of all, BDCs are great income investments because they are required to pay out nearly all of their earnings as dividends.
With a $1.05 billion investment portfolio, Fifth Street's specialty is lending to private equity firms so they can acquire "middle market" businesses -- that is, businesses that earn less than $50 million annually before interest, taxes, depreciation and amortization (EBITDA). Fifth Street lends across all industries, but focuses mostly on the health care sector.
As of June 30, the most recent data available, Fifth Street had investments in 60 companies. More than 80% of the investment portfolio consists of first-lien loans, which are considered the safest, since they have the highest priority for repayment. Also, 65% of Fifth Street's portfolio loans have floating interest rates. This means Fifth Street is likely to enjoy immediate earnings and dividend gains if interest rates rise.
The right place at the right time
Many BDCs reduced dividends when the 2008 financial crisis forced them to write down the value of millions of dollars in assets. Some are still recovering. Fifth Street, however, was one of a fortunate few to escape serious damage because the company had minimal risky debt on its balance sheet when the crisis hit.
Fifth Street's superior deal-making skills were recognized this year when it was given top industry awards for Debt Financing Agent of the Year, Senior Lender of the Year and Dealmaker of the Year. The company's CEO, Leonard Tannenbaum, is well-respected in private-equity circles and serves on the boards of several companies affiliated with Greenlight Capital, a leading private-equity manager. His industry connections are a competitive advantage for Fifth Street. Since private-equity firms know him, they are more likely to turn to Fifth Street for funding, thus strengthening the company's pipeline of new deals. Tannenbaum also showed confidence in Fifth Street's growth prospects in August, when he purchased $1.9 million of the company's stock for his personal holdings.
Because BDCs earn profits from the spread between their borrowing and lending costs, locking in as much fixed-rate financing as possible is key. Fifth Street excels in this area. The company raised $172.5 million in April from a convertible bond offering, closed a $65.1 million equity financing in June and, more recently, upsized its credit facility with ING Bank from $215 million to $230 million at a lower interest rate. Fifth Street is close to signing a deal with a larger multinational lender that will greatly expand the company's borrowing capacity and access to lower-cost capital, according to management.
By the numbers...
Fifth Street's net income rose 5% during the third fiscal quarter ended June 30 to $47.1 million when compared with the same period last year. This is primarily because the company ramped up its investments. Fifth Street invested $119.2 million in the third quarter, which was nearly double the $56.3 million investment made in the same quarter of 2010. The average investment size was also larger -- $20.3 million compared with $16.6 million in last year's third quarter.
Fifth Street's average yield on debt investments was 12.6%. Earnings per share (EPS) more than doubled, from $0.40 in the same period in 2010, to $0.87 in this year's quarter. Analysts look for Fifth Street to deliver a total of $1.03 in this year and $1.17 next year. The improvement should come from the company's steadily improving competitive positioning through bigger deals and more first-lien loans.
Risks to consider: At present, Fifth Street is paying out 120% of earnings as dividends. If earnings don't continue to grow, then the company may be forced to reduce the dividend. However, I don't see this happening. Even if Fifth Street were to cut its dividend in half, then the shares would still yield 7%, which is still a nice dividend by any measure.
Action to Take -- > Fifth Street's stock is cheaply valued at a price-to-earnings (P/E) ratio of 9 and is trading at a 15% discount to book value. Even better, Fifth Street pays $0.11 in monthly dividends and sports a 14% dividend yield. This is an exceptional opportunity to lock in regular income by buying a great quality at a low price.