Fed Fears Have Decimated This Sector -- And Now It's Time to Buy

David Sterman's picture

Thursday, September 10, 2015 - 12:30pm

by David Sterman

"The market has already done the Fed's dirty work."
 
That's a refrain you'll hear quite often these days, because so many interest rate-sensitive sectors have already sold off sharply in anticipation of higher interest rates. When rates do finally start rising (perhaps as soon as mid-September considering the August employment report), investors will likely realize that they have over-reacted.

After all, the Federal Reserve is expected to act "low and slow," meaning that interest rates are expected to be boosted at a very slow pace over an extended period. That means that 12-18 months from now, rates aren't likely to be much more than 50 or 75 basis points higher than they are today. And by anybody's math, a Federal funds rate under 2.0% is still extremely low by historical standards.

Interest rate fears have really hurt sentiment in yield-focused investments such as the master limited partnerships (MLPs). A wide range of bargains have now emerged in that group, led by Enterprise Product Partners (NYSE: EPD).
 
Yet it's hard to find any group that has been tarnished as badly as the business development companies (BDCs). These firms act as lender and investor to small and mid-sized privately held firms. BDCs borrow money at low rates, and typically garner returns that are roughly five to seven percentage points higher. That allows them to deliver robust dividend streams.

BDCs do have a degree of interest rate sensitivity. As rates rise, so does their cost of capital. And in a tightening cycle, some companies in their portfolio will default on their loans. But right now BDC stocks are trading as if interest rates were sky high and portfolio holdings were defaulting on their bonds at a rapid pace. That's just not the case.

How cheap is this group? Looking at the top 15 BDCs, the average price-to-book value is just 0.81. In effect, you can buy these firms for just 81 cents on the dollar. And what's the average BDC dividend yield? 12.8%. That's the result of a sell-off that has been taking place for more than a year, ever since concerns about Fed rate hikes began.

Frankly, almost all BDCs hold appeal right now in the context of the macro backdrop noted above. Yet some hold greater appeal than others. It's best to know the factors behind the wisest BDC investments. If you apply the right framework, then you can find the best BDCs to own in any given quarter or any given year.

Of course the first measure is the relationship of market value to tangible book value. In tough times, when some of the BDC portfolio holdings run into financial trouble, you can assume that tangible book value may need to be written down, perhaps 5% to 10%. As a result, buying a BDC that trades below 90% of tangible book value has a margin of safety built in. Right now, Medley Capital Corp. (NYSE: MCC) and Saratoga Investment Corp. (NYSE: SAR) trade for less than 70% of tangible book value.

You'll find a few other BDCs selling at such price-to-book discounts, but these two firms currently offer dividends that are lower than their income. Some BDCs are trying to stand by dividends that they just can't support, and at some point, the dividends will need to be cut. For example, Capitala Finance Corp. (Nasdaq: CPTA), TICC Capital Corp. (Nasdaq: TICC) and Oxford Lane Capital (Nasdaq: OXLC) spend more than $1.30 on dividends for every dollar they earn. That's unsustainable.

In that context, I like to find companies that are living within their means (i.e. they generate more than enough cash flow to support the dividend) and still sport double-digit dividend yields. By this measure, Medley Capital again fits the bill, with a 14% yield. Investors may also want to consider Monroe Capital (Nasdaq: MRCC) which pays out just 81% of its income towards the dividend. (BDCs ostensibly must pay out 90% of their income in dividends to retain their dividends, but accounting factors can cause that figure to temporarily dip below 90%).

Subscribers to StreetAuthority's premium advisory High-Yield Investing know that we're also fans of Prospect Capital (Nasdaq: PSEC). Nathan Slaughter has had this BDC in his model portfolio since June 2014. Back then, he noted that PSEC almost exclusively makes loans to high quality, profitable companies in steady industries such as pharmaceuticals, aerospace and electronics.

Nathan's rationale for the best BDC investments: "it's important to evaluate the firm's credit track record. Some are simply better than others at judging a borrower's creditworthiness -- an important skill where one bad loan can wipe out eight good ones." And in his analysis of the BDC sector, he found that Prospect Capital has established a very strong track record.

This BDC has net assets of $3.7 billion, but a market value of just $2.8 billion. And its dividend yield sits north of 13%.

Risks To Consider: BDCs would likely fare quite well if interest rates only rise at a moderate pace. But if rates climb very quickly, or of the U.S. economy tilts into recession, then BDCs have further to fall before any rebound.

Action To Take: Medley Capital and Prospect Capital offer compelling value right now. Investors may also want to pursue the fund of funds approach by buying a BDC ETF such as the Market Vectors BDC Income ETF (NYSE: BIZD).

Editor's Note: Recently, High-Yield Investing's Nathan Slaughter uncovered eight elite stocks that returned more than 300% on average in the past decade; more than 3 times the S&P's total return. But the best news -- their upside is only just beginning. Get the names of each of these stocks by accessing the new report here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.