Get Romney-Sized Returns from These Little-Known Stocks

Thursday, September 27, 2012 - 2:30pm

by Lisa Springer

Whatever your political views, there's no dispute that Mitt Romney has been extremely successful as an investor. At Bain Capital, Romney used the power of private equity to earn huge returns by investing in underperforming companies, turning these businesses around and sharing in the profits. Investing like Romney requires millions of dollars in capital upfront and considerable business expertise.

Or does it? The good news for average investors is that there is a way to invest in company turnarounds and reap Romney-size returns.

You can accomplish all of this by investing in business development companies (BDCs).

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.  

BDCs are like private equity firms -- they lend money to businesses that need capital but are too small for a public offering or too untested to qualify for a bank loan. BDCs can charge higher lending rates than banks, thus locking in more profit, and many BDCs also take an equity stake in their portfolio companies, occasionally resulting in windfall profits if the company goes public.

A key difference, however, is that BDCs must follow regulatory guidelines designed to make them safer. These include maintaining a diversified investment portfolio, holding debt no greater than equity and revaluing portfolio investments every quarter. 

But unlike private equity, BDCs are open to all investors.

Best of all for dividend investors, BDCs offer much higher yields than your typical stock. Many BDCs yield 8% to 10% -- and some as much as 12%. Yields are generous because BDCs are required to pay out 90% of their taxable income to shareholders every year in order to avoid paying taxes at the corporate level.

Right now is a terrific time to invest in BDCs. Interest rates are near record lows and many banks remain reluctant to lend to smaller businesses, which means BDCs have an opportunity to fill the void and secure a lot of deals. In addition, mergers and acquisitions (M&A) have picked up this year, which has caused the pipeline of deals to grow accordingly. Many BDCs are anticipating record M&A transactions in the fourth quarter of this year, as buyers and sellers look to close deals ahead of 2013 tax code revisions.

Of course, not all BDCs are created equal. In picking good BDC investments, I look for companies that pay dividends from income (rather than portfolio-depleting asset sales), have portfolio yields that exceed borrowing costs and keep leverage low.

Here are three high-yielding BDCs that look attractive based on my criteria:

1. Triangle Capital Corp. (Nasdaq: TCAP)
Yield: 8%
Triangle invests in middle-market companies from a wide range of industries. The portfolio includes companies such as Axxiom Manufacturing (air-blasting equipment maker), Botanical Laboratories, (vitamins manufacturer), Eckler's (classic car parts), Hallmark Lighting and hundreds of other companies. Triangle's typical investment amount ranges from $5 million to $25 million.

Last year, Triangle boosted investment income 30% to $2.06 a share compared with the previous year, which provided plenty of coverage for the $1.77 dividend. So far this year, the company has produced $1a share of net investment income and paid 97 cents per share in dividends.

Triangle has grown its dividend 12 times in the past five years. Dividends have grown 18.2% this year to a 52-cent per share quarterly rate. The forward yield on Triangle shares exceeds 8%.

Triangle has one of the highest efficiency ratios in the BDC industry at 17% and earns 15% average yields on its debt investments. However, leverage is a bit high compared to peers, with debt at 68% of equity.

 

2. Prospect Capital (Nasdaq: PSEC)
Yield: 3%
Prospect also invests in middle-market firms. Well-known names from the company's portfolio include LHC Holdings (health care), Pre-paid Legal Services (business services) and Anchor Hocking (durable goods). Prospect is managed by Prospect Capital Management, a 24-year-old investment advisor that earns a 2% management fee for its services.

Prospect reported a 48% increase in net investment income to $1.63 a share for the fiscal year ended June 30, which more than covered $1.22 a share paid out in dividends. The company made $1.2 billion of new investments during fiscal 2012 and ended the year with a portfolio valued at more than $2 billion and consisting of 82 investments.

Prospect pays dividends monthly. The current annualized dividend of $1.22 per share yields a hefty 11%. Dividend growth has not been consistent, but increases have been generous. Prospect has paid dividends of $10.40 a share since its July 2004 IPO on what was an initial investment of a $15 a share. The company's balance sheet is more conservative than Triangle; the debt-to-equity ratio is below 44%.

 

3. Hercules Technology Growth Capital (Nasdaq: HTGC)
Yield: 9%
Hercules invests mainly in technology companies, including biotech, life sciences, information technology and clean-tech industries. The company has committed more than $2.9 billion of financing to more than 200 companies and was a major investor in recently public Facebook (Nasdaq: FB).

Hercules generated distributable net investment income of 54 cents a share during the first six months of 2012, up 6% from the same period last year, and more than sufficient to cover 47 cents a share of dividend payments. Hercules' portfolio yield rose to 15.2% during the second quarter from 14.6% in the first quarter and so far this year, the company has originated more than $330 million of new investments.

Hercules increased its dividend 5% in February and another 4% in May. The new 96 cents-a-share annual dividend rate yields about 8.5%. Hercules has paid cumulative dividends totaling $7.40 a share since its 2005 IPO, which is a 65% return based on the current $11.40 share price. The company has a stellar balance sheet with a 25% debt-to-equity ratio and most of its debt consisting of senior secured liens, the least risky type of debt.

 

Risks to Consider: Most of the BDC dividend is considered ordinary income and thus taxed as income rather than the lower 15% dividend rate. For that reason, it usually makes sense to hold BDCs in a tax-advantaged account. BDCs are also very sensitive to swings in interest rates and a sudden sharp rise could make dividends and share prices volatile.

Action to Take --> My top pick is Triangle Capital because of its superior investment income and dividend growth and strong dividend coverage. Prospect Capital should appeal to investors who want monthly dividends and Hercules is a good holding for those who prefer technology-based stocks.

P.S. -- As I mentioned before, Andy's special report "Everything You Need to Know about BDCs," is probably the single best way to educate yourself about these special companies. To learn how to get this report, follow this link.

Lisa Springer does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of HTGC in one or more of its “real money” portfolios.