Business development companies (BDCs) that lend to small and mid-size businesses and pay out most of their income as dividends often find their way onto my income screen -- but they've gotten no love from the markets this year.
Some of the recent weakness is understandable. The U.S. economy actually shrank 1% in the first quarter, and the International Monetary Fund just cut its 2014 outlook for GDP growth to 2%, saying the country would not likely return to full employment until 2017.
That doesn't sound like the kind of environment for business development, and investors are worried that the high dividend yields offered by BDCs are unsustainable. (In a recent look at his favorite BDC, my colleague Adam Fischbaum identified yet another factor in the sector's slump.)
The problem with this thesis is that the economic environment has improved drastically over the past couple of months and several catalysts point to strong demand for business loans. The rest of the market does not want to believe the story of an improving environment for BDCs -- but here's why you should...
My favorite company in the space pays a 10.4% yield and reported a solid second quarter in March, even on the decline in the general economy. Better yet, the current fear in the market means you can buy this stock at a discount to the value of the loans on its books.
Small businesses account for 54% of all U.S. sales and 55% of jobs, so the lack of growth has limited the overall economy, even against high earnings growth at large firms. Things started to turn around in March as pent-up demand from the harsh winter started to improve business owners' confidence. The NFIB Small Business Confidence index surged to 96.6 in May for the third consecutive increase and the highest level since 2007.
Burned by the subprime crisis and a weak economic rebound, many banks have been hesitant to lend. Although deposits at commercial banks ballooned by 24.5% between 2009 and 2014, bank credit has increased by just 4.1% in that time. The Federal Reserve Board Senior Loan Officer Survey in April showed strengthening demand for commercial and industrial loans -- but only 9.9% of banks were willing to ease credit standards for small firms, compared with 2.8% that tightened standards.
If small-business owners are finally looking to start hiring and take out loans but banks are unwilling to meet the demand, then BDCs will be there to pick up the slack.
Fifth Street Finance (Nasdaq: FSC) reported solid fiscal second-quarter results in March with net investment income of $34.2 million, just slightly off $36.2 million in the previous quarter. Fifth Street sold $250 million in five-year bonds during the quarter at a fixed interest rate of 4.875%. The company's weighted average yield on debt investments is 10.8%, with nearly three-quarters of that on floating-rate terms. That means that as interest rates rise, the company will collect more on investments but still pay the same on its own debt.
Net asset value as of the last quarter was $9.81 per share, nearly 5% higher than the current price. Not only do investors have the chance to get in ahead of what should be strong growth over the rest of the year, but they are able to do it at a discount to the asset value of the company.
Sluggish economic growth and an uncertain rate environment have not helped BDCs lately. Adjusted for dividends, the Market Vectors BDC Income ETF (NYSE: BIZD) has fallen nearly 2% since the beginning of the year and is basically flat over the past 12 months. Fifth Street has done relatively well, but shares are still off 13.6% below their 52-week high.
Short interest in FSC has risen since December to 7.8 million shares. This amounts to a $73.9 million bet against the company, and shares must eventually be bought back to close out the position.
At the current average volume of 1.3 million shares traded daily, it would take nearly six days to unwind the short position. Now, even a great quarter or year would not shake out all the shorts, but the company regularly averaged about 2 million shorts before this year.
That means an improving business environment and fundamentals could mean demand for 5.8 million shares to be cleared from short positions. At an additional 4.5 days of trading demand, that is another strong upside catalyst on top of the potential for increased loan demand.
Risks to Consider: Fifth Street pays out greater than 90% of its income as dividends, so it regularly needs to raise cash through debt or share issues. Shares may be volatile if the company is not able to raise funds at a reasonable cost.
Action to Take --> Strengthening confidence by small-business owners but hesitancy by traditional banks means stronger demand for companies like Fifth Street. The company has a strong loan portfolio and has immunized itself from rising rates by lending out on a floating-rate basis. Grab shares at a discount to net asset value ahead of what could be a very strong third-quarter report. Set a buy-under target of $10 a share ahead of August's third-quarter results with a target of $11 on full-year earnings per share (EPS) of $1.12. Estimated earnings are more than enough to cover the $0.083 monthly distribution, and investors could see a higher payout on stronger earnings.