Another Favorable Look At Business Development Companies

If you run a stock screener looking for yield, you are going to come across several so-called Business Development Companies. While doing my due diligence to write this article, as an example, I found Full Circle Capital Corporation (FULL), Fifth Street Finance Corp. (FSC), Prospect Capital Corporation (PSEC) clustered together. Their yields, respectively, are: 12.09%, 11.68%, 10.99%.

Questions come to mind. If they collectively yield so much, maybe it is because their sector is volatile, or risky. Maybe their dividends are falling or not sustainable. It's possible they are all falling knives, so to speak.

BDCs focus on investing in private companies, rather than publicly traded companies. They mostly invest in debt instruments. Equity investments play a smaller role, but they provide additional profits that come from capital gains when they exit a position. Thus, by investing in a BDC, shareholders enjoy the liquidity of a publicly traded stock, while participating in the private equity industry. Most BDCs are registered as regulated investment companies (RICs), which requires them to pay out at least 90% of their profits in dividends. American Capital (ACAS) is a case in point. It currently does not pay a dividend. It continues to be a business development company, but it no longer is a registered investment company. Compared to other financial firms, BDCs use very modest leverage. In fact, they are only permitted to be leveraged on a 1:1 basis.

Meet the meat

There's one secret about Business Development Companies: Make sure you invest in BDCs where the dividend is covered by Net Investment Income:

For investment companies, NII is the amount of income left after operating expenses are subtracted from total investment income, and it is typically expressed on a per share basis. To find the net investment income per share of a company, divide the net investment income by the shares outstanding. This amount is the amount available to shareholders in the form of dividends.

Also, we have the benefit of insight. We are able to see how BDCs behaved during the recent downturn. They, in turn, have been able to see how their respective borrowers behaved in a recession. A benefit of perspective not available previously. This has helped managers make more informed loans as the downside scenario for company performance can be measured.

Collecting Metrics, Tracking Trend

Management is important. Good management sets growth trends. In turn, trends tend to have inertia. Trends that have inertia translate into higher dividend growth and higher stock price appreciation.This is why it is important to track them. In future posts, I will look at the following metrics:

• Earnings per share

• NII per share

• Net Asset Value (NAV) per share

• Dividends

With these metrics at hand, we'll be able to figure out which BDCs to purchase and which to avoid. One of the BDCs that I follow is Fifth Street Finance Corp., which is also a member of the Laid-Back Porfolio.

Not All Business Development Companies Are Created Equal

From time to time, I run a stock screener to find high yield dividend companies. This time I narrowed my analysis to BDCs that yield more than 9% at the time of writing this article. I found seven companies, sorted by dividend yield:

Full Circle Capital Corp. 12.09%

Fifth Street Finance Corp. 11.68%

Prospect Capital Corporation 10.99%

Ticc Capital Corp. (TICC) 10.91%

Solar Capital Ltd. (SLRC) 10.78%

PennantPark Investmnt Corp. (PNNT) 10.47%

Triangle Capital Corporation (TCAP) 9.53%

A chart says it all

Chart below compares the seven companies we are examining today. (Click charts to enlarge)

We can observe that over the last two years, the best performers are TCAP and PSEC. While over just one year the best performer is TCAP (see below).

It is not surprising, in my opinion, to find out that the best performer is also the lowest yielding of the bunch. Quality has a price.

Examining TCAP numbers

First, I want to look at dividend payment history. For example, on 12-27-07, TCAP declared a dividend of $0.3 per share. Last dividend available was on March 12, 2012. TCAP declared $0.47 per share. It is a 56% increase over somewhat more than four years. Over that time frame, TCAP never reduced its dividend.

As per last quarter report, Net Asset Value per share was $14.59, vs. 04/04/2012 market close price per share of $19.66. TCAP does not disclose earnings per share on its latest annual report. But we know that that data is not essential. What's important is NII. So, last thing I want to do is to see is whether NII covers dividend payment. Answer is positive. Last quarter, NII was $0.52, while the dividend, as we have seen above, was $0.47.

Sum Up

TCAP is thus my next selection for my Laid-Back Portfolio. I'll (fictitiously) buy $10,000 worth of TCAP shares one day after publication on Seeking Alpha, at mid-day prices, so I don't have an unfair advantage over you, the reader (not that I think I will be able to move a stock).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.