Renewed Bullish Confidence Shores up BDC Sector

After eight months of bearish sentiment and price action, business development companies (BDCs) are starting to rebound.

There are no big moves yet, but the trend is up, nonetheless. BDCs are similar to real estate investment trust (REITs) but have one very different feature — they can employ derivatives. That means BDCs can attach equity kickers to the loans they write to the borrowing companies.

Because BDCs are regulated investment companies (RICs), they must distribute more than 90% of their profits to shareholders. That RIC status, though, means BDCs don’t pay corporate income taxes on profits before they distribute them to shareholders.

BDCs lend money to small to medium-sized privately held companies that typically generate between $5-50 million in sales. It is assumed that once companies start generating revenue above $50 million, they can negotiate more attractive terms than what the BDC market offers.

But if companies need immediate access to capital and want to avoid the lengthier process of bank credit lines and Small Business Administration (SBA) loans, then BDCs are a viable option for companies that need access to capital quickly. That money typically comes at a higher cost and is primarily in the form of floating-rate loans that start at 8-10% interest and typically demand 11-14% depending on the borrower’s company profile and financial strength.

Seeing that BDCs loan to, and invest in, what can be described as micro-cap companies, the market tends to correlate the performance of the BDC sector to that of the Russell 3000 Index (RUA). And quite frankly, it’s a very bullish pattern.

Most technicians would salivate over a chart like the Russell iShares ETF (IWV) below — a quintessential double-bottom, higher-low formation, with a high-tight flag handle.

BDCs are not going to trade up like pure small-cap growth stocks, as they pay out most of their retained earnings in the form of dividends with yields in the range of 7-15%. It should be well understood that these securities are structured in such a way that income takes priority over capital appreciation.

However, the timing of taking a hard look at BDCs right here, right now is compelling, in that, after the top five or 10 BDCs all posted third-quarter results, it became very clear that their loan portfolios are on pretty solid ground. There are 44 publicly-traded BDCs that are listed on major exchanges. You can find them at www.bdcinvestor.com.

Below is a table of the top 10 BDCs by net asset value (NAV) and market cap from the website. One can also filter by highest-to-lowest yield, price-to-NAV, most leveraged and rate of return comparisons. It is a very helpful way to research BDCs, but I highly recommend going through Q3 transcripts of any candidates for one’s portfolio with a special focus on sector exposure before investing.

Here’s the investment proposition. Not only are their underlying loans performing as the economy continues its V-shaped recovery, but these top BDCs are also paying current dividend yields of 8-13%, trading at an average discount of 30% to Net Asset Value (NAV) and are trading at an average of 35% below pre-pandemic levels.

Ares Capital Corp. (ARCC) is the largest BDC by net assets ($6.96 billion) and market cap ($6.58 billion), so it serves as a good barometer for the health of the sector — at least in my view. But in the past three months, insiders have made 13 open market purchases totaling 149,316 shares — the equivalent of just over $2 million — with no record of any stock sales. Ares Capital is a core holding in the Cash Machine model portfolio.

Source: www.nasdaq.com

Shares of ARCC pay a dividend yield of 10.25% and have broken out to the upside.

So, here we are entering 2021, with a vaccine(s) forthcoming, a stimulus plan on the way, more Fed quantitative easing expected and a rebounding economy where companies have gotten very mean and lean. Imagine how well profits will flow to the bottom line when the broader economy gets back to normal, especially for the smaller companies that have had no margin for error and have withstood the trial by pandemic fire.

For income investors who are wondering where the next great opportunity lies for locking in big-time yields and generating serious cash flow, look no further than the highest quality BDCs. From the Q3 reports, forward guidance and insider activity, it indicates that a great deal of the unknown risks clouding the sector for the past many months have been clarified — and the least path of resistance for the sector looks higher.

I recommend five BDC stocks in my Cash Machine advisory service. Take a tour and consider using this newfound bullish sentiment to put some BDCs to work while they are still on sale.