Gladstone: A Duo of Financial Favorites

03/04/2016 10:00 am EST

Focus: FINANCIALS

Adrian Day

Chairman and CEO, Adrian Day Asset Management

Business Development Companies—a specialized niche in lending and finance—have been hit hard in recent months. Adrian Day, editor of the Global Analyst, highlights two favorites offering high yields and trading at discount to their net asset values.

Steven Halpern:  Joining us today is Adrian Day, money manager and editor of Global Analyst.  How are you doing today, Adrian?

Adrian Day:  I’m fine, thank you, and you, Steven?

Steven Halpern:  Very good. Thank you so much for taking the time.  Now, you’ve been a longstanding expert in a specialty area known as business development companies and investment management companies.  First, could you explain this general financial niche?

Adrian Day:  Sure. Well, business development companies—BDCs if you like—they lend money. Essentially, they lend money to small- or medium-sized businesses.

There’s a whole range of these companies.  Some are more conservative, some are more speculative, some only do senior collateralized loans for example. 

Others will do mezzanine or subordinated debt.  Some will do equity.  Some have a niche either in technology, for example, and others are more broad based, but generally speaking, that’s what they do…and they compete. 

They’re not really like hedge funds, or they don’t invest in startups, so their main competition, if you like, are the banks, but banks—as we know—blow hot and cold as to when they will lend us more businesses.

So business development companies still fill that sort of niche, they compete with banks in good times and they fill the niche, the gap that banks, when banks are absent from the market.

Steven Halpern:  Now, you follow two related companies.  One is called Gladstone Capital (GLAD) and Gladstone Investment (GAIN) and perhaps no other analyst is more familiar with these outfits than you are.  Could you walk us through a brief overview of these two companies?

Adrian Day:  Sure.  Both of these companies were founded by David Gladstone; he started Gladstone Capital in 2001. David Gladstone has a long history in the business in the BDC sector, in fact, was one of the founders of that whole era, if you like. 

Gladstone Capital, which we’ll call GLAD, that’s the larger of the two companies.  It has offices in Washington, Chicago, New York, Los Angeles. These are cash flow-based loans to middle market companies, so middle market for them is companies with between $3 million and $15 million of income or earnings rather. 

Gladstone Investment, on the other hand, tends to buy businesses and those businesses might have sales between $20 million and $100 million.

But when it buys a business, the buyout will be both some debt and they can be secure first debt or they can be second lien debt, but they also take a significant equity in trust and they often do these loans, the purchases, buyouts with other people. 

They might do it with the management of the company or they might do it with other BDCs or other private equity sponsors.

But the big difference, I guess, between the two would be that Gladstone Capital, GLAD, is senior collateralized loans, Gladstone Investment are buyouts including second lien and mezzanine financing, and also equity, and equity can be around 25% of the total portfolio. 

Steven Halpern:  Both of these stocks recently fell following their respective quarterly results, declines which you have stated are based on views that are possibly misunderstood by investors.  Let’s begin with Gladstone Capital.  What happened here and what is the overall market getting wrong?

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Adrian Day:  Okay, let me just back up a little bit, if I may, and just say generally speaking, the whole business development sector from the smallest to the largest, from the more aggressive to the most conservative, it’s…they’ve all been extremely weak in the last six months because of the turmoil, if you like, in the high yield market and particularly within an open-ended mutual fund.

Third Avenue, they stopped redemptions on their high yield mutual fund and that, of course, made a lot of the prices in the secondary market of this debt fall, so the whole sector has been on edge recently, and anytime a company, any company, comes out…the market is focusing on the negative not on the positive, so I should make that as the background to this.

These two companies are by no means unique, but the market has sold them off.  With Gladstone Capital, essentially two things happened.  First of all, the net asset value fell fairly significantly by $0.68 down to $8.38 a share, net asset value, and largely, that was…well, there were two reasons for that.

One was because they’d raised some equity during the quarter, so, obviously, the net asset value per share went down, other things being equal, even if the net asset value for the whole company doesn’t go down…and then the other thing that happened was they had some unrealized appreciation on their portfolio. 

One of the things that one needs to realize is that, Gladstone Capital in this case, Gladstone Capital has third party independent values on their loan portfolio every quarter. 

In the case that Gladstone Capital is S&P, so S&P values their loans for them.  They don’t do it themselves.  One of the things that S&P, one of the criterion that S&P uses is what they call public sector comparables. 

When you have the high yield market in turmoil and the prices in the secondary market collapse, obviously that affects the net asset value, the value that S&P puts on those loans.

But why I say it’s overdone, if you think about it, is because with a mutual fund, you can have people redeeming every day so you’ve got to have that liquidity and you might have to sell a loan even at a bad price. 

These are public companies—publicly-traded companies—similar, if you like, to a closed-end fund.  They don’t have to sell, so if you sell Gladstone Capital, if everybody is selling Gladstone Capital, the company itself doesn’t have to sell any of their loans of high sale prices, so I think using public market comparables.

I mean, it’s obviously a criterion to look at in valuing the portfolio, but it doesn’t really affect the ultimate value that the company gets, so that’s the main thing with Gladstone Capital. 

The other thing, very quickly, was they do have about 16% of their portfolio in energy, and energy, of course, with the oil price down, people are running scared of energy, but in the industry classifications that are used, energy can be everything from an oil exploration company to a utility company. 

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They are all classified as utilities, and in the case of Gladstone, all three of the companies that they own, representing 16% of their portfolio, they’re all leaders in their segment, they’re all service companies.  They’re all servicing their debt and they’re all profitable companies, so I think, again, that’s an overblown concern.

If we look very quickly at Gladstone Investment, again, in the case of Gladstone Investment, two things happened. Their net asset value fell by a little over 4%, so for much the same reason as the Gladstone Capital, we don’t need to repeat that. 

The other thing that happened, however, was that their net investment income fell and it fell below their quarterly dividend.  These companies are like real estate investment trusts.

Like REITs, they pay out, they have to pay out to maintain a tax-free status at the corporate, they have to pay out, essentially, essentially all of their net investment income, and in this case, the net investment income fell below the quarterly dividend. 

That’s a one-off in my view, and they were able to make up the dividend from crude income from the previous quarter, so on an annual basis, they still made the dividend. 

It was only this quarter they didn’t make the dividend.  The company has said firmly that they feel they’re in a very strong position to cover the dividend going ahead. It was a one-off occasion so I’m not particularly concerned about that. 

Steven Halpern:  Now, you mentioned the dividend here.  These are attractive from a yield standpoint.  Could you just touch on the return that investors get as a result of the dividends these companies pay out?

Adrian Day:  Well, sure.  Because of the turmoil in high yield market and then the collapse—and I’ll use the word collapse in the prices of the business development sector overall—the yields on these are very, very attractive. 

Gladstone Capital, or GLAD, for example, is trading right now at $6.29.  That’s a yield of 13.4%, and in the case of GLAD, a dividend that’s fully covered by net operating income.  It’s yielding at a 25% discount to that net asset value.

But I think, it is understating the value of a portfolio, so this is very, very cheap, and these companies rarely—they did cut the dividends in 2009 for unusual reasons—but other than that, they’ve never cut the dividends, so I think that’s an astonishing dividend. 

Gladstone Investment, not quite as cheap, but it’s still yielding 11.4%, also trading at virtually 25% discount to that net asset value, and Gladstone is trading very close to its low, and again, as I mentioned, Gladstone Investment is trading very close to its low and that’s at $6.50 to $6.60.

Let’s say $6.60, and, as I mentioned, even though they didn’t make the dividend this quarter with the current quarter’s income, they covered it with excess earnings from the previous quarter, so on an annual basis, they’re still earning their dividend.

Steven Halpern:  Again, our guest today is Adrian Day of the Global Analyst. Thank you so much for a fascinating look into an area that is not well covered in the stock market.  Thank you for your time.

Adrian Day:  Thank you.

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