"Glad" to "Gain"

03/03/2006 12:00 am EST


Adrian Day

Chairman and CEO, Adrian Day Asset Management

"Investors can earn high, growing dividends on solid BDCs, a lesser-known income vehicle known as business development companies," notes Adrian Day, editor of  Adrian Day's Global Analyst. Here, he looks at this specialty niche and offers a pair of favorite plays.

"BDCs are financial firms that lend money to small and middle-market companies and pass on the income generated to shareholders. Dividends tend to be high, dependable, and growing. BDCs differ among themselves, of course: they can be more or less conservative; invest in more or less equity, sometimes owning entire companies; and have other different attributes.

"Gladstone Capital (GLAD NASDAQ) is arguably the most conservative of the BDCs, investing almost exclusively in senior debt, always fully collateralized. In addition, CEO David Gladstone is conservative by nature and currently cautious. Since going public in 2001, it has invested funds slowly, while the pace of pre-payments was ‘never expected’, with the result that the company has been on a treadmill of late.

"In the latest quarter, for example, $26.7 million was invested in new companies, but $38.7 million came back in repayments and exits. Given that Gladstone—investing as it does in senior debt—rarely gets equity with its loans, this makes it difficult for the company to grow. And this has tested the patience of the market, specifically some analysts. But, though we would love to see a faster pace of investments and more growth, we are not concerned.

"We have every confidence that David Gladstone is doing the right thing. Long-term success in investing depends largely on picking one’s spots. If there is nothing in which to invest, hold on to the cash. Is the dividend secure? The pipeline of new investments remains very full, but the pricing is still too aggressive, and Gladstone has made it clear that he will not change his credit criteria or his return objectives just to spend the money. So while he waits, we wait as well, collecting our none-too-shabby 7.55% yield.

"The company's credit quality remains solid and book value has increased to $13.74. At 1.5 times book, Gladstone Capital is trading marginally above its peers, which I believe is justified because of its more conservative nature. Because of the cautious investing stance, GLAD is using little leverage, with $55 million borrowed and $155 million in equity. This gives it plenty of room to grow should market conditions change; BDCs can leverage themselves one-for-one.

"Gladstone Investment (GAIN NASDAQ) is Gladstone’s newest company, and focuses on smaller investments, less senior debt, and garners more equity. As such, it is less conservative than GLAD, but has much more appreciation potential. GAIN, which has been public less than a year, has put its money out at a more rapid pace than GLAD, with $90 million invested, about 40% of its IPO funds. However, much of this is in syndicated senior loans, simply parking places for the money, until it can make more of its typical buyout investments.

"It is still very slow at investing in these higher-yielding investments. (GAIN can invest profitably in lower-yielding syndicated senior loans since it is using IPO funds, whereas GLAD is now borrowing money for new investments, so it would make no sense to borrow money only to invest in low-yield vehicles.) This switch over is underway, however, and the pipeline is strong. The dividend has increased again, to 7 cents a month, from 4 cents, and Gladstone said he expects the full-year income will cover the year’s dividend by year end.

"Clearly, there would have been no need to increase the dividend by that amount were they not confident of so doing. (The indicated yield is 5.6%, but given that the company has yet to see its one-year anniversary, this number is not totally meaningful.) David Gladstone believes that the year-ending March 2006 ‘should be on target, while March 2007 will be a wonderful year.’

"Right now, the stock is trading little above net asset value at $13.91. Given that more than half of that is in cash, and the company has plenty of room to grow, this makes it a high potential investment at very low risk. As more money is put to work, and increasingly more in buyouts, the dividend should continue to grow. Although the stock has jumped from under $13.50 in mid-December to the current price just under $15, it is still a very good buy, if you can accept a lower current yield. We would be very aggressive on any weakness."

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