BDCs: An Income Niche

03/18/2005 12:00 am EST

Focus:

Adrian Day

Chairman and CEO, Adrian Day Asset Management

While many of our readers will know Adrian Day as an expert in the natural resource sector, the advisor has also developed an expertise in a niche market known as BDCs. Here, he explains this income-generating area and his top picks.

"We own two Business Development Companies (BDCs), which we view as income stocks. BDCs make loans to small- and middle-market companies and generally pass through their income to shareholders. It has been a strong environment for such companies, with strong demand for loans and active merger & acquisition activity. Not surprisingly, then, our two recommended BDCs continue to do well, picking up the pace of lending activity, though each is following its own path.

"American Capital (ACAS NASDAQ) recently reported a very strong quarter, capping an active year in which it invested $2 billion in new loans, fueling growth in fee income (as well as costs). The pipeline for future loans remains strong. New operating income was up 9%. Importantly, ACAS has turned the corner in credit quality. The company has been making more senior loans lately, which improves the overall quality of the portfolio, though it also reduces the income growth. But the company’s performance over time is very strong, with a loss rate on assets of only 0.3%, considerably lower than the typical bank. There has also been significant appreciation in the portfolio, laying the groundwork for capital gains ahead. The net asset value moved up over $3 to $21.11. Given the lending activity, the firm emphasized, surprisingly perhaps, that the dividend might not grow much over the year ahead, with guidance of between $3 and $3.14. At the higher end, that would equate to an almost 9% dividend yield, still strong and within the historical normal for ACAS.

"Our analysis: Although the stock has appreciated strongly over the past few months and year after hitting a low of $25.27 last May, it is still reasonably valued, trading within its historical norm on an absolute yield basis and below the average spread with low-quality bonds. Moreover, the difficult credit patch is behind the company, while the outlook for continued growth remains strong. Clearly, the groundwork for ongoing revenue and gains has been laid. Look for any weakness to take long-term positions.

"Gladstone Capital (GLAD NASDAQ) has experienced slower asset growth, as one would expect since it is the more conservative of the two BDCs. However, the pace of loan originations has picked up recently, and last quarter was one of the company’s strongest yet. Unfortunately, a high level of repayments is hindering net growth in the portfolio. The stronger companies to which GLAD typically lends are generally more able to pay off their loans faster. Credit quality remains very strong, with all companies paying on time, and CEO David Gladstone promised that the company would not change its loan parameters just to boost the loans on the books.

"Our analysis: The dividend has some catching up to do with the stock price, though we do expect some dividend growth in the period ahead as the company utilizes its lines of credit. We are extremely comfortable owning the stock, and those without a position can take an initial stake on any weakness."

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