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Plaehn Picks in BDCs: Main Street and Hercules

07/19/2018 5:00 am EST

Focus: FINANCIALS

Tim Plaehn

Investment Research Analyst, Investors Alley

Business development companies (BDCs) operate under special legal and tax rules that make them pass-through entities. They do not pay corporate income tax and are required to pay out 90% of earnings as dividends to investors, explains Tim Plaehn. Here, the editor of The Dividend Hunter highlights the two BDCs that earn a spot in his model portfolio.

Main Street Capital Corporation (MAIN) is by far the top of the pack, high-quality company out of the 50 or so publicly traded BDCs.

Most BDCs focus on the lending side, making high interest rate loans. The big challenge of the BDC business model is loan defaults, which are inevitable from the types of companies served by the BDC sector. Main Street Capital has taken a different approach. It views itself as a partner as well as a lender with many of its customers.

As a partner, it receives equity ownership in the businesses. Also, as a partner it provides expert advice to help the companies succeed. MAIN continues to receive partnership distributions even after loans have been paid off. If a client company gets sold, MAIN will earn capital gains.

The result is that MAIN has paid monthly dividends that have steadily increased since the company went public a decade ago.

Many other BDCs have been forced to cut their dividend rates. For the last six years MAIN has also paid semi-annual bonus dividends, the result of gains in the equity investments.

Since I added MAIN to the recommendations list in mid-2014 the stock has returned 50.3% to investors, which is up 9% since I did this review last year. MAIN currently yields 5.9%.

Over the last few years, MAIN has been discovered by the income focused investment crowd. The stock market correction early in 2018 has provided a nice opportunity to add shares.

With no alternative in the BDC space of comparable quality, I do not expect investors to abandon this stock. The monthly dividend will continue to grow, and the share price will either level off or continue higher. Do not look for a big pullback.

Hercules Capital Inc. (HTGC) is the second of two BDCs on our recommendations list. Hercules provides loans to companies sponsored by venture capital firms. It provides debt financing for venture capital supported businesses in the final stages before they IPO or are sold to a larger company.

The company typically receives equity warrants that pay off when a portfolio company gets bought out or goes public. In contrast to many BDCs that have been forced to slash dividend rates in recent years, the HTGC dividend has been level for three years and is 50% higher than it was coming out of the 2008-2009 bear market.

In May 2017, the Hercules leadership made a proposal to take the company from an internal management arrangement to an external manager. The proposed contract was too fee heavy and the investing public reacted by selling off the stock.

The financial analysts have been very negative about Hercules since the externalization announcement. It was a serious misstep. However, I see the company as the same business with the same management as before the announcement. At the current lower share price, I see HTGC as a great value with a yield of 10%.

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