Every once in a while over the twenty years we've been investing in BDCs, we get one - or a series - of "down days" so severe that our heads reel. For a time, we question all the research and analysis we've done and our own judgement. That's especially the case when we are "bullish" (not an everyday occurrence) and the market is "bearish".
The week ended September 23, 2022 - capped by a Frightening Friday - was one of those times. As we wrote in the BDC Reporter's Common Stocks Market Recap, the sector dropped by (7.2%) over the five days, even as the promise/threat of higher interest rates from the Fed for as far as the eye can see promised a sustained upward shift in earnings, dividends and return on investment. We spent most of our time in the Recap defending our view that even in a recession the credit damage to BDC earnings will be dwarfed by the benefits of the almost universal increase in interest income coming this way.
Calm. Carry On.
On reflection, we recognize this is a critical moment and a rare "buying opportunity". Most of the time there's a general consensus about the direction of the sector and only modest variations between investors as to which BDC offers the best value. This keeps BDC prices fairly valued and limits investor upside. Not now. Based on what's been happening to BDC prices - sharply down across the board - the market consensus is very gloomy. We, by contrast, are optimistic about the sector. This makes for the best buying conditions we've seen since BDC prices reached rock bottom levels in March 2020 - and the best all year.
Going By The Numbers
The Expected Return Table projects an AVERAGE 5 year return of 105.3%, or 20.7% per annum. More pertinently for any would-be investor there are 26 BDCs calculated to offer a 100%+ return. In there are BDCs from every segment of the market and many well known and respected names. We can't discuss each of them, but here's a selection skipping down alphabetically:
Market leader ARCC offers - by our estimate - a 108% total return over 5 years - or 21.5% per annum. That begins with a current yield of 10.5% on 2022's payout and 10.9% on our projection for 2023. The Price to Expected 2023 Earnings is a modest 8.5x, and the stock is trading at a (7%) discount to net book value per share. Yes, our Target Price is $26.88 - above the $23.00 highest level ARCC has ever reached - but we're also budgeting for record EPS and distributions.
Leaving out the Covid period, ARCC has not been available at this sort of price since 2019. Over the last 5 years - and despite the recent pullback - ARCC has returned its shareholders 77%. Now there's an opportunity to lock away a long term return 40% higher. Final word: we're worried - based on the latest analyst EPS projections for 2023 - that we may be undershooting what ARCC will pay its shareholders in the years ahead, and might have to up our numbers, which would only boost the potential return.
We've written about lower middle market focused CSWC a lot of late so we'll just say that the latest projected return is 113%/22.7% per annum - better than than 102% achieved in the last 5 years. (By the way, according to Seeking Alpha data, that's the second best historic total return of the 37 public BDCs that have a 5 year track record). Also, we can't help noting that our terminal projection for an annual distribution by CSWC of $2.2200 is only 6% higher than the annalized level of the just announced IVQ 2022 regular distribution. Like with ARCC above, our dividend projections may be too modest.
Similarly, we wonder if our projection for FSK's distributions in the years ahead is too low. Our model is promising a 125% 5 year return, or 25% per annum. (By the way, FSK's historic 5 year total return is only 22%, so this is more than 5x better). The analysts are projecting substantially higher EPS than we are assuming in distributions in 2022 and 2023. For the moment we're holding off any change in the numbers because we're more worried about FSK than most BDCs involved with large cap borrowers due to the multitude of underperforming borrowers still on the books from a run of poor underwriting that occurred years before when another manager was in charge of deal doing. KKR will get the BDC through whatever recession we get, but there may be more challenges here than elsewhere.
Venture-debt leader HTGC is the BDC with the top 5 year historical return, according to Seeking Alpha, with 114%. At the moment, this proven performer who managed to survive the Great Recession and the defection of its principal senior secured lender at the time (long story) is showing a prospective return of 122% for the next 5 years. Our Target Price for HTGC is $20.00, which does not seem so high when you consider the BDC was trading at $19.01 as recently as April of this year.
Just a few months ago, investor favorite and (mostly) lower middle market focused MAIN was trading as high as $45.67 even as many of its peers had begun to slump in price. Now MAIN has dropped (20%) in price and offers a 104% 5 year return. In the last 5 years - thanks to its high price and recent slump - MAIN has generated a return of only 37%. Admittedly, we have projected significant distribution increases in the years ahead for this BDC. However, the current analyst consensus EPS projection for 2023 is materially higher than the dividend we've projected. The yield in 2023, based on the current price and assuming our payout projection is right, is 8.7%. For any other BDC that would be an OK yield. For MAIN that's huge.
Knock Knock ?
We could go on and on but we want to keep these Market Snapshots reasonably short. The bottom line is that if we are right - and we might not be - the BDC price pullback might offer the best opportunity in a very long time to more than double one's capital in a 5 year period in any combination of BDC players from every corner of the market. In many cases, annual dividend yields could be in the low to mid teens...We recognize that swimming against the market stream is very hard to do. What do all those sellers know that we do not ? Even if one is game to invest, there's always the possibility that BDC prices will drop even further and those bargains will loom ever larger. Every investor tackles these imponderables as they see fit. All we can say is that there are many, many Best Ideas on offer for anyone who wants to invest in BDCs right now.