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3 Stocks to Buy From the Prospering SBIC & Commercial Finance Industry

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Swayta Shah
·8 min read
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The Zacks SBIC & Commercial Finance industry is bearing the brunt of a low interest rate environment and subsequent rise in prepayments. These are likely to continue hurting the industry players’ profitability to some extent.

However, regulatory changes and gradual economic recovery are expected to support the industry in the coming days. Also, stimulus packages have supported the firms in which these companies invest, thereby aiding credit quality. Therefore, some of the industry players like Ares Capital Corporation (ARCC), Golub Capital BDC, Inc. (GBDC) and Main Street Capital Corporation (MAIN) are likely to benefit from these developments.

About the Industry

The Zacks SBIC & Commercial Finance industry consists of companies that provide finance to small and mid-sized privately-held developing firms, which are generally underserved by traditional banks and other lenders. Firms suffering from financial distress are the primary target clients of these lenders.

Products offered by the industry participants also include mezzanine loans that typically pay high interest rates and could be converted into equity in the target firm.

3 SBIC & Commercial Finance Industry Trends to Keep an Eye on

Solid Asset Quality a Tailwind: Following the virus outbreak and subsequent halt in business activities last year, the majority of sectors wherein SBIC & Commercial Finance companies provide loans were hit hard. This had raised fears of deterioration of asset quality for industry players. Nonetheless, support from administration in the form of stimulus packages, vaccine breakthroughs and subsequent inoculation drive, and gradual revival in business activities are expected to lead to revival of economic growth. Thus, these are likely to prevent substantial rise in delinquency rates for industry players.

Regulatory Changes Offer Support: In 2018, an amendment to the Investment Company Act of 1940 by the Small Business Credit Availability Act eased the leverage limits for such companies, allowing them to increase their debt-to-equity leverage to 2:1 from 1:1. This helps these companies to reduce portfolio risk by investing in higher capital structures without foregoing current returns. In other words, the act has provided extra funding flexibility to these companies and will continue offering more growth opportunities.

Low Rates Weigh on Performance: The Federal Reserve cut interest rates to near zero in March 2020 with an aim to support the U.S. economy from coronavirus-induced slowdown. In the January FOMC meeting, the central bank signaled no change in rates in the near term. Thus, this has resulted in reduced investment income, and is likely to hurt SBIC & Commercial Finance stocks’ top-line growth. Further, a spike in prepayments and refinancing is expected to hamper profitability to some extent.

Zacks Industry Rank Indicates Bright Prospects

The Zacks SBIC & Commercial Finance industry is a 34-stock group within the broader Zacks Finance sector. The industry currently carries a Zacks Industry Rank #115, which places it at the top 45% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates underperformance in the near term. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the top 50% of the Zacks-ranked industries is a result of encouraging earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are gradually gaining confidence in this group’s bottom-line growth potential. Since September 2020-end, the industry’s earnings estimates for the current year have been revised 4.3% upward.

Thus, given the bright near-term prospects, we are presenting a few stocks that are well positioned to outperform the market based on a strong earnings outlook. Before doing this, let’s check out the industry’s recent stock market performance and valuation picture.

Industry Underperforms Sector and S&P 500

The Zacks SBIC & Commercial Finance industry has underperformed both the S&P 500 composite and its own sector over the past year.

While the stocks in this industry have collectively gained 1% over this period, the Zacks S&P 500 composite and the Zacks Finance sector have soared 30.4% and 18.2%, respectively.

One-Year Price Performance

Industry’s Current Valuation

One might get a good sense of the industry’s relative valuation by looking at its price-to-tangible book ratio (P/TBV), which is commonly used for valuing loan providers because of large variations in their earnings results from one quarter to the next.

The industry currently has a trailing 12-month P/TB of 0.96X. This compares to the highest level of 1.10X, lowest level of 0.40X and median of 0.95X over the past five years. Additionally, the industry is trading at a substantial discount compared with the market at large, as is evident from the trailing 12-month P/TB for the S&P 500 composite of 18.99X, as the chart below shows.

Price-to-Tangible Book Ratio (TTM)

As finance stocks typically have a low P/TB ratio, comparing SBIC & commercial loan providers with the S&P 500 may not make sense to many investors. But a comparison of the group’s P/TB ratio with that of its broader sector ensures that the group is trading at a decent discount. The Zacks Finance sector’s trailing 12-month P/TB of 3.91X is way above the Zacks SBIC & Commercial Finance industry’s ratio, as the chart below shows.

Price-to-Tangible Book Ratio (TTM)

3 SBIC & Commercial Finance Stocks Worth Investing

Ares Capital: Headquartered in New York, Ares Capital is a specialty finance company that primarily invests in U.S. middle-market companies (firms having annual earnings in the range of $10-$250 million). As of Dec 31, 2020, the company had total investments (fair value) of $15.5 billion and net asset value (NAV) of $16.97 per share.

The acquisition of American Capital in 2017 has provided substantial support to Ares Capital’s financials. Notably, last year amid the coronavirus pandemic, it originated $6.7 billion of gross investment commitments to new and existing portfolio companies. The company is expected to continue witnessing an increase in investment income and investment commitments, given the favorable regulatory changes and rising demand for customized financing.

Ares Capital’s capital deployment policy seems impressive. In February 2019, the company had hiked its quarterly dividend by 2.6%. Also, it has a share repurchase program worth $500 million in place, with an expiration date of Feb 15, 2022. Given its earnings strength, the company is expected to be able to sustain the current capital deployment plan.

Shares of this Zacks Rank #2 (Buy) company have rallied 33.2% over the past six months. The Zacks Consensus Estimate for 2021 earnings has moved 4.2% up to $1.73 over the past 30 days. Likewise, the same for 2022 has been revised 4.1% upward to $1.77 over the past month.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Price and Consensus: ARCC

Golub Capital BDC: This Zacks Rank #2 stock makes investments mainly in one stop (a loan that combines characteristics of traditional first lien senior secured loans and second lien or subordinated loans) and other senior secured loans of middle-market companies. Based in New York, the company invests roughly $10-$75 million of capital.

Following the acquisition of Golub Capital Investment Corporation in September 2019, Golub Capital became the fifth largest externally managed, publicly traded business development company in the United States, in terms of assets. The deal continues to support the company’s financials.

As of Dec 31, 2020, Golub Capital had total investments (fair value) of $4.5 billion in 253 portfolio companies and NAV per share of $14.60.

The company’s shares have gained 19% over the past six months. The Zacks Consensus Estimate for earnings has moved 11.5% and 1.8% north to $1.26 and $1.16 for fiscal 2021 and fiscal 2022, respectively, over the past 30 days.

Price and Consensus: GBDC

Main Street Capital: Headquartered in Houston, TX, the company provides customized debt and equity financing to lower middle market firms (having annual revenues in the range of $10-$150 million), and debt capital to middle market firms (having annual revenues between $150 million and $1.5 billion). The company is also into asset management business with an aim to diversify income sources.

As of Dec 31, 2020, Main Street Capital had total investments (fair value) worth $2.7 billion and NAV of $22.35 per share. Additionally, the company pays regular monthly dividends, which has grown 86% since its IPO in October 2007.

Shares of this Zacks Rank #2 company have risen 25.3% over the past six months. The Zacks Consensus Estimate for 2021 earnings has moved nearly 1% up to $2.18 over the past 30 days.

Price and Consensus: MAIN

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