Editor’s note: This column is part of our Best Stocks for 2020 contest. Neil George’s pick for the contest is Hercules Capital (NYSE:HTGC).
2020 should be setting up for a challenging stock market. After all, 2019 has been a solid success with a huge performance from the base of the S&P 500. As of this writing, that index has returned 26%. Driving that return has been a U.S. economy which remains in growth mode while other major global economies are sluggish or in near recessionary conditions. U.S.-centric companies have been the go-to for successful portfolios and I see the same for much of 2020.
But there is a catch.
On Nov. 3, 2020, there is a general election in the U.S. And this brings a whole lot of uncertainty as to how potential leadership changes in Washington may change the economic and business landscape.
My single stock recommendation for 2020 is set up to continue to capitalize on the U.S. economy. But it’s also capable of dealing with potential changes in government.
It is one of a great collection of companies that is set up under the Investment Companies Act of 1940 as well as the Small Business Investment Incentives Act of 1980. Under these laws, the company can make specific investments in its operations while avoiding federal income taxes. This means shareholders receive more cash. And the company can even reinvest without sharing more cash with the U.S. Treasury.
Business Development Companies
This format is known as a business development company (BDC) and allows my pick to provide loans and financing to companies much like commercial banks. But unlike commercial banks, BDCs are shielded from the litany of regulatory woes which continue to plague banks after the 2007-2008 financial mess.
This means that BDCs can operate without the onerous capital and compliance costs which have crippled many of the commercial banks in the U.S. This means lower costs and better operating margins. And it shows up in a much better efficiency ratio, which measures how much it costs to generate each dollar of revenue.
Unlike commercial banks, these companies don’t need to rely on deposits. Given the current yield environment, deposits are still costly when compared to lending rates for short- to intermediate-term loans. This means better net interest margins.
And then we get back to the elections. There has been a lot of rhetoric over re-regulating or further restricting U.S. banks and financial institutions by some on the campaign trail. And while major banks do have a lot to fear — none of this is focused on my pick and its peers in BDC segment.
This makes the company an under-the radar-opportunity which has been faring well and should continue to fare well into 2021 regardless of electoral results.
And it is not just about the structure of the company, but its focus and successful history in providing and capitalizing on one of the U.S. economy’s best growth segments in technology.
Technology is like alchemy. Whether it is taking grains of silicon and transforming it into the must-have new electronic gizmo or generating innovative ideas that propel services to transform industries, it makes something near worthless into riches.
And the epicenter for global tech is Silicon Valley, in the pleasant town of Palo Alto, California.
This is where so many modern technologies have been conceived, developed and brought to eager markets. And those behind the whiz-bang products and services often become billionaires in the process.
But this isn’t just something that happens. Just as there have been many tech titans that have created and built impressive companies, there are many more that that never make it out of their parent’s garages. This is where financial backing and guidance come in. Ideas are only as good as they can be brought to the market. Companies are only as good as their management and their labs.
Best Stocks: Hercules Capital
Source: Chart by Bloomberg
One of the best companies that specializes in investing and guidance is Hercules Capital (NYSE:HTGC).
Based in the heart of Palo Alto, Hercules is an investment company that focuses on financing and guiding technology from start to IPO. It is structured as a BDC, which as noted above, means that as an investment company it does not pay corporate income tax but pays its shareholders its profits on a pass-through basis.
The company has more than 350 current investments in varied groups of technologies. They include internet consumer services, clean and green technology businesses, and drug development companies.
It has a long track record of participating in many successful companies — including some in its current portfolio. They’ve included Box (NYSE:BOX), the cloud-based storage company; Pinterest (NYSE:PINS) in social media; FanDuel in gaming/gambling; Sling Media in video steaming; Ancestry.com for history and green energy companies including BrightSource Energy.
The company scouts out innovators in various stages of development. And in turn, it creates financing to fund their development. But beyond just making loans, it also takes equity stakes in the companies either directly or via warrants. These stakes provide the ability to cash in when companies complete their IPOs or other exit strategies.
It has been in the business since 2004, and since coming to the public market in June 2005, it has generated a return for investors of 353.1% which equated to an average annual equivalent of 11% per year.
And for 2019 year-to-date, it has generated a return of 42% — well above the S&P 500.
Hercules By the Numbers
Source: Chart by Bloomberg
The company continues to ramp up revenues, with the average over the trailing three years running at gains of 9.8%. And as noted above, revenue gains over the past four quarters have been accelerating with the recent reported quarter showing gains of 31.6%.
Its net interest margin is more than ample at 9.4%, which means that its cost of funds is significantly below its loan revenues. This is a dream of most banks trying to compete with HTGC.
And unencumbered by regulatory woes, its efficiency ratio is running at 52.5%, meaning that it only costs 52.5 cents for each dollar of revenue. This again is an envy of many traditional lenders in the U.S.
HTGC’s efficiency ratio means a return on its assets of 5.4% — which is multiples of traditional lending banks. And the return on equity is also an ample 10.7%.
Leverage is not a threat, as its debts are a mere 49.8% of assets. This means that if the U.S. credit markets run into issues for 2020-2021, the company is in good credit condition.
The Bottom Line on HTGC Stock
Source: Chart by Bloomberg
Now comes some really good news about the company. The current dividend yield is running at 9%. And the regular distribution is running at 32 cents per share, and has been on the rise. Just over the past year it has risen by 5.6%, continuing a nine-year long pattern.
And it gets better. Hercules also pays regular special dividend distributions throughout the year, bringing the annual dividend yield up to 9.4%.
Now, you might expect to pay up for the stock of such a good company. But it is only valued at 1.4 times its impressive book of assets. And that book value continues to advance so that investors aren’t just getting a rising stock price, but rising underlying assets.
All of this comes down to a well-run technology investment company with tax advantages and big and rising dividends. 2020 and beyond should be rewarding for this alchemy investment in Hercules Capital.
Neil George was once an all-star bond trader, but now he works morning and night to steer readers away from traps — and into safe, top-performing income investments. Neil’s new income program is a cash-generating machine … one that can help you collect $208 every day the market’s open. Neil does not have any holdings in the securities mentioned above.
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