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Time's Running Out To Find 10% Yields In One Of Our Favorite Industries

David Sterman

While we spend a lot of time at StreetAuthority researching large, well-established companies, the most robust growth opportunities are often being pursued by young and unknown companies.

From health care to energy to retail, new businesses emerge each year, with each hoping to eventually become an industry dominator. These firms have also historically produced the bulk of new jobs in the United States, offsetting the downsizing and offshoring moves by larger companies. 

Trouble is, a lot of the best small companies are still private, and there's no way to invest in them -- unless you take a stake in a business development company (BDC). 

Indeed, BDCs are among our favorite investments, and we've been tracking the industry's key players as they've gone on to deliver stellar shareholder gains. Even in the face of rising interest rates, which have diminished the appeal of yield plays like these, they've still largely kept pace with the S&P 500 this year.

What is most remarkable about these BDCs are their still-robust dividend yields, despite solid share piece gains in the past few years. (Note that American Capital (ACAS) will shift from buybacks to dividends once shares move above book value, and though Capital Southwest (CSWC) eschews a fixed dividend, it did pay out more than $5 a share in dividends in 2012, on an ad hoc basis.)

Frankly, with this group gaining 54% since the start of 2012, investors should not be focusing on further upside from here. Indeed, rising interest rates might keep these income-oriented investments from moving much higher in coming quarters.

But those yields remain at impressive levels, and explain why you need to stay focused on this group. To be sure, rising rates have a pair of offsetting implications for them. On the one hand, it raises their cost of capital, as they are no longer able to borrow at rock-bottom rates and lend at very wide spreads. 

On the flip side, rising rates will likely come from a steadily strengthening U.S. economy, which reduces the default risk among portfolio holdings, and also stirs greater business activity, opening the door for a fresh round of investment opportunities for these BDCs. 

Simply focusing on the BDCs with the strongest yields isn't always the right way to approach this group. The fact that KCAP Financial (KCAP), Fifth Street Finance (FSC), Medley Financial (MCC) and BlackRock Kelso (BKCC) sport yields above 10% means that investors suspect that the dividend either may get reduced, or at least not grow very much. 

The key is to focus on BDCs that appear positioned for solid dividend growth. These firms continually raise fresh capital by selling fresh stock, and if they don't redeploy the proceeds in a way that boosts profits -- on a per-share basis -- then they are not really growth vehicles.

Though many of these BDCs are expected to boost profits at a double-digit pace, a rising share count means that only four of them will do so -- on a per-share basis. It's notable that only KCAP Financial sports a double-digit yield and is expected to boost earnings per share (EPS) at a double-digit pace in 2014 (which is a good predictor for dividend growth as well). 

Investing in BDCs also requires a fair bit of qualitative analysis to identify firms with the strongest management teams. In this instance, I'll defer to my colleague Andy Obermueller, editor of our Game-Changing Stocks advisory, who is StreetAuthority's resident expert in this niche. Andy recommends three BDCs, including:

  • Main Street Capital (MAIN): "The company gets its edge by focusing on simple, traditional businesses that generate strong cash flows -- not risky high-tech startups."
  • Triangle Capital (TCAP): Triangle "looks for opportunities with businesses that have experienced management teams, a strong competitive position, a varied customer base (to better weather economic downturns) and significant invested capital."
  • Fifth Street Finance (FSC): This BDC "sets itself apart by investing smaller sums in mostly small and mid-size companies. This strategy can be riskier than investing in a bigger company with room for growth, but the reward is greater."

Risks to Consider: As these BDCs grow, they are starting to step on one another's toes in terms of investment opportunities, and that rising competition may hinder returns as they must pay higher deal prices. 

Action To Take --> These BDCs are no longer a well-kept secret, as they were a few years ago. But their still-impressive yields stand out in a world where most fixed-income opportunities offer relatively low yields.

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