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Author: yodaorange Big red star, 1000 posts Feste Award Nominee! Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 77105  
Subject: Re: BDCs on Barrons Date: 4/29/2013 6:08 PM
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Factoids, who is infinitely more knowledgable about BDC’s wrote a reply to a post that I did on BDC’s. I have added a few comments:

1) For example, calling ALD and ACAS two of the biggest and best managed BDCs is a statement that I question. They were two of the biggest - but were they the best? No way.

It is easy for us to say in hindsight that ALD and ACAS were not well managed. That is NOT what I recall before the crash. I recall they were widely praised, other than David Einhorn’s criticism of ALD. Matter of fact, he was “wrong” for many years about ALD. I recall many write-ups about ALD having continuously paid dividends since the 1960’s IIRC. The implication was that if ALD was smoke and mirrors, it would have blown up earlier. I recall many write-ups on how outstanding ACAS CEO Malon Wilkus was.

2) And what about the implication that you can judge the full BDC sector based on the experiences of those BDCs? Would it not be equally wrong to judge REITs based on the history of GGP and KIM? GGP eliminated their dividend for several years. KIM cut its dividend from $0.40/quarter in 2008 to $0.25 in 2009 to $0.16 in 2010.

ALD and ACAS were by far the largest market cap BDC’s before the crash. I am working on a more detailed post that will quantify this. I am going to guess they were >= 50% of the entire BDC market cap. So I do NOT think it is unreasonable to judge the entire sector based on the performance of these two, since the majority of BDC investor funds were tied up in these two. ALD lost say 90% and ACAS is down say 75%. When half of the industry has this performance, it is tough for me to ignore. I am not aware of a market cap weighted index that goes back to 2007, but let’s assume it would be down about 50% on a total return basis.

Contrast this to the largest market cap REIT’s SPG, HCP,VTR and GGP. Let’s just use VNQ as a proxy for Equity REIT’s since it is market cap weighted. It’s all time high of 87.44 was on February 8, 2007. Its total return to today’s close has been +13.8. So an industry to industry comparison is NOT close. BDC’s lost about 50% and Equity REIT’s gained 13.8%. Yes, many REIT’s cut their dividend. Yes, GGP went bankrupt but re-emerged with stockholders still owning shares, i.e. they were not wiped out. So even if the dividend cuts and GGP bankruptcy, investors still have a positive return.


3) I see all equity investments with a "yield plus dividend CAGR" (CAGR being the acronym for the projected Compound Annual Growth Rate) perspective. I do include risk metrics in my valuation calculations - but for now, let us leave that consideration out. An investment that only offers an 8% "yield plus CAGR" is a terrible investment. My goal as an investor in individual stocks is to have a portfolio that is dominated by 11, 12 and higher "yield plus CAGR" investments. There are a lot of sub 1% dividend CAGR projection equities. Not all of those are high risk. For those investments to have near correct valuations, they need to have high yields. It is the perspective that leads me to conclude that the statement "any investment that is currently paying 8%+ yields today is HIGH RISK" is an under nuanced conclusion.

I agree with the yield plus dividend CAGR approach. This is the “Gordon Dividend Model” which says that the total return of a stock is its dividend yield plus dividend growth rate. I posted about this a long time ago. The underlying assumption is that the P/E or P/FFO ratio does NOT change. If it does not change, then the model works fine.

Let’s talk about the issues that have dividend CAGR’s of <=1.0%. I would consider these “bond proxies” since bond interest payments do not grow over time. So what does it take to get an 8% yielding bond these days, at say 10 years? I just ran a screen with one of my bond brokers. I looked at all corporate bonds that mature in 2023. Late in the day, they had 254 active offerings. The highest rated issues like Coke, Colgate and Berkshire have ~ 2.5% yield to maturity. I currently only see one offering at >=8.0% and that is Borden chemical at 9.91%. It is rated Moody’s Caa2 and SP CCC+. These ratinsg both indicate the rating agencies think default is IMMINENT.

So comparing a zero growth 8.0% yielding BDC to the corporate bond universe is my basis for the “high risk” belief. Yes, BDC’s and bonds are not exactly the same, but this tells me that investors have low confidence that the BDC yields will be consistent and/or that the share prices will be flat to up.

4) I strongly believe that BDCs are an economically sensitive sector - and that brings added risk. I have a self imposed sector allocation to BDCs - and they are currently around 6% of my portfolio.

I do NOT worry about Factoids losing a bunch of money with his 6% allocation to BDC’s. In the worst case if BDC’s dropped in half, it would not have a material impact on the portfolio. What I DO worry about is other people that invest a higher allocation in BDC’s, strictly based on the high yields. If someone had 60% allocated to BDC’s, I would be very concerned.

If we never have another recession or mini-depression, I think BDC’s as a sector will do fine. I suspect but cannot prove that ACAS and ALD would have done fine if the downturn hadn’t flown in. I do NOT understand exactly what damaged ACAS and ALD. I am sure Factoids understands why. The first question I would ask about any current BDC’s is how their business model is different because of the downturn experience of ACAS/ALD. This does not guarantee smooth sailing, but it is a start.

It strikes me that BDC’s are similar to CLNY and STWD. All of them rely on paper assets. All of them rely on valuing “obscure”, “one-off” paper where there is no active market. Maybe the better comparison would be BDC’s versus CLNY/STWD.

One other point to remember is Yoda’s approach. It is being the most conservative investor around these parts. What is high risk/unacceptable to Yoda might be OK for your particular situation.

I was working on a more detailed analysis of BDC’s and will post it when completed. I wanted to go ahead and respond to Factoids excellent points in the meantime.


Thanks,

Yoda
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