I’ve always loved hearing Ellis Island stories. When people trace their ancestry, the struggles endured and the hope they felt. They all had a vision, which was the American Dream. This dream is a perception on the minds of the US and non-US citizens that want to have a brighter future.
Building your business from scratch and following your true passion comes at a great capital expense and is not for the faint-hearted. However, some business owners are not eligible to take out loans from banks, so what would be their solution?
This is where "Business Development Companies" (or "BDCs") come into play. BDCs are a class of companies that are known as “Big Dividend Companies.” BDCs play a unique role in the American economy, allowing retail investors to participate in the growth of small to medium-sized companies (or start-ups) which are not listed on the market.
This industry has great potential as there are many opportunities. Yet it's very problematic for retail investors to invest directly in these growing companies as most of them are available only for private equity and large investors. BDCs allow investors to take part in a wide range of small to medium-sized companies, similar to how a REIT allows for simple diversification into a wide variety of real estate. These are businesses that propel the American economy and sometimes become the "next big thing," turning into massive publicly held companies.
The greatest feature is that BDCs are "regulated-investment corporations," meaning they must pay the majority of their taxable income in the form of dividends to their shareholders. As a result, this is inherently a high yield sector with yields typically ranging from 7% to 12%.
BDCs are well-positioned to prosper through the super-charged recovery of the American economy and have market-beating gains, as well as loads of cold hard cash for your trading account. This is the reason why we call BDCs "Big Dividend Companies."
An Opportunity For Investors And Businesses
The opportunity to establish and develop a small company is at the core of the "American Dream." These businesses can be found all over the United States. BDCs are funds that invest in small to medium-sized businesses that usually have a few hundred to a few thousand employees.
The ability to secure funding is often a problem for these companies. Sometimes, reaching Big American Goals can involve the need for a large sum of capital. These businesses have much less access to debt than most publicly traded companies, whether needed to fund purchase orders, expand to a new location, or even buying out a new competitor.
This is where a BDC comes into play. The BDC acts like a Venture Capitalist in this situation as it is willing to be more open in structuring a deal than a bank. BDCs would not only provide a cash loan, but also use structured repayments and the acceptance of preferred, common equity, and/or warrants as partial payment. The terms should be tailored to the specific needs of the company while also ensuring that the BDC is sufficiently compensated for the risk.
This can be quite appealing to a business that wants to invest but still avoiding excessive interest costs. Generally, banks are not going to be interested in equity in your company, no matter the potential the company has.
As a result, the underwriting procedure for a BDC differs significantly. While underwriting borrowers, the BDC will look at the company's financial strategy and growth opportunities, not just the present or previous year's cash flow. A BDC resembles an investor rather than a banker.
A Super-Charged Recovery
The economic rebound in the United States is well underway. While the market fears the rising long-term yields, the reason they are increasing is that the outlook for the future looks better. Businesses are either recovering from the disasters caused by COVID or creating new strategies to survive despite it. Governments are loosening restrictions, employment growth was solid in February, and the U.S government passed another generous stimulus package.
One of the key differences between the COVID crisis and previous recessions was that liquidity remained abundant. To ensure that the American consumer could spend, boosted unemployment benefits, direct stimulus payments and debt forbearance programs were put in place. Additional funds were provided exclusively to small businesses, like the Paycheck Protection Program. These programs helped and benefited the small businesses that BDCs lend to.
The outlook for small-to-medium businesses in the U.S. is bright. As a result, the BDCs who invest in them have a promising future. Today we will be highlighting our top two picks.
1. NEWT—Projected Yield 9% to 11%
Newtek Business (NASDAQ:NEWT) Services Corp. is a business development company (BDC) that has a unique niche. NEWT is the largest non-bank originator of small business association (SBA) loans; and it's one of our best picks for the year 2021.
NEWT uses the flexibility of the BDC structure to offer their clients a whole suite of services that are commonly needed by small growing businesses. They offer services like payroll, payment processing, IT, among others, through several portfolio companies that they control. This provides a solid pipeline of referrals for their bread and butter business, origination SBA loans.
The strategy has been wildly successful, and NEWT has been one of the fastest-growing BDCs. When COVID hit, NEWT was able to pivot quickly from their SBA loans to offering loans under the Paycheck Protection Program.
For lawmakers, using the rules of the SBA was an easy way to target small businesses; for NEWT it meant their customers were the ones being specifically targeted for aid. NEWT will be one of the biggest beneficiaries of the Government stimulus programs. For example, NEWT just closed on Mar. 22 a $100 million line of credit, on top of their existing $75 million lines, for the purposes of originating SBA 504 loans. NEWT will originate the loans, season them and then sell the entire loan for capital, retaining nothing on their balance sheet.
NEWT just announced guidance to hike its dividends this year by 17%—a 40% increase over last year's $2.05 dividends as their profits continue to see fast growth. It is very rare to see such a huge hike in dividends!
NEWT has enormous growth in their future and they are the only BDC that does what they do. Another great reason to own NEWT is that it is internally managed whereby the management owns 4.5% of the company's shares, which is significant and makes management aligned with shareholders. If you haven't jumped on the NEWT bandwagon, their 9% to 11% dividend, with future dividend growth, is an opportunity you don't want to miss!
2. Capital Southwest Corporation—Yield 9.6%
Capital Southwest Corporation (NASDAQ:CSWC) is a BDC, that invests in small- to mid-sized companies. The company spun off most of its assets in 2016 to assume its current structure. Since 2016, investors have enjoyed a total return of approximately 152%. NAV has grown approximately 14.7%. It has consistently paid high dividends to its shareholders.
What makes CSWC unique is:
- They invest in the highest quality companies around.
- Their loans generate high yields and carry first liens on the company's assets. So CSWC has some hedge (and protection) against these loans.
- Since they also take a small position in the equity of the company, this provides a strong upside potential and NAV upside from these growing businesses.
First lien loans are currently 91% of the CSWC portfolio. They are first in line to collect if something goes wrong. These loans tend to be the safest but carry a lower interest rate than loans further back in the collection line. I like this approach as it's best to play it on the safe side.
Another way that CSWC reduces risk is that they target companies that have low leverage. The weighted average leverage ratio measured as debt-to-EBITDA is at 3.8 times.
Another big plus is that this is an internally managed company with management owning a large amount of their own stock, making them aligned with their shareholders.
CSWC has just hiked its dividend in February 2021 by 2% despite the COVID challenges seen the previous year. The forward yield stands now at 9.6%. This is a big vote of confidence by management that their portfolio is rock solid. With the economy on track for a strong recovery, CSWC is set to hike its dividend again in early 2022. Buy it today and lock the high yield for the very long term!
Conclusion
With the economy on the rebound, now is a perfect time for investors to purchase "economically sensitive" stocks that are poised to prosper in such an environment. Small- and medium-sized businesses, which keep America's heart beating, are one of the best bets to bank on the country's economic recovery. These businesses are best positioned to benefit from continued government stimulus and the re-emergence of the American consumer.
Rida Morwa recently joined the ElliottWaveTrader.net analyst team, bringing his hugely popular High Dividend Opportunities service, the largest-known service for income investors and retirees, with over 4000 members, and featuring a model portfolio with a 9-10% overall dividend yield.