SLRC - 2 Gems In The Rubble Yields +10%

2023-04-19 07:35:00 ET

Summary

• Building a stable and sustainable income-producing portfolio takes time and discipline.
• Bear markets offer a rare opportunity to accelerate your retirement goals.
• We offer two discounted gems with +10% yields - for a lifetime supply of income.

Co-authored with Hidden Opportunities.

Diamonds, the most famed and fabled of all gemstones, are one of Earth's most precious naturally occurring substances. Diamonds weren't formed overnight - it took over 3 billion years under intense heat and pressure deep within the Earth's crust to crystallize carbon atoms to form diamonds. Pressure and time create natural beauty.

Bear markets exert noticeable downward pressure on your portfolio and can significantly stress an investor's emotions. Often, these result in poor untimely decisions that can hurt your financial future. Many questions arise: Should I sell now and buy in another month? How is the employment data going to look? Will Chairman Powell have a dovish tone in the next meeting?

No one knows what will happen tomorrow.

I don't know - and perhaps with a bias - I don't believe anybody knows what the market is going to do tomorrow."

On [October 11, 1987], markets went down 22% in one day. In 1914, they closed the stock market for about four months. After 9-11, they closed the markets for four days. …. But, nobody knows what's going to happen tomorrow." - Warren Buffett .

Because of the pressure on prices, bear markets can enhance your income portfolio and set you up for early retirement. The greater the pressure on the market, the higher yields available for you to invest. When the pressure lets up, you will find a portfolio full of glittering dividend-paying gems.

There are three C's of buying good quality diamonds - Color, Cut, and Clarity. Similarly, there are three Ds of financial health with income investing - Diversification, Dividends, and Discipline.

We will now discuss two deeply discounted picks to use this bear market pressure to form diamonds. Let's dive in!

Pick #1: SLRC - Yield 10.8%

According to the Equipment Leasing and Financing Association , nearly eight in ten U.S. businesses use equipment leasing and financing to acquire the productive assets they need to operate and grow. This business is expected to maintain stability in demand through economic pressures as companies try to reduce dependence on labor and increase their use of automation and other labor-saving equipment.

This business experienced a quick rebound and hit new highs following the Global Financial Crisis ("GFC"), demonstrating the necessity and criticality of the offering for growing businesses. Financing the essential assets instead of buying them up front provides a company with significant flexibility for its cash flows.

SLR Investment Corporation ( SLRC ) is a Business Development Company ("BDC") specializing in asset-based lending to middle market companies primarily through senior secured loans and financing leases. SLRC was born during the GFC and became a public-listed BDC in 2011. Source .

Several of SLRC's asset-based lending programs focused on active coverage of the financial services industry to take advantage of funding dislocations resulting from the 2008 credit crisis. As such, the BDC is time-tested in taking advantage of opportunities.

At the end of FY 2022, 99.8% of SLRC's loans were senior secured, with asset-based loans constituting ~35% of its portfolio, followed by equipment financing at 32%. The BDC's weighted average asset yield stood at 12.2%. Source .

SLRC ended the fiscal year with a Net Debt-To-Equity of 1.08x, in the mid-range of their 0.9-1.25x target. This means the BDC has room to leverage up more as opportunities present themselves in this fearful and cautious economy.

SLRC's investment portfolio is diversified across ~800 unique issuers operating in over 120 industries, with an average exposure of $3.7 million or 0.1% per issuer. The BDC's credit quality remains strong, indicating SLRC's high degree of selectivity and their rigorous underwriting process. As of December 2022, 98.3% of SLRC's portfolio was performing at or above expectations.

SLRC distributes $0.1367/share to shareholders every month, a 10.8% annualized yield. Notably, the BDC has had issues covering its distribution in early 2022, but since its merger with SUNS, the integration and faster realization of synergies, the BDC covered its Q4 distribution with Net Investment Income ("NII"). As the company continues growing its asset portfolio, management revealed confidence in further improving NII in FY 2023. It is important to note that the SLR team is a significant insider, owning ~8% of the company's stock, and a considerable percentage of their annual incentive compensation is tied to it. This ensures management alignment with the interests of the average shareholder.

SLRC trades at a ~18% discount to NAV, presenting a bargain in this unique BDC that provides essential solutions to middle-market companies. Investors can reap up to 10.8% yields from this company that was born to cater to the needs arising from the financial crisis and has delivered consistent returns to shareholders through market cycles since.

Pick #2: BRSP - Yield 13.9%

BrightSpire Capital, Inc. ( BRSP ) is a commercial mortgage REIT (real estate investment trust), and it invests primarily in senior-secured mortgages. These are floating-rate mortgages, which have led BRSP to have growing earnings over the past year. Last quarter, BRSP had distributable earnings of $0.27 and paid a dividend of $0.20 for a very conservative payout ratio of 74%. This is a sector where most peers have payout ratios in the 90-100% range.

BRSP's share price is completely disconnected from its fundamentals. BRSP is currently trading at a staggering 50%+ discount to undepreciated book value. While we would admit that there are times an mREIT deserves to trade at a very large discount to book value, there does not seem to be any compelling reason to believe that BRSP should be trading this low. Let's look at the components of the book value: Source .

BRSP has $2.37/share in cash and net assets; $2.20 of that is unrestricted cash on hand. Let's pretend that the receivables and other net assets are worth nothing. Then we'll go out on a limb and suggest that $2.20 in cash is worth $2.20. Note that the only recourse debt that BRSP has is its corporate revolving line of credit, which had a balance of $0 at the last report.

BRSP's physical real estate portfolio is experiencing strong performance, with 8 of the 10 properties 100% leased for an average term of 10.7 years.

The only two properties that aren't fully leased are two office properties that are 85% leased. These properties are contributing $2.47/share to undepreciated book value.

BRSP's mezzanine loans and preferred equity are their riskiest investments. Note that BRSP does not use any leverage on these. So, that is $1.05 in book value that a reasonable analyst might determine is suspect. BRSP has seen some realized losses in its mezzanine portfolio, and it is very likely it will see more. The mezzanine loans are the legacy of prior management, and BRSP has been intentionally weeding them out of the portfolio.

This leaves us with the bread and butter of BRSP's portfolio, its Senior Mortgage Loans currently contributing $6.53 to book value, which is more than BRSP's current trading price. These loans have a weighted-average loan-to-value of 69%, and BRSP has an intentional focus on multifamily mortgages.

The office sector is one that has been creating a lot of headlines and angst. CEO Mazzei addressed concerns about offices in BRSP's portfolio in particular:

"Shifting to BrightSpire, we took into consideration these work-from-home factors in our post-COVID office loan originations. We focused on drive to work markets, office properties with diverse rent rolls as well as lower average loan sizes. Portfolio granularity was a major consideration for our strategy. We contemplated the liquidity and dry powder that theoretically might be required, should there be a need to protect the balance sheet for larger multi $100 million loans. We believe that boxing in your designated weight class for loan sized concentrations is a critical part of risk management. Hence, our average new office loan size was $32 million. We further recognize that our loans are non-recourse and that even large institutional borrowers have financial limits and in the end will act in their own economic self interests."

He went on to say that he expects some of the best lending opportunities to come from the office sector in the future, but for now, is focused on maintaining a highly liquid position.

BRSP is very conservatively positioned. At 2.0x debt to equity, BRSP is modestly leveraged and has significant cash on hand. It is covering its dividend by 135%, and distributable earnings will continue to go higher as rates drift upward since the loans are floating-rate. Management clearly has a sober outlook of the future and has identified the potential risks they want to be prepared for.

It isn't every day that you can look at an investment with a yield that is solidly into the double-digits and describe it as "conservative." Yet when the market panics, rational pricing goes out the window.

BRSP experienced a significant price hit from sheer volume when former manager DigitalBridge ( DBRG ) announced it was selling over 30 million shares. With such a large seller, the price crashed. The price was just starting to recover when Silicon Valley Bank failed, and the market became hyper-focused on bank risks. Wall Street responded by indiscriminately selling everything "financial," including mortgage REITs. In such a sell-off, it didn't matter that BRSP's price was already artificially deflated by DBRG's massive sale. Traders sell first and ask questions later.

For income investors like us, this is a fantastic opportunity. We can get a mid-teen yield that is easily covered by cash flow and management that is being conservative and carefully managing their balance sheet.

Conclusion

They say, "Diamonds Are Forever." I say that is how the income production potential of your portfolio should be. At High Dividend Opportunities, we strongly emphasize the three Ds of income investing. We diversify our portfolio across 42+ equities with a +9% overall dividend yield for our model portfolio. We believe that every investor should maintain a high degree of discipline with portfolio limits for each stock/security, so the income generated is protected against sector/company-specific headwinds.

This report discusses SLRC and BRSP, two deeply discounted investments among several gems in our model portfolio. Pressure creates diamonds, and we are using this bear market pressure to create a lifestyle-supporting income stream. Two income gems with over 10% yields for you to get started if you have not done so!

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