GAINZ - Gladstone Investment: A Strong Monthly Payer But Looking A Bit Rich

2024-01-09 15:02:05 ET

Summary

• Gladstone Investment has been performing exceptionally well and pays a solid monthly dividend.
• They take a more unique approach compared to other BDCs, with a focus on both debt and equity investments for buy-outs.
• The recent surge in share price and supplemental distributions have made the stock look more expensive, warranting a bit of caution for new investors.

Written by Nick Ackerman.

Gladstone Investment ( GAIN ) has been on a solid run, and the business development company pays a solid monthly dividend. BDCs across the board have been getting a lift lately, but for GAIN, they seem to be running a bit too rich. While I don't plan to sell the position, now doesn't appear to be the time to be adding aggressively for those who would want to initiate a position.

The latest push higher for the share price, along with the regular dividend plus several supplementals throughout 2023, has provided some very attractive results since our last update. However, it has been a while since we've revisited GAIN, going back to the end of September 2022.

However, more recently, we have been writing some puts on this name . Those puts ultimately expired worthless. It certainly would have been a scenario where being assigned was the better result, but fortunately, we have some exposure through the Core Portfolio anyway, so we've been able to ride up the latest surge. We are also carrying a number of other BDCs that have also been participating in some strong upside.

GAIN Basics

GAIN isn't your typical BDC. Here's how GAIN describes itself :

Gladstone Investment makes debt and equity investments in established private businesses in the U.S. Debt investments primarily come in the form of three types of loans: senior term loans, senior subordinated loans and junior subordinated debt. Equity investments primarily take the form of preferred or common equity (or warrants or options to acquire the foregoing), often in connection with buyouts and other recapitalizations. Gladstone Investment's individual investments typically total up to $70 million, although investment size may vary. Gladstone Investment intends that the investment portfolio over time will consist of approximately 75% in debt securities and 25% in equity securities, at cost.

While they invest in plenty of first-lien senior secured loans that your traditional BDC often does, they have a tilt toward equity investments as well. This is because they also take a buy-out approach, acquiring business with management teams providing "most, if not all, of the equity and debt capital required to close a transaction."

This overall makes it a more aggressive BDC, but it is still something I'm comfortable with in my Core Portfolio for its more unique approach. They've certainly delivered a solid track record, even being externally managed. In this case, I don't view the external management as too much of a detriment.

Business Outlook

Given the state of the Fed wanting a tighter economy, it wasn't necessarily the best place to be, but as a long-term investor, I hold through thick or thin. Deal flow may have been slower in this regard, but the added benefit from the higher rates on their floating rate loans still helped the company through the thin period of the last couple of years. The management team had noted even in the last earnings call that deal flow seemed to be picking up a bit. That should bode well going forward.

In that regard and looking forward, currently, deal flow seems to be picking up sellers who have been holding back in the past 8 months, I believe, are starting to test the market. And we do hear from a lot of the merger and acquisition and the sell-side investment bankers that we deal with that the backlog of new opportunities seems to be building. There is -- obviously, continues to be significant liquidity with buyout funds that we compete with which reinforces a strong competitive environment, so we must remain value-sensitive, while aggressively competing for new acquisitions.

One thing we should note in this environment, of course, with interest rates being relatively high with somewhat lack of liquidity in the debt side from the commercial banks which generally provide the leverage to the traditional private equity fund, who we compete with, we have the benefit of providing both the debt and the equity when we make an acquisition. So we believe that looking ahead that we have somewhat of a competitive edge because we are the supplier of the debt and the equity when we do compete for a specific new potential add on -- a new potential investment.

As the Fed looks to cut rates in the coming years, this could potentially be more promising. Of course, a solid monthly distribution also helps make an investment easy to hold through the thin periods as it has been supported.

Getting Rich In More Ways Than One

In fact, speaking of a strong dividend and these buy-out deals, that's what brings us to where we are today. Recently, GAIN declared a supplemental distribution of $0.88 on the back of exiting a business , Counsel Press Holdings Inc., in late October 2023. The large supplemental was paid in December with an ex-date on December 4.

This wasn't the only supplemental in 2023 either. They paid three other supplementals in the amount of $0.12 and another at the start of the year for $0.24, totaling $1.48. That was in addition to the regular monthly $0.08 that worked out to $0.96, making the supplementals easily more than double the regular dividend. So, GAIN has certainly been making shareholders much richer this year, but this has also caused the valuation to get a bit richer as well.

Certainly, it was a strong year, but I did expect GAIN to lose steam after that particularly large supplemental. Instead, the shares have only seemed to surge even higher. Over the last year, it pushed it enough that on a price return, it surpassed the S&P 500 Index. Not that this is a direct comparison, but it can help provide some context of what sorts of surges we are dealing with.

My hesitation now comes from how richly priced I believe shares of GAIN are relative to its net asset value. That's the beauty of a BDC; they tell you exactly what they are worth every single quarter.

The last NAV was provided on September 30, 2023, and it came in at $14.03. That would put the current premium for GAIN at under 6%. Historically speaking, that's not bad at all. Under normal circumstances, it is certainly not a level where there would be concern or hesitation to add. There have been periods where the premium has been much richer, and this name has pretty consistently traded above its peer group in the last five years. So, at the very least, from this graph alone, the valuation doesn't look stretched enough to really be worried. I'd also mention that 2021 and 2022 were more of an outlier in terms of the premiums they achieved. Generally, the 10%+ premiums we've seen for GAIN have been relatively short-lived.

However, this isn't really normal circumstances. This is because there was such a large supplemental that was paid during this period, which resulted in exiting one of their buy-outs for a significant gain. It was what brought the NAV up to $14.03 in the first place from $12.99. That's an 8% jump in the NAV, and that is absolutely huge for a single quarter.

We'll ignore the other $0.12 supplemental that also went ex-date during this period and the regular distributions. We'll chalk those up to being covered through the fund's regular course of business, the net investment income and whatever other smaller gains they may have realized or unrealized. The BDC generally covers its regular dividend through NII. For example, NII last quarter was $0.24, with FQ1 2024 at $0.25. So, this isn't too much to assume.

In addition, we know on the public side that there was a rally across the board in November and December after a really tough October, so some NAV increase here would be entirely expected as well. That would be picked up in the unrealized appreciation bucket and 'cover' whatever shortfall there would be for the regular and that additional supplemental.

That said, the $0.88 supplemental is really my main focus. If we take that out of the NAV now, we would see the NAV fall back down to $13.15. That would still make it 1.23% above the $12.99 NAV reported prior to the exit of Counsel Press. Here is a look back at the NAV for the last four quarters.

If one assumes that GAIN was able to deliver another 8% NAV bump in the FQ3 2024, then the premium isn't too much of a problem at this time. It isn't impossible to have that, but I generally feel it is fairly improbable. Therefore, more conservative or cautious investors may assume that the NAV is reported closer to $13.15, and that's where we start to run into the premium, which is nearly 13%. That's where we start seeing it in the more richly priced territory. That's where taking a bit of patience before buying aggressively at these levels seems to make sense.

Fortunately, we don't have too long to wait as they have historically reported their earnings in early February.

Conclusion

GAIN has delivered a solid 2023 of regular and supplemental distributions. It may not have been the best period for the strategy of this BDC over the last couple of years, but they were able to deliver strong results anyway. They have a track record of delivering superior results above other BDCs thanks to their unique approach.

Sometimes good things take a bit of time, though, and there will be years that they lag, such as the year reflected above. However, the above only reflects through FQ2 2024 for GAIN ending September 2023. That doesn't reflect the significant capital gain they were able to produce from the exit of Counsel Press.

While all this is the case, I do believe that some patience and constraint is probably appropriate here after such a strong run for this name. At least until we get a bit more detail in terms of how the NAV is looking for the latest quarter, when we can get a better idea of what the value is here. Simply put, I believe GAIN is priced a bit too optimistically here.

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