PNNT - PennantPark: A Smart Investment To Avoid Recessionary Headwinds

Summary

• In 2023, PennantPark Investment Corporation is poised to outperform market volatility and provide investors with healthy cash returns.
• Because of its floating-natured portfolio, the company's business model benefits from high rates and tight market conditions.
• Its strategy of providing first-lien loans to core middle-market companies with high EBITDA growth reduces the risk of loss ratio.
• Increasing investments in high-yielding assets, expanding stake in PSLF joint venture, and rotating out of equity stakes would improve its earnings growth quality in the long run.

As a potential recession and high-interest rates could make 2023 another difficult year for stock market investors, it makes sense to buy stocks like PennantPark Investment Corporation ( PNNT ) to lower portfolio volatility and earn returns that outperform the market. The small-cap business development, company's solid portfolio management strategy and healthy bottom-line growth rates give it the potential to generate robust returns even in difficult times. Fortunately, PennantPark's stock is also currently providing a good entry point for new investors. I believe that investing in stocks like PennantPark Investment can help investors avoid market volatility in 2023.

2023 Outlook and Stock Picking Strategies

Following a disastrous 2022, the markets seem to be at risk of posting a second straight negative year in a row, a situation that has only occurred four times since 1927. Furthermore, when markets fall for two years in a row, the subsequent fall may be more severe. Possible recessions, more interest rate hikes, and one of the largest drops in earnings are among the headwinds in 2023. JPMorgan predicts earnings in the range of $205, while Morgan Stanley has lowered its S&P 500 earnings forecast to $190. Even with a gloomy outlook, astute investors can still stay on top of market trends by chasing high-yielding stocks. A high yield contributes to improving overall returns while lowering stock price volatility. Historical trends also favor high-yield investing in turbulent times, but caution should still be exercised when choosing high-yield stocks, because several high-yielding sectors, such as real estate, are likely to underperform in the current market environment.

I believe putting money into business development companies can help investors successfully ride out the recessionary year. This is because the entire BDC industry has been flourishing due to high demand and floating nature portfolios. Particularly, business development firms like PennantPark Investment, which target cash-hungry middle-market companies, continue to experience high portfolio yields. In 2022, most BDCs increased their dividends, and many offered huge supplemental dividends as well. This trend is expected to continue into 2023 as the Fed strives for a terminal rate above 5%, up from a current range of 4.25 to 4.50 percent.

PennantPark's Middle Market Strategy is Key for Lofty Risk-Adjusted Returns

PennantPark aims to generate a healthy investment income and dividend growth for investors by focusing on core middle-market companies with high EBITDA potential, primarily in sectors such as business services, consumer products, government services, healthcare, software, and technology. While markets perceive core middle market companies to be riskier, data shows that core middle market companies have higher growth rates, lower default rates, and higher recovery rates than loans to companies with higher EBITDA.

In fact, companies with EBITDA of around $20 million provide significantly safer returns than companies above this threshold. As shown in the chart above, PennantPark's investments in companies with EBITDA of less than $20 million turned out to be more profitable than those with higher EBITDA. PNNT's low annualized loss ratio of 9 basis points since inception also reflects the strength of its investment strategy and the strong performance of middle-market companies. As of September 30, 2022, it had only one portfolio company on non-accrual.

Aside from targeting appealing market areas, the company's portfolio management strategy has been playing a critical role in generating high-risk adjusted returns. As of the end of the third quarter , the company was managing a well-diversified and secured investment portfolio of $1.2 billion, consisting of $631.0 million in first-lien secured debt, $129.9 million in second-lien secured debt, $141.3 million in subordinated debt, and $324.1 million in preferred and common equity. In the future, the company's returns might become more attractive as it aims to increase its stake in the PSLF JV from roughly $730 million to $1 billion. Over the previous quarters, the company's PSLF JV generated a double-digit return on equity for the company. PSLF's portfolio consists of 80 companies, with all of its investments being first liens and floating in nature, yielding 9.4% at cost. Furthermore, PennantPark has been attempting to gradually exit its equity investments and redeploy capital into cash-pay yield instruments, a strategy that would reduce portfolio risk and help generate more predictable returns.

Portfolio Strategy Leads to Higher Investment Income and Dividends

The company's portfolio strategy appears to be effective based on the impressive net investment income growth rates. Its investment income increased to $28 million in the third quarter of 2022 from $23 million in the previous year's quarter, and its core net investment income of $0.18 per share was more than enough to cover its quarterly dividends. Consequently, the company raised its quarterly base dividend by 10% to $0.165 per share. The dividend growth appears safe because the company is likely to benefit from high-interest rates in 2023 along with its aggressive strategy of pursuing high-yielding opportunities. PennantPark is expected to generate $0.77 per share in net investment income in 2023, representing a 17% increase over 2022, with earnings potentially increasing to $0.83 per share in 2024. The company received an A-plus grade on the earnings revision from the Seeking Alpha quant system because 9 out of 9 analysts have raised their forecasts for 2023, and 8 out of 9 expect the growth trend to continue in 2023.

An Attractive Entry Point for New Investors

When it comes to stock market investments, finding a compelling entry point is essential because share price performance is a significant factor in boosting overall returns. PennantPark's stock valuations appear to be appealing, with an A+ grade from the Seeking Alpha quant system. The company also received a high grade on growth and profitability, two key factors that support valuations and boost investor confidence. Its forward price-to-earnings ratio of 7 versus the sector median of 10 provides plenty of room for share price growth in 2023. The stock also appears to be significantly undervalued, with a price-to-book ratio of 0.67 versus the sector median of 1.36. Its current stock price of approximately $6 is also lower than its adjusted net asset value of approximately $9 per share.

In Conclusion

In one of the most unpredictable years for value and growth investors, it makes sense to invest in high-yielding stocks with low beta. One of the stocks that can provide shareholders with impressive cash returns is PennantPark Investment. The company's business model benefits from high rates, and its portfolio management strategies position it for long-term growth. The stock is also trading at attractive valuations, with the potential to outperform the broader market if stocks decline for the second year in a row. It may also perform well if the market enters a recovery phase.

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