SAR - Saratoga Investment: A +10% Yield And Discount To NAV

2023-08-02 10:33:45 ET

Summary

• Saratoga Investment Corp offers a high yield of 10.5% that's well-covered by net investment income.
• SAR has a well-diversified portfolio and has maintained a steady NAV per share in recent years.
• The stock currently trades at a discount to NAV and should continue to benefit from high interest rates.

Many people have heard of the marshmallow test, in which you can either get a marshmallow now, or wait and get 2 later. While there are merits to waiting for something better, what if there is a fire drill and you never get what you're waiting for? As such, there are merits to getting rewarded now, because nobody knows what the future may hold.

The same principle applies to investing as well. While it may be tempting to buy the S&P 500 ( SPY ) today, for potential capital appreciation later, there are no guarantees that will happen. At a 1.4% yield, it could take another decade before it reaches a near 3% yield, based on its past 10-year dividend CAGR of 6.9% .

This brings me to Saratoga Investment Corp (SAR), which currently yields a far higher 10.5% yield. I last covered SAR here back in April, highlighting its NII growth and portfolio quality. The stock has given investors a 16% total return since then, far surpassing the 10.6% rise in the S&P 500 over the same time. In this piece, I discuss why SAR remains a good high yield choice for income investors.

Why SAR?

Saratoga Investment is an externally-managed BDC that lends money to U.S. middle market companies. At present, it has a $1.08 billion portfolio fair value that's primarily allocated towards first lien debt, representing 85% of the portfolio total, with the remainder being second lien debt (1.4%), common equity (8.9%) and unsecured/other securities (5%).

Like most BDCs, SAR has largely benefitted from higher interest rates, with its portfolio yield at 12.7% as of fiscal Q1'24 (ended May 31st), sitting much higher than the 9.5% portfolio yield at the end of fiscal 2022. Importantly, SAR has produced a steadily NAV per share while delivering a high yield for investors. As shown below, SAR has managed to grow its book value since 2014 and hold it steady over the past 3+ fiscal years.

These factors have contributed to outperformance over the BDC sector. As shown below, SAR has produced a 66% total return over the past 5 years, comparing favorably to the 39% return of the Wells Fargo BDC Index (BDCZ).

Meanwhile, SAR maintains a well-diversified portfolio across 42 different industries, with healthcare software, IT Services, and HVAC Services being its top 3 industries, representing a quarter of the portfolio total. It also substantially out-earned its $0.70 quarterly dividend by generating adjusted NII per share of $1.08. The $0.38 per share in overearnings gives SAR plenty of buffer against adverse economic events and also serves as a spillover bucket from which SAR can dip for future dividends should the need arise.

Looking ahead, SAR should continue to benefit from higher interest rates, as 99% of its assets are floating rate. This is also considering the recent 25 basis point rate hike implemented by the Federal Reserve in July. SAR also carries high credit quality, with 96.5% of investments being rated in its highest category, and only one investment is currently on non-accrual status. As shown below, management has a strong track record of maintaining credit quality with net realized gains far outpacing losses over the past 10+ years.

Risks to SAR include its higher than average leverage, with an asset coverage ratio of 1.56x, which equates to a debt to equity ratio of 1.79x. While this sits below the 2.0x regulatory limit, it also means that SAR doesn't have too much capacity to continue to grow its portfolio outside of raising fresh equity capital. Plus, materially higher interest rates could make future financing or rounds more expensive and could pressure the bottom line if SAR's borrowers are not able to withstand higher rates.

Some of these risks appear to be priced in, however, as SAR currently trades at $26.68, equating to a price to NAV of 0.94x. I believe the discount and spillover income provides equity investors with an adequate cushion, while, getting paid a yield that's north of 10%. Investors holding this in a Roth IRA can reap the full benefit of the high yield, which more or less matches the long-term annual returns of the S&P 500.

Investor Takeaway

Saratoga Investment Corp has a demonstrated strong track record of shareholder returns. It's managed to maintain a steady NAV per share while paying out a healthy yield for investors. Its portfolio credit quality also remains very strong, which should give investors confidence that SAR will continue to deliver sustainable dividends going forward, especially since it well out-earned its dividend during the last reported quarter. Lastly, the stock currently trades at a discount to NAV, thereby giving investors a buffer against adversity while collecting a 10%+ yield.

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