SCM - Stellus Capital: Thanks To Market Volatility An 11.5% Yield Is Available

2023-03-30 13:32:39 ET

Summary

• The market slide related to SVB’s failure creates a buying opportunity for Stellus Capital.
• The BDC has a well-managed, safety-focused investment portfolio and covers its dividend with net investment income.
• The stock is now available at net asset value.

Fears of contagion following Silicon Valley Bank's failure in March have led to a selloff in the BDC and financial sectors, in my opinion, for no good reason.

This selloff has reduced the price of a number of well-managed and diverse BDCs, including Stellus Capital Investment Corporation ( SCM ) , which primarily invests in First Liens.

Stellus Capital Investment also continues to cover its dividend with net investment income and recently increased its monthly dividend by 43%, so I believe passive income investors should consider SCM on the decline as the stock now pays a well-covered 11.5% dividend yield.

Well-Diversified Investment Portfolio

Stellus Capital provides income investors with a diversified and safe investment portfolio. The BDC's portfolio is primarily composed of highly rated First Liens (94%), the majority of which are floating rate (the floating rate percentage was reported as 97% at the end of the BDC's fourth quarter).

Furthermore, the BDC invests in non-First Liens infrequently, with Second Liens accounting for approximately 6% of investments.

Stellus Capital, in contrast to other business development companies, owns almost no Unsecured Debt and Equity, making the BDC, in my opinion, particularly suitable for passive income investors concerned about the impact of a potential recession on portfolio and credit performance.

Stellus Capital's portfolio was valued at $844.7 million as of December 31, 2022, representing 9% YoY growth. The portfolio contained 85 investments in total, up from 73 at the end of 2021.

Stellus Capital's portfolio is well-diversified, and the BDC focuses on industries that are less vulnerable to economic downturns, such as business services, healthcare, and pharmaceuticals. See the diversification chart below for more information.

Dividend Coverage

There are business development companies with better dividend coverage than Stellus Capital, Hercules Capital, Inc. ( HTGC ) being a good example , but the BDC's net investment income provides adequate support for the dividend payout to be sustained.

The dividend payout ratio in 2022 was only 82%, and the pay-out metrics improved steadily in the second half of 2022 as the BDC benefited from higher net interest income from its floating rate debt portfolio.

Stellus Capital currently pays a quarterly dividend of $0.40 per share, paid monthly in pops of $0.1333 per share. In 1Q-23, the BDC increased its dividend by 43% YoY. Right now, the forward dividend yield is 11.5%.

Get An 11.5% Yield And Pay Only Net Asset Value For SCM

I'm in the mood for a bargain, so I'm adding Stellus Capital Investment's 11.5% yield on the dip, primarily because the stock is practically available at net asset value.

Stellus Capital's net asset value as of 31 December 2022 was $14.02, representing a 0.2% discount to net asset value for passive income investors.

Stellus Capital sold at a premium to NAV just before the March drop, which is why I believe passive income investors should seize the opportunity to purchase Stellus Capital stock. Given the portfolio's high quality and focus on safety, I believe investors can get a very solid, long-term dividend yield here.

In the aftermath of the SVB failure in March, many other business development companies have begun to trade at either lower premium multiples or higher discounts to the net asset value.

Given that SCM's portfolio is heavily weighted in the safest types of debt and that the BDC recently increased its dividend by an eye-popping 43%, I believe the stock is a good buy for yield-seeking investors. SCM traded at a higher discount to NAV last year, but this was before the central bank got serious about raising interest rates.

Because 97% of the BDC's assets are invested in floating rate debt, the central bank's ongoing push to raise interest rates may result in higher net investment income and a better dividend coverage ratio in the future. These are all reasons why I believe SCM deserves a higher NAV valuation.

Why Stellus Capital Could See A Lower Valuation

Given the backdrop of Stellus Capital's price decline in the aftermath of the Silicon Valley Bank fallout, it is possible that investors will continue to sell stocks and buy safer investments, especially if new bank runs agitate the U.S. banking system.

However, a larger discount to net asset value would cause me to double down on Stellus Capital's stock rather than sell it. Given Stellus Capital's aggressive approach to floating-rate debt, a negative for the company would be if current banking system problems result in interest rate cuts, preventing SCM from realizing its incremental income upside.

My Conclusion

Stellus Capital is a well-managed business development company with a portfolio heavily weighted in highly rated first liens, and the BDC earns its dividend through net investment income.

In my opinion, the dividend payout ratio is the most important criterion for determining whether or not a BDC is worth purchasing. Stellus Capital is a BDC that consistently earns its dividend through NII.

Stellus Capital provides everything I look for in a well-managed BDC, which is why I believe its 11.5% dividend yield is still a good buy for passive income investors.

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