2023-08-01 07:35:00 ET
Summary
- The 8th month of the year is upon us and it's time to look at what should be the 8th wonder of the world: compounding income.
- We look at a company that is run by a management team that knows what they're doing and is wanting to reward you every quarter.
- I want my portfolio to provide for my needs and not need to be needy itself.
Co-authored by Treading Softly
I have always greatly enjoyed it when August comes around. For many, August is one of the warmest months of the year, but it is also the month that, as it progresses, the temperature slowly declines as the first hints of fall come in the breeze. In essence, it's giving you a chance to enjoy those last days of summer before you can feel the whispers of fall on the wind. It also reminds you that you have just a little bit of time left in the year to make big changes and see those results before the year is over.
When it comes to the market, you're rapidly approaching the 4th quarter. September marks the close of the third quarter for most companies, and the last time you get a hint of what they are going to do as we look towards the 4th quarter of the year.
For value investors, we start seeing tax loss selling season kick in as the last dividends of the year arrive. Many companies that are already down will start seeing even more abusive selling as people close out positions to be able to claim those losses. As an income investor, I love the opportunity to buy good companies that people are selling.
It also means that for many dividend-paying companies, we are going to get the last dividend declaration that they're going to pay this year. We often see end-of-year dividend raises and special dividends declared in September.
Today, we will take a look at a pick in the latter group. It isn't likely to see tax-loss selling, since it is up significantly so far this year. Yet it has had significant earnings, and a history of paying special dividends in December.
Let's dive in!
August's Pick
Capital Southwest ( CSWC ), yielding 10.5%, is a BDC (Business Development Company) that focuses on the "lower middle market". These are companies that don't have easy access to public markets while having annual EBITDA in the $3-$20 million range.
Like most BDCs, CSWC provides investments as a combination of debt and equity. CSWC provides a first-lien loan and also gets an equity position in the company. The loan provides a stable and predictable income, while the equity position provides significant upside potential.
CSWC has thrived following COVID, taking advantage of a favorable lending environment and rising interest rates to more than double the size of its portfolio. Source
Additionally, CSWC has seen the size of its average position decline from 2.3% before COVID to just 1.3% in March. This means that CSWC is better diversified and more insulated from the impact of one company experiencing issues.
BDCs borrow at fixed interest rates and lend at floating rates. So, as interest rates rise, their income increases while their liabilities are fixed. CSWC has been benefiting from this tailwind, reporting record earnings last quarter and raising its dividend, plus paying a supplement.
We can expect the supplements to continue as interest rates remain high, but we all know interest rates won't be high forever. This is where we want to look at the permanent improvements that CSWC is making.
With scale, CSWC has become more efficient. Since 2016, CSWC has seen its operating expenses decline from 4.9% of assets to 1.9% of assets. This improvement means more profits flowing to the bottom line for investors and supporting the dividend.
Another recent development is that CSWC received an investment-grade rating from Moody's on its Capital Southwest Corp. 7.75% notes due 8/1/2028 ( CSWCZ ). CSWC is in the business of lending and is able to use leverage to improve returns because it can borrow at a lower rate than the companies it lends to. Having an IG rating will ensure that CSWC can continue to access cheaper capital and will improve returns for shareholders.
As of March 2023, CSWC's leverage was at 0.88x, well below the 1.1x it was at last year.
The 0.88x leverage is below management's target range, and combining that with the new debt issuance in June, we can conclude that CSWC was expanding last quarter, likely leveraging up slightly into the 0.9s. Slightly higher leverage, combined with higher interest rates, and CSWC should be in a great position to see rising earnings and possibly another dividend raise.
We continue to be impressed with CSWC's management, and this is a BDC that we are willing to hold for the long term. CSWC is a great BDC to own now but is also laying the groundwork to be a great BDC to own in any environment.
CSWC reports earnings on August 7th, along with its quarterly dividend declaration.
Conclusion
With CSWC, we can join hands with a company that is providing strong income to its shareholders. They are able to do this because management is executing strongly on the business model, and while they are enjoying an extra buoy from raised interest rates due to the Federal Reserve's combat with inflation, they have prudently taken steps to allow their dividend to remain strongly covered while paying special dividends on the side. The reason I like these special dividends so much is that when those special dividends go away as interest rates fall, CSWC is not going to have to cut its normal dividend - the dividend that you and I should be depending upon. Take a special dividend for what it is: It's something special, something extra, and should not be counted on.
The reason that I like CSWC so much for August is that you can buy it here before that final dividend is announced for the year and then enjoy that dividend before the year is done. If you're not a shareholder already, you can be rewarded by the company even before the year is done. If you are a shareholder and you add to your position, you can be even more richly rewarded than you were before.
I view CSWC as a blue-chip BDC in the making. If you don't consider it a blue chip already, you will in the coming years as management continues to excel in their responsibilities. Being a professional income investor, CSWC is the type of company that I am looking for to have in my portfolio: A strong company that knows its role, provides strong returns to shareholders, and is unabashedly uninterested in pursuing outside interests. You know of a few BDCs where the management desired to pursue a different role and maybe even leave the BDC space altogether to enrich themselves over their shareholders - this is not the kind of management team that will do that.
This is the kind of asset in my portfolio that allows me to go on a 12-day Alaskan Cruise, never once having to look at my portfolio, and knowing that the dividend will be there for me when I need it.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
Buy This, Even If You Buy Nothing Else In August