2024-01-04 08:00:00 ET
Summary
- Capital Southwest has been a strong performer, returning 28% in the past half year and offering a dividend yield of close to 10%.
- The company benefits from rising interest rates, resulting in higher net interest margin and increased investment income.
- While there is some risk of credit issues in a potential recession, Capital Southwest should be able to handle losses and maintain its attractive dividend yield.
Article Thesis
Capital Southwest (CSWC) has been a strong performer over the last year. Still, even following nice gains, shares are not expensive, and Capital Southwest also still offers a pretty nice dividend yield of close to 10%. While waiting for a pullback could allow for an even better entry point, investors should do well in the long run if they buy at current prices.
Past Coverage
I have covered Capital Southwest three times in the past, with the most recent article being released last June. I gave the company a Buy rating then, and so far, that thesis has played out well -- Capital Southwest has returned 28% since then, quadrupling the broad market's 7% return over the same time frame.
Now, a little more than half a year later, it's time to update my thesis on Capital Southwest -- what has changed, what has remained the same, and how good does Capital Southwest look today?
Capital Southwest: Strong Execution
As a business development company, or BDC, Capital Southwest is influenced by several macro items. The first important macro factor to consider is the interest rate environment. Most of Capital Southwest's loans are floating-rate loans, meaning that the company benefits from rising interest rates. When the Fed ups its main interest rate, then Capital Southwest earns higher interest on most of its loans, all else equal. While the company borrows money as well, in order to finance some of its loans, it generally borrows at fixed rates. Eventually, it will have to refinance its own debt and will experience higher interest rates there as well, which will result in higher expenses, all else equal, but that happens with a time lag, while the benefit from higher rates on the interest the company earns materializes immediately. In a higher rate environment, Capital Southwest will thus not necessarily earn more money forever, but at least until all its borrowings have been rolled.
We see the positive impact of higher interest rates on Capital Southwest's profitability in the company's recent results. While Capital Southwest continues to originate new loans, which results in growth in its portfolio, revenues also saw a huge boost from a higher net interest margin, which is why total investment income soared by almost 60% during the most recent quarter compared to one year earlier.
The strong revenue increase did result in a huge net investment income increase as well, which is Capital Southwest's earnings equivalent. However, it is important to note that Capital Southwest, like many other business development companies, issues new shares regularly in order to finance some of its new investments with equity. This share issuance results in a climbing share count, which is why the company's net investment income does not grow as fast as its company-wide net investment income. During the most recent quarter, net investment income rose from $14.4 million one year ago to $27.2 million, which made for a hefty 89% increase. On a per-share basis, however, net investment income grew from $0.52 to $0.69, which pencils out to a growth rate of 33%. That is still very strong, but not as outstanding as the company-wide net investment income growth rate might suggest. Ultimately, earnings per share growth is most important for the trajectory of a company's share price, thus the net investment income per share number is the one investors should focus on. The result, here, is still pretty strong, at a little more than 30%, which is especially good when we consider that Capital Southwest is an income investment primarily, not a growth company.
While interest rates play an important role for Capital Southwest and other BDCs, other macro items are important as well. Economic growth impacts loan demand and thus influences how many investment opportunities materialize, while lack of economic growth can result in higher credit losses -- when companies are hurting, the risk of them becoming unable to pay their debt rises.
Capital Southwest makes first lien secured debt investments primarily, but it also makes some second lien debt investments and additional equity investments in some cases. While the risk of losses in the first lien secured debt portfolio, which makes up 97% of CSWC's overall credit portfolio, is rather small, the second lien loans and the equity investments are riskier, on average. During the most recent quarter, Capital Southwest's loans were looking pretty good in most cases, as we can see in the following presentation slide from the company's most recent earnings release:
CSWC credit quality (Capital Southwest earnings presentation)
The four-tier investment rating, where "1" means the lowest risk and highest quality, while "4" means the highest risk and lowest quality, sees 97% of debt investments in one of the upper two rating categories. While the ratio of loans in the lowest quality category, "4", has risen from zero to 0.6% during the most recent quarter, the ratio of loans in the lower two rating categories has declined from 3.9% to 3.1%. We can thus say that among the weaker quality loans with a "3" or "4" rating, some got better and do now have a rating in the upper half, while some got even weaker and were downgraded from "3" to "4". I overall see this development as relatively neutral and the important thing is that the very vast majority of loans remain in the upper two investment rating categories.
Economic growth has remained solidly positive during the last couple of quarters, but there is no guarantee that this will remain the case going forward. Some analysts and investors expect a recession during the current year, caused, at least partially, by the Fed's tightening over the last two years. If that were to happen, investors should expect that some additional credit issues materialize in Capital Southwest's portfolio. Losses will not necessarily soar, but more credit rating downgrades and at least some losses in CSWC's credit portfolio should be expected in case we get into a recession. A recession could also hurt the value of the equity investments Capital Southwest has made in the past. That being said, I do not believe that a moderate recession would be a disaster -- Capital Southwest should be able to stomach some credit losses without too much trouble. Supplemental and special dividends could be cut in case higher investment losses result in temporarily weaker profits, however. This gets us to the next point and one of the most important ones for CSWC's shareholder base -- the company's dividend payments.
CSWC: Still A Very Nice Yield
Capital Southwest has, like many other BDCs, experienced nice gains over the last year. Compared to one year ago, Capital Southwest has gained almost exactly 40%. A share price return this high is great news for investors who held CSWC over that time frame, but it also means that the dividend yield shares are trading at declines meaningfully, all else equal.
Still, despite the dividend yield compression that was caused by CSWC's share price gains, the dividend yield remains quite attractive, at 9.5% when we only account for CSWC's regular dividend payments, and at 10.5% when we also account for the company's supplemental dividend payments of $0.06 per quarter (in the recent past). There is no guarantee that the dividend will be maintained at this level forever, neither for the regular dividend nor for the supplemental dividends. But the dividend growth track record is very positive, and I believe that at least the regular dividend is safe unless we get into a deep recession. Since the yield on the regular dividend alone is close to 10% already, investors would likely not fall into a panic even if the supplemental dividend were to be cut or reduced -- after all, CSWC would still be a very nice income-generating investment in this scenario.
Takeaway
Capital Southwest has been a very strong performer over the last year. While net investment income soared, share count dilution offset some of that growth, but even on a per-share basis, CSWC's net investment income has appreciated nicely over the last year. Net asset value per share has risen as well, but not as drastically, which is why CSWC has become more expensive. When we add the fact that CSWC's dividend yield has compressed, one can argue that investors should wait for a better buying opportunity before investing additional money into CSWC, but I believe that long-term oriented investors will do well with a CSWC investment at current prices, even though the company is not as cheap as it was a year ago any longer. I thus am moderately bullish on CSWC but acknowledge the fact that Capital Southwest was a better investment last year.
For further details see:
Capital Southwest: Attractive 10% Yield