2023-11-02 10:00:00 ET
Summary
- Although BDCs have experienced some share price weakness in the last month, CSWC still trades roughly $5 above its NAV price.
- CSWC recently reported Q3 earnings and posted some strong growth.
- The company raised its regular dividend by 1.7%, and continued its supplemental, both payable in December.
- Over the last 5 years, CSWC has outperformed the S&P and its peers, returning 118%.
- With a high probability of another rate hike, investors should keep an eye out for a rise in non-accrual loans going forward.
Introduction
For those who have read my articles, you know I'm a huge fan of BDCs. As a dividend investor, my main goal is income and what better investments to reap that reward from than Business Development Companies? I'm a long-time holder of Capital Southwest (CSWC) and it's one of my absolute favorites in the sector. I last covered the stock in August where I discussed that CSWC was one to hold for the higher for longer environment. Since then, the BDC has performed well. But as we get closer to the end of the year, readers may be asking "Is CSWC still a good investment?" In this article I get into why it is a great investment for any environment, not just higher interest rates.
Why Capital Southwest?
Besides the fact that this BDC has been thriving in the current environment, up double-digits at almost 16%, CSWC is a long-term hold for any (environment), not just the current one. It's true that these stocks outperform when interest rates are high, like now, but they also do well in low interest rate ones. Below is how Capital Southwest performed prior to the rapid rise in interest rates in March of last year. From March 1st of 2021 to March 1st of 2022, CSWC's price rose double digits. If you would have invested $10k in the stock during that year period, it would worth over $11k now. This is if you would have invested before the FED raised rates by .25 bps. A double-digit return before rates were raised, imagine the return when rates are high like now.
Below is how CSWC has done over the last year. The BDC is up nearly 16%, 6% higher than prior to the start of hikes. In CSWC's first quarter in April of '22 after the start of rate hikes, the BDC paid a regular dividend of $0.48 and announced a special of $0.15 which was payable in June of last year.
Growing Dividend
Since April 2022, CSWC has rewarded its shareholders very nicely. Over an 18-month period they have increased the regular dividend by nearly 19% from $0.48 to $0.57 and paid a supplemental or special the whole time. Net investment income has also grown 38% over the same period from $0.50 to $0.69 at the end of Q2. One thing I like about CSWC is that they conduct small increases to the regular dividend and the board usually declares a supplemental at the same time. They could elect to be more on the conservative side like Ares Capital ( ARCC ), but chooses to reward shareholders with supplementals quarter after quarter. One reason is their internally-managed structure compared to an externally-managed structure, like that of ARCC.
Latest Earnings
CSWC reported Q2 earnings on October 30th where they beat analysts' estimates by $0.05. Total investment income of $42.78 million was ahead by $0.82 million, and up by $2.38 million in the quarter prior. This was also up nearly 60% from Q2 of '22 total investment income of $26.8 million. CSWC also managed to increase their total portfolio value from $1.3 billion in the prior quarter to $1.4 billion. This increased from $966k in March of this year. One way they managed to increase this was by committing to $110 million in new credit investments. All of these were first-lien senior secured loans, bringing CSWC's total to 97%. This is in comparison to their largest peer ARCC, who has nearly 42% in first-lien senior secured loans.
This is especially important because this allows CSWC to be much more defensively positioned than ARCC. For those familiar with first-lien loans, having a higher concentration in these loans means the lender has first dibs when getting paid. A lower concentration means the BDC has a higher chance of loans going on non-accrual. And with the higher for longer environment, this is key as borrowers become stressed from the current macro environment. With their floating rate portfolios, BDCs typically enjoy extra income from this, but their borrowers can experience stress.
That's why it's also important to know who these companies' loan to as well. In the quarter, CSWC invested in 5 new portfolio companies for $81.7 million, and add-on commitments in six portfolio companies for $28.3 million. These include CityVet, a veterinary practice offering pet care services, and Institutes of Health, a healthcare facility serving patients in the workers' compensation space, traumatic brain injury, chronic pain, PTSD, and depression. The other three were Swenson's drive-in restaurants, Jackson Hewitt Tax services, and Damotech, a rack safety leader in North America.
As a military member, the investment into the healthcare space stood out to me. Since the pandemic there has been a rapid rise in those with symptoms of mental health issues such as PTSD, anxiety, and depression. Not just in the military but globally. Depression is the fourth leading cause of death in 15-29 year-olds.
And honestly I think this need for mental health services will continue to increase. So, the types of companies these BDCs loan to is extremely important, especially for steady income. Strong companies in certain sectors, especially healthcare, are less likely to default on their loans. At the end of Q2 non-accruals accounted for 2%, well-below the KBW average of 3.8%.
Superior Total Returns vs Peers
When you compare CSWC to its peers, the BDC continuously outshines over a 1, 3, and 5-year period. In the last year, CSWC has a total return of 26.57%, beating the S&P and all of its peers with the exception of Blackstone Secured Lending ( BXSL ). BXSL also happens to be another one of my favorites but has a shorter track record, having formed just 5 short years ago.
If you look out over 5 years, CSWC is the clear winner against its peers and the S&P returning 118% in comparison to ARCC's nearly 80%, and the S&P's 55.33%.
Strong Balance Sheet
In my opinion CSWC does everything right. Rewards its shareholders, continuously grows its portfolio, is internally managed, and has a strong balance sheet with no debt maturities until 2026. 2023 has been a wild ride for a lot of companies and 2024 may continue to put pressure on many, especially those with debt maturities coming up in the next year. Although I still expect the first rate cut to happen sometime in the 2nd half of '24, high interest rates will continue to be a headwind for those with large amounts of debt maturing.
CSWC's earliest debt is in January of 2026 with $140 million worth of notes due. This has an interest rate of 4.5%. Furthermore, the BDC has debt due in March & October of 2026, bringing the year's total of $357 million, but none due until 2028 after that. At quarter end, they had a total of $23 million in cash, an increase from $21 million in Q1. Additionally, they managed to increase NAV by $0.08 to $16.46 from $16.38 in Q1. This was driven by new portfolio investments in the quarter.
Valuation
Although CSWC is down over the last month by nearly 6%, the stock is still trading at almost 30% above its NAV price. In my last article, I rated the stock a hold. They were trading over $22 then. In comparison ARCC, is trading at a better price right now as it's currently below its NAV of $18.99. But Mr. Market typically rewards CSWC with a higher premium to its peer, and as seen by their performances against the S&P, you can clearly see as to why.
As I mentioned to a few readers, I suspect CSWC's price to stay elevated until the first sign of a rate cuts. When this happens, I see BDCs and REITs switching places with CSWC falling back to its normal range, somewhere between $18 to $19. I consider them to be one of the highest quality but currently I consider them overvalued, and investors looking to start or add to their position should wait if you want any margin of safety.
For those with a long-term outlook on the stock and plan to dollar cost average in, then now could be a good time if you plan on buying all the way down. You get to collect a nice dividend check while you wait. I personally like the stock in the $17-$20 range and haven't added to my position in quite some time. Their trailing P/E is both below the sector median and its 5-year average so as I mentioned earlier those with a longer outlook, or a buy and hold forever mentality like me could establish a position here. But be warned, I do think BDC prices will fall as rates decline.
Risks
The largest risk for BDCs, although they've benefitted from the current environment, is a further rise in non-accruals. Further rate hikes will certainly put even more stress on portfolio companies as borrowing costs become higher. In short, as they become higher with the rise in rates, the harder it becomes for companies to pay back their loans to the BDCs, who typically loan at floating rates. So although they enjoy higher income, as more companies become financially stressed, this could affect finances going forward.
Another risk is interest expenses. In Q2 CSWC's interest expense was $10.5 million. This was an 8.2% increase from the $9.7 million in Q1, and the $6.6 million in the year prior. The expected recession could also have an impact on the business as companies and consumers become more stressed due to lay-offs & tighter spending. Throw in higher rates on top of that and the stock could see some volatility in the foreseeable future.
Investor Takeaway
CSWC has had some strong quarterly performances since the start of rate hikes. The BDC has rewarded its shareholders with raises and/or specials/supplemental dividends in every quarter since then. Even before the company was a stellar performer with a 10% change in price in the year prior to the start of rate hikes. In every quarter, CSWC has managed to out-earn its dividend and increase its NAV over the same period. They've also increased their total portfolio investments from $1.1 billion to $1.4 billion year-over-year. With their first-lien focus, strong balance sheet, and superior returns vs its peers, CSWC is a great addition to any investor's portfolio focused on income, not just during a high-interest rate environment. With its price roughly $5 above its NAV, I suggest investors wait for a pull-back in price. Due to its price appreciation, I continue to rate the stock a hold.
For further details see:
Capital Southwest Q3: A Top-Tier BDC For Any Environment