2023-05-26 07:30:39 ET
Summary
- Capital Southwest remains an under-the-radar but high-quality and well-managed BDC.
- As far as stocks yielding ~12% go, CSWC is probably one of the safest, if not 'the' safest, you could own going into a recession.
- The floating rate portfolio is performing well, and the balance sheet is very strong, illustrated by Capital Southwest's recent receipt of an investment-grade credit rating from Moody's.
- I compare CSWC to two other top-tier BDC peers.
Capital Southwest ( CSWC ) is a top-notch business development company ("BDC") based in Dallas, Texas. The BDC makes senior (primarily first-lien) loans to lower middle-market businesses across various industries and sectors.
Despite enjoying similar levels of quality as industry leaders Main Street Capital ( MAIN ) and Ares Capital Corporation ( ARCC ), CSWC is much more under-the-radar with a smaller but growing following in the investor community.
In my last article on CSWC in November 2022, I opined that CSWC looks like a good buy under a price to net asset value ("NAV") of 1.2x and a strong buy at a price near NAV. Right now, at a NAV per share of $16.37, CSWC's premium to NAV sits at 11%.
After reporting very strong fiscal Q4 (first three months of 2023) results , I am reiterating my view that CSWC is a good buy for income investors with a moderate risk tolerance (no almost 12%-yielding stock is "low-risk," in my opinion). But I would go further than that and state that CSWC is one of the best, if not the best, double-digit-yielding stocks to own going into a potential recession this year.
Let's explore why, and in the process, we'll compare CSWC to MAIN and ARCC.
Comparing CSWC To Top Tier Peers
Here are a few important metrics to compare CSWC to its two other top-tier BDC peers:
Price To NAV | Avg. Price-to-NAV Range | Regular Dividend Yield | Debt/Equity | Non-Accrual/Portfolio (Fair Value) | |
Capital Southwest | 1.11x | 0.9x - 1.7x | 11.9% | 0.88x | 0.3% |
Main Street Capital | 1.44x | 1.3x - 1.8x | 7.0% | 0.77x | 0.6% |
Ares Capital | 1.01x | 0.9x - 1.2x | 10.3% | 1.12x | 1.3% |
All three are trading on the lower end of their historical average price-to-NAV ranges, as the market balances the benefit of higher interest rates on their floating rate loan portfolios against the strong likelihood of a recession that could cause some weakness in those portfolios' performances.
Critically, notice that CSWC enjoys the lowest non-accruals as a percentage of their total portfolio at fair value -- 0.3%. This metric has come down steadily since the initial COVID disruption in 2020.
In fact, from the end of 2022 to the end of March 2023, the performance of CSWC's borrowers has improved. Nearly 15% of loans are performing above expectations, while ~81% are performing as expected, and only 4.3% are performing below expectations.
This strikes me as close to ideal portfolio performance amid a weakening economy this year.
All three BDCs have conservative leverage profiles, but CSWC and MAIN boast particularly conservative debt-to-equity ratios under 1x. Notably, CSWC obtained its first investment grade credit rating of Baa3 from Moody's in March.
It makes sense that Moody's would award CSWC with an IG rating especially when you take a look at CSWC's debt maturity schedule. The BDC has no debt maturing until calendar year 2026 -- over 2.5 years from now.
This goes a long way in insulating Capital Southwest from the negative side of higher interest rates while allowing the BDC to enjoy the positive side of higher rates in its floating rate loan portfolio.
The "SBA debentures" are 10-year, fixed-rate loans extended and securitized by the Small Business Administration intended to promote small business growth and job creation.
From FQ1 2023 to FQ4 2023, interest expenses increased a whopping 61%, but total investment income surged an even larger 65%. Given that TII is significantly larger than interest expenses, this resulted in total NII growth of 80% during that 9-month period.
Of course, CSWC issued equity to help fund portfolio growth during that time, so NII per share increased only 30%. But that is still impressive growth for a BDC -- in only 9 months!
In fiscal 2023 (ending March 31st 2023), CSWC paid out 88.3% of pre-tax net investment income ("NII") as regular dividends, and in fiscal Q4 (first three months of 2023), the regular dividend payout ratio fell to 81.5%. And the payout ratio is coming down despite quarter after quarter of regular dividend increases!
It is impressive that CSWC has established a record of regular dividend increases over time, on top of supplemental and special dividends . The 54 cent regular dividend declared for FQ1 2024 (2nd quarter of calendar year 2023) represents 12.5% growth from the same quarter the previous year and 25.6% higher than the equivalent quarter from two years ago.
To be fair, though, the supplemental dividend has shrunk as management has increased the regular dividend. But this is a positive, in my view, because management has expressed greater commitment to maintaining the regular dividend.
As CEO Bowen Diehl explained on the FQ4 earnings conference call :
These increases in our regular dividends are a result of the increased fundamental earnings power of our portfolio given its growth and performance, as well as further improvements in our operating leverage. We have continued to be prudent in increasing our regular dividends, always endeavoring to set the regular dividend at a level that can be maintained even if market base rates return to more historical norms.
Notice that last point: Management sets the regular dividend at a level that they believe can be maintained even if interest rates normalize to a lower level than today.
As such, when management raises the regular dividend to $0.54, they are basically communicating that their floating rate portfolio could still generate at least $0.54 in NII per quarter (as opposed to the $0.65 earned in the most recent quarter) in a lower interest rate environment.
Rather than simply coming from higher interest rates, then, this regular dividend growth is coming more from portfolio growth. And growth in CSWC's loan portfolio has been strong and consistent over the past 7 years, with the vast majority of new loans being first lien (highest in priority).
As the portfolio has grown and diversified, the average holding size has decreased from 5.6% in 2016 to 2.3% in 2020 and finally 1.3% so far this year.
Bottom Line
As I summarily stated in my November article on Capital Southwest, "All in all, both in terms of the investment portfolio and the balance sheet, CSWC exudes quality and conservatism."
I stand by that statement today, and I view CSWC as one of the safest ~12%-yielding dividend payers that one can own going into a recession. (Granted, most stocks yielding 12% are very risky, so CSWC's competition isn't terribly strong.)
I come to this conclusion based on CSWC's regular dividend payout ratio in the low 80% range, its strong balance sheet with debt-to-equity under 0.9x and no debt maturities until 2026, and the significant shareholder-alignment of the skilled management team.
Main Street Capital are widely considered the highest quality BDC, and there is only one other BDC with which Main Street co-manages a senior loan fund. It's CSWC. They co-run the I-45 Senior Loan Fund, named after highway I-45 that runs between Dallas (where CSWC is headquartered) and Houston (where MAIN is headquartered). That says something about the similarities in investment strategy, underwriting, and risk management between the two lenders.
The biggest risk to CSWC's high-yielding dividend isn't lower interest rates but potential erosion in loan performance during a recession. This is a real risk, and I don't want to downplay it. But we have seen no erosion in performance of CSWC's loan portfolio as of it. And it's notable that CSWC continued both its regular and its supplemental dividend right through the chaotic pandemic environment of 2020.
For income investors with a moderate risk tolerance (or room for a "moderate-risk" stock in their portfolio), CSWC looks like a great buy today.
For further details see:
Capital Southwest: The Best Among High-Yielding Dividend For A 2023 Recession