2023-08-10 09:00:00 ET
Summary
- During its recent earnings, Capital Southwest exceeded analysts' expectations, beating on NII and total investment income.
- CSWC elected to raise the dividend for the second time this year by 3.7% and declared a supplemental of $0.06 payable in September.
- CSWC has beaten both peers Main Street Capital and Ares Capital in price and total return over the last 5 and 10 years.
- Although high-interest rates continue to benefit several BDCs, investors have to consider the rise in non-accrual loans when investing in them.
Capital Southwest ( CSWC ) has been one of my favorite dividend stocks and BDCs for quite some time now. I can't quite remember, but I think it was one of my first dividend stocks I invested in when I began building my dividend portfolio. I'll admit I fell for its high yield, which BDCs typically have, but the dividend stock turned out to not be a fluke, or trap like many high-yielders. The stock has continued to be one of my best performers in my portfolio . And in the last few months, the stock has witnessed some nice capital appreciation. Lots of investors consider BDCs risky and therefore elect to invest in high dividend growth stocks such as Starbucks ( SBUX ) or Home Depot ( HD ). I've always been kind of a risk-taker, so I never shied away from these companies. Although the BDC increased its NAV, grew its portfolio from $1.2 to $1.3 billion at fair value, and raised the dividend since my last article, I think investors should wait for a pullback in price before opening a position or adding to their current investment.
Benefits of Higher Rates
The Fed raised rates another .25 bps last month to its highest level in 22 years, putting rates in the 5.25%-5.50% range. Most SA readers know that BDCs typically benefit from this due to the structure of its business. In short, BDCs borrow money at a fixed rate and loan money to private, lower to middle market businesses at a floating rate, and sometimes take an equity stake in the company as well. Since the cost of borrowing is higher due to the current macro environment, BDCs are similar to banks in that they make loans to these companies and charge them a higher interest rate on that same loan. CSWC has continued to benefit tremendously from this, as seen by its latest earnings report. The company exceeded analysts' expectations on both NII and total investment income. They reported NII of $0.67 and total income of $40.4 million, beating the consensus estimate by almost $2 million. The BDC also increased their credit facility earlier this month to $435 million from $400 million and extended the maturity period by two years until 2028. Furthermore, the company also has no debt maturities until 2026! What interest rates headwinds?
To further flex its muscle, the company also announced a dividend raise after its earnings beat from $0.54 to $0.56 payable at the end of next month. They also elected to pay a supplemental dividend of $0.06 to be paid during the same time. This was the second time the BDC raised its dividend this year. They first raised it back in April by 1.9% from $0.53 to $0.54.
Strong Portfolio Growth
The company's total investment portfolio is valued at $1.3 billion, with 97% in 1st lien senior secured debt. This is up from $1.1 billion over a year period. The company also manages to grow its NAV by a penny to $16.38 from the prior quarter. CSWC is continuing to strengthen its portfolio by making new investments. At the end of 2022, the BDC had a total of 81 companies compared to the 89 that it currently holds. And while their NAV did decrease year-over-year from $16.54 to $16.38, they did manage to decrease their debt to equity ratio from 1.10x to 0.87x over the same period. This is lower than Ares Capital's ( ARCC ) whose current debt to equity ratio stands at 1.10x. To be fair, though, ARCC is a much larger BDC with 475 companies in its portfolio compared to CSWC's 89.
The company made $119.9 million in new investments during the quarter in six new portfolio companies and seven existing ones. They also exited one investment during the quarter, generating $3.4 million in proceeds. Additionally, they also received an BBB- investment grade rating from Fitch back in June, which I discussed in a previous article . This shows its quality, joining the likes of premier BDCs such as Main Street Capital ( MAIN ) and ARCC, two peers with an IG rating.
Extraordinary Returns
BDCs are not normally known for their price appreciation or total returns. They're usually held by income investors for their high dividend yields. But CSWC has proven that it's not your average BDC. My readers know by now that I look to invest for total return, but that doesn't mean that price return is not just as important. Over the last 5 and 10 years, CSWC has a price return of 33.96% and 103% respectively. This more than doubles ARCC's 5-year return and is almost more than 7 times that of their 10-year return! MAIN fares a bit better, with 66.30% over a 10-year period.
Consistency Is Key
One of the advantages of investing in an internally managed BDC is that their goals are usually aligned with shareholders. And this is a very true statement when it comes to CSWC. As I mentioned earlier, the BDC raised the dividend for the second time this year while also paying a supplemental on top of giving shareholders a 3.7% raise. It wouldn't surprise me if the BDC decided to reward investors with an end-of-the-year special to close out 2023. As seen below, they have been consistently raising the dividend while paying out a supplemental even during COVID, further showing their resilience during economic downturns. So I think it's safe to say if we do fall into a recession, this BDC will do just fine.
Overvalued?
Over the last 5 months, CSWC's price had appreciated 36% touching a 52-week high of $22.92 on August 9th. As recently as last month, they were trading less than $20 a share. Quality usually comes with a premium, but I believe the stock is overvalued, trading almost 37% higher than its NAV of $16.38. Back in June, I rated CSWC a strong buy due to price and newly assigned investment grade credit rating from Fitch , but since then the stock's price has seen some major price movement since making it a hold for now. It is possible that the stock's price could continue trending higher from here, but I believe the BDC is due for a pullback in price. And with a price target of roughly $23, investors get very little upside and margin of safety. I like the stock in the $17-$19 range and think it's a decent buy under $20.
Risks
No great investment comes without risks, and while CSWC is one of my favorites, it has drawbacks like any other well-run company. One of the biggest headwinds for this sector is the rise in non-accruals. While high interest rates are usually tailwinds for BDCs, they do come with some downsides as well. CSWC saw a rise in its non-accrual loans from 0.3% to the current 1.7% since last quarter. This is still below the sector average, but investors should keep an eye out for this in future quarters. I suspect the FED will pivot at the beginning of next year and non-accruals should start to slowly decline. Should non-accruals creep close to the KBW BDC average of 3.8% over the next few months before the FED decides to cut rates, I do believe the dividend will still be safe. If anything, management will elect to suspend their supplemental while continuing to raise the regular dividend.
Investor Takeaway
CSWC continues to be one of my favorite BDCs and dividend stocks. I think they are a great long-term hold, as seen by their stellar track record and consistent delivery of dividend raises. In comparison to ARCC, the company is still considered small with only 89 companies compared to ARCC's 475, but this just shows the company has a lot more room for growth in the future. CSWC has seen a rise in price over the last month and was last trading closer to its NAV in March of this year. Due to its current premium, investors looking to open or add to their position should wait for a pullback in price, preferably below $20.
For further details see:
Higher For Longer Rates? No Problem. Consider Capital Southwest