Published by Bob Ciura on July 18th, 2017
As the saying goes, if something looks too good to be true, it usually is just that. This can often be applied to unusually high-yielding dividend stocks.
For example, Stellus Capital Investment Corp. (SCM) has a 10% dividend yield, which is very attractive on the surface. The S&P 500 Index, on average, has a dividend yield of just 2%.
Stellus is one of 405 stocks with a 5%+ dividend yield. You can see the full list of established 5%+ yielding stocks here.
Not only that, but Stellus pays its dividend each month, rather than each quarter like most companies. You can see the entire list of all 34 monthly dividend stocks here.
However, while double-digit dividend yields are very appealing in a low-rate environment, investors must make sure the dividend is sustainable.
Stellus has a very high payout ratio, which is teetering near 100%.
This article will attempt to find out whether Stellus’ 10% dividend yield is indeed too-good-to-be-true.
Stellus is a Business Development Company, or BDC. It makes investments in small, predominantly private companies, that are usually at an early stage in their growth cycles.
Stellus is a middle-market investment firm, and makes equity and debt investments in private middle-market companies. As of March 31st, 2017, Stellus had an investment portfolio of $352 million.
It has a highly diversified investment portfolio, both geographically and in terms of industry concentration.
Source: Q1 Investor Presentation, page 13
The types of companies Stellus invests in, typically generate $5.0 million-$50.0 million of EBITDA (earnings before interest, taxes, depreciation and amortization).
Stellus will make a variety of debt investments including first lien, second lien, uni-tranche, and mezzanine financing.
The investments are placed in a variety of industries, including business services, industrial, healthcare, technology, energy, consumer products, and finance.
Invested capital is used for a wide range of purposes, including acquisitions, growth investments, and more.
Stellus is externally-managed, by Stellus Capital Management LLC, a registered investment advisor.
The company follows a disciplined investment strategy. It has closed less than 2% of deals reviewed. Its relative selectiveness allows the company to focus on the highest-quality investments.
Stellus generates particularly high yields from its first lien, second lien, and unsecured debt investments.
Source: Q1 Investor Presentation, page 16
This is one reason why net investment income soared in 2016, to $17.3 million, from $4.7 million in 2015.
On a per-share basis, net investment income was $1.39, up 4.5% from the prior year. Net investment income covered dividends of $1.36 per share for the year.
The other reason for Stellus’ net investment income growth, is because its portfolio is growing. This will help fuel continued growth in future profitability.
A strong catalyst for Stellus is its growing investment portfolio. Last year, Stellus invested $66.5 million, across 10 new investments.
Stellus has seen its investment portfolio rise at a rapid pace over the past five years, which has allowed the company to earn higher investment income.
Source: Q1 Investor Presentation, page 15
In the fiscal 2017 first quarter, total investment income rose 4.2% from the same quarter last year. However, rising expenses wiped this out. Stellus generated flat investment income per share for the quarter.
Both total investment income, and per-share income, missed analyst expectations, by $0.23 million and $0.02 per share, respectively.
The good news is, that the investment portfolio continues to grow, as does the company’s net asset value. Continued growth could help expand dividend coverage.
Another potential catalyst for Stellus could be higher interest rates. As a primary debt investor, Stellus could benefit from higher yields on its future investments.
The company is already adept at reaping high yields from its investments. The overall portfolio held a weighted average yield of 11.3% in the first quarter, which was up slightly from 11% at the end of 2016.
Only 5% of the portfolio was made up of equity investments at the end of 2016. Moreover, the debt portfolio consisted of 77% floating rate investments, versus 23% fixed rate investments.
On a valuation basis, Stellus trades for 10 times its net-investment-income-per-share. In addition, Stellus had a net asset value of $13.84 per share at the end of the first quarter, which is right around its current share price.
This means the stock is likely not overvalued, and could be undervalued, given its growth potential.
When combined with dividends, the total return potential for Stellus is attractive, albeit not without a significant amount of risk.
As far as dividend stocks go, Stellus is not a typical choice. It has only paid a dividend for five years, which means it has not yet developed a long track record of consistency.
Stellus currently pays a monthly dividend of $0.1133 per share, which equates to an annualized payout of $1.36 per share.
Stellus has a dividend payout ratio of 98%. This means the current dividend payout is sustainable, but just barely.
The company does not have much wiggle room. Even a modest decline in investment income could cause the payout ratio to rise above 100%, which signals an unsustainable dividend.
It is very important that Stellus continue to increase its investment, as its recent results indicate.
Stellus is a high-risk, high-reward dividend stock. If the company’s growth stays on track, investors will receive a 10% return just from the dividend, plus any capital appreciation from a rising share price.
Buying a stock at 10 times earnings, with a 10% dividend yield, could be a highly rewarding investment, so long as the dividend remains covered with interest income.
Even if the company does maintain its dividend, investors should not expect much in terms of dividend growth going forward.
As a result, Stellus is not an attractive investment for dividend growth investors. It has appeal to investors looking for income right now, but only investors with a fairly high tolerance for risk should consider buying the stock.
Stellus could be an attractive pick, if everything goes well. It has a 10% dividend yield, a modestly valuation, and growth potential.
Plus, Stellus pays its dividend each month, which helps boost the compounding effect of reinvested dividends.
Of course, there is no guarantee the company’s growth plans will be successful. With a payout ratio nearing 100%, there is not much room for error.
As a result, investors must accept the risk of a future dividend cut, if financial results deteriorate. Only investors willing to take this risk should consider buying the stock.