Updated on March 14th, 2019 by Nathan Parsh
It is not hard to see why Business Development Companies—or BDCs—are popular investments among income investors.
Consider that the S&P 500 Index currently has an average dividend yield of just 2%. With the 10-year U.S. Treasury Bond yielding 2.6%, bonds aren’t much better right now.
This underscores the challenge for income investors. In a climate of low interest rates, yields are very low.
Meanwhile, BDCs typically offer very high dividend yields. For example, Gladstone Investment Corporation (GAIN) is a BDC with a current dividend yield of more than 8% when supplemental dividends are taken into account.
It is one of 390 stocks with a 5%+ dividend yield. You can see the full list of established 5%+ yielding stocks by clicking here.
And, it is one of a select few stocks that pays its dividend each month. GAIN is one of roughly ~40 monthly dividend stocks. You can access the complete database below:
This article will discuss GAIN’s business model, and whether the sky-high dividend yield is too good to be true.
GAIN is a Business Development Company that places debt and equity investments in small and medium privately-held companies, which are at an early stage of development. These companies usually have annual revenues in the range of $5 to $50 million.
A collection of GAIN’s portfolio investments is as follows:
Source: Investor Presentation
Its debt investments primarily consist of senior term loans, senior subordinated loans, and junior subordinated loans.
On the equity side, investments primarily consist of preferred or common stock, or options as a means of acquiring stock. Equity investments are usually made in anticipation of a buyout or some form of recapitalization.
Investments are made in the lower-middle market segment, meaning companies that are medium-sized. GAIN intends its portfolio to have a 75%-25% split between debt and equity investments.
GAIN makes money in two ways. First, when its investments are successful, it will realize capital gains. In addition, it receives interest and dividend income from securities held.
As of December 31st, 2018, the portfolio consisted of equity or loans in 30 companies, located in 16 U.S. states and in 17 different industry groups.
The company aims to invest in businesses that provide stable earnings and cash flow, which GAIN can use to pay operating expenses, meet its own debt obligations, and make distributions to shareholders with residual cash flow.
GAIN’s investment strategy has been very successful over the past several years. From 2014 through the first three quarters of fiscal year 2018, GAIN’s portfolio value grew at a double-digit annualized rate.
An image of the company’s investment income growth since 2014 can be seen in the below image.
Source: Investor Presentation
The company reported results for the third quarter of fiscal 2018 on February 5th and the results were very strong. Net investment income of $0.24 was 30% above what analysts had been expecting.
Total investment income rose 14.3% during the quarter to $15 million. Net Asset Value, or NAV, rose 1.9% to $12.53.
More important for GAIN, was growth in interest income, grew 4.6%, though this is below the company’s historical average.
One important factor for GAIN moving forward is interest rates. Since it predominantly invests in debt securities, rising interest rates could be a negative drag.
Fortunately, the vast majority of GAIN’s debt portfolio is variable-rate, with a floor or minimum. This will help protect interest income in a rising-rate environment.
Continued growth going forward will rely on the successful implementation of the investment strategy, which appears likely, given the company’s history of proven results.
GAIN shareholders benefit from the company’s strong investment performance, through a high yield and growing dividend payout.
Competitive Advantages, Risks, and Recession Resiliency
GAIN also has a durable competitive advantage due to its unique expertise in the lower middle market private debt & equity segment.
Lower middle market companies are broadly defined as those with between $5 million and $50 million of annual revenue. This segment is generally too small for commercial banks to lend to, but too large for the small business representatives of retail banks to lend to.
GAIN fills this gap. By putting money to work in this unloved group of private companies, GAIN can realize outsized returns compared to its larger commercial bank counterparts.
Listed below is GAIN’s net-investment-income-per-share and distribution per share both before, during and after the last recession:
- Net-investment-income-per-share 2007 – $0.67
- Net-investment-income-per-share 2008 – $0.79 (18% increase)
- Net-investment-income-per-share 2009 – $0.62 (22% decrease)
- Net-investment-income-per-share 2010 – $0.48 (23% decrease)
The company’s historical distributable net income during the Great Recession is shown below:
- Distributable-net-investment-income 2007 – $0.85
- Distributable-net-investment-income 2008 – $0.93 (9% increase)
- Distributable-net-investment-income 2009 – $0.96 (3% increase)
- Distributable-net-investment-income 2010 – $0.48 (50% decrease)
GAIN saw severe declines in net-investment-income-per-share during the last recession, though the company did return to growth by 2011. Results for this metric have varied from year to year recently.
Distributable-net-investment-income managed to increase during the last recession, but was cut in half in 2010. Distributable-net-investment-income for the current fiscal year is expected to be $0.82 per share, the highest total since 2009.
One reason why BDCs like GAIN can pay high dividends is because of a favorable tax structure. GAIN qualifies as a regulated investment company.
As such, it generally is not subject to income taxes, so long as it distributes taxable income to shareholders.
GAIN is a very attractive stock for dividend investors. It pays a monthly dividend of $0.068 per share. On an annualized basis, the $0.82 per-share dividend represents an 7.2% dividend yield.
The company has made more than 162 consecutive monthly dividends since inception. Over the past five years, dividends have grown by 25%.
Source: Investor Presentation
Not only that, but GAIN also provides supplemental dividends from undistributed capital gains and investment income.
For example, the company announced a $0.06 per-share supplemental dividend payment for December 2018. Going forward, GAIN plans to make two such supplemental dividend payments each year. Including supplemental dividends, the yield is north of 8%.
GAIN has a modest capital structure, which helps secure the dividend.
Leverage was less than 35% of total assets, as of December 31st, 2018. And, the company has solid liquidity—the fair value of GAIN’s assets more than triple that of all liabilities.
Valuation & Expected Total Returns
Shares of GAIN currently trade for ~$11.45. Based on expected net-investment-income-per-share of $0.77 for the current fiscal year, the stock has a price-to-net investment-income of 14.9.
We have a target price-to-net-investment-income of 11.9 for 2024. If shares were to revert to our target, annual returns would be reduced by 4.4% through 2024.
We expect profit to grow by 3.6% annually through 2024, the same growth rate that the company has produced over the past five years.
Expected total annual returns are as follow:
- 8.2% dividend yield (including supplemental dividends)
- 3.6% net-investment-income growth
- 4.4% multiple reversion
In total, we expect that GAIN to offer a total return of 7.4% annually through 2024. Stocks with potential returns of at least 10% are often given a buy recommendation from Sure Dividend.
In the case of GAIN, likely multiple reversion results in expected returns below 10%, which means the stock is classified as a hold.
GAIN’s strongest competitive advantage is its investment strategy, which is to make long-term investments in high-quality businesses, with strong management teams. This has produced strong results for GAIN since inception.
Plus, shareholders can expect GAIN to make two supplemental dividend payments each year, when its investment strategy performs well. Investors depending on income from their holdings, however, should be aware that the company cut its dividend in 2010.
We rate shares of GAIN as a hold due to our expected total return of 7.4% per year over the next five years. Investors interested in owning shares of a BDC are encouraged to wait for a pullback in GAIN.