Are Business Development Companies Cheap Stocks or Ticking Time Bombs?

By Markets Fool.com

Continue Reading Below

Few sectors in the financial industry seem to offer as compelling of a value proposition right now as business development companies, many of which are trading for healthy discounts to book value.

The question, in turn, is whether or not value investors should take this as a cue to pile into BDCs before the rest of the market, at least in theory, catches on.

Charles Sizemore, the chief investment officer of Sizemore Capital Management, thinks the answer is yes. Here's his logic:

BDC valuations fell off a cliff during the 2008 meltdown before recovering into 2010. But the overall trend in price/book valuation has been down. As a group, this is the cheapest the BDC sector has been since the crisis.

Can cheap sectors get cheaper? Of course. But given the alternatives in a broadly overpriced market, I'll gladly take the 8.7% dividends on offer from BDCs.

Suffice it to say that Sizemore is onto something. If value investors aren't willing to put their money on the line when valuations are low, then what's the point in being a value investor?

Continue Reading Below

Yet when it comes to BDCs -- and, specifically, the ones that trade for the largest discounts to book value -- there's a growing body of evidence suggesting that investors should be particularly cautious before acting on this impulse.

The risks, so to speak, don't concern the BDCs themselves. They revolve instead around the ability of their portfolio companies to weather a rising-rate environment.

Critical context for understanding BDCs
There are three things to keep in mind here. The first is that BDCs, by nature, invest in companies with high debt-to-equity ratios. As a result, many of the companies held by BDCs are atypically vulnerable to higher interest rates.

Second, many of the loans to these portfolio companies are indexed to short-term interest rates. At Prospect Capital, 72% of its assets bear interest at floating rates. And, according to its consolidated schedule of investments, roughly the same seems to be true at Ares Capital.

The third thing to keep in mind is that a healthy portion of any BDC's holdings consist of subordinated or otherwise unsecured debt instruments. In the event of default, these will only pay out after senior claims have been satisfied.

Now, to be fair, none of this is new. So, why should investors be concerned today as opposed to, say, three or five years ago?

The reason is that many BDCs spent the last few years bulking up their balance sheets with leveraged loans. Since the beginning of 2011, Prospect Capital's total assets have grown fourfold; Ares Capital's have doubled.

Yet it was at precisely this same time that financial regulators started identifying systematic weaknesses in the underwriting standards used to originate leveraged loans.

Most notably, a multiagency review of leveraged loans originated in 2012 found "material widespread weaknesses in underwriting practices, including excessive leverage, inability to amortize debt over a reasonable period, and lack of meaningful financial covenants."

Take it from someone who has spent time studying the credit cycle, this is a serious concern. So serious, in fact, that it would be surprising if the fastest-growing BDCs over the last few years didn't suffer significant losses once the borrowing costs at their portfolio companies start to tick up.

My point is that there are good reasons many BDCs are trading for discounts to book value. How big of a discount should they be trading for? That's impossible to say. But, at least for the time being, I'd encourage all but the least risk averse investors to steer clear.

The article Are Business Development Companies Cheap Stocks or Ticking Time Bombs? originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Oaktree Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.