These High-Yield Stocks Should Be Buying Back Stock By the Billions

By Markets Fool.com

Few things in finance are as controversial as share repurchases. Proponents argue that they represent a tax-free way to send wealth to shareholders. Others contend that companies are poor market timers -- buybacks tend to peak with stock prices.

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Deciding to buy back shares, and deciding how much to purchase, is very much an inexact science. After all, the efficacy of a repurchase plan hinges on whether or not a stock is truly undervalued. And the true impact of a repurchase plan can only be judged years after it happens.

One industry that puts the debate to rest
There is one industry in which it is almost impossible to argue against repurchases. That's the business development company industry, in which a type of finance company lends money to small, private businesses and pays out 90% of its earnings as dividends.

Business development companies are much like closed-end funds. They make debt and equity investments in private companies, then carry these investments on their balance sheets. Each quarter, BDCs are required to value their assets and report these values in their financial reports. These valuations are then summed, and from that number BDCs subtract their liabilities to establish a figure known as "net asset value," or book value.

Most BDCs currently trade for less than their book values. Thus, they can buy back their stock for less than what they say their stock should be worth. Nonetheless, few companies are acquiring stock.

Think about how ridiculous that really is. On one hand, BDCs are reporting that their assets are worth, say, $10 per share, but they aren't repurchasing stock at, say, $8 or $9 per share.

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Frustration is growing. On a recent conference call for Medley Capital , one of the few BDCs that has enacted a repurchase plan, an analyst voiced his annoyance with the industry's avoidance of repurchases. "First of all, I'd like to commend you for the share repurchase program and your commitment to it. I've heard every excuse under the sun for not doing this from other companies and I think it's a very strong expression about your desire to be shareholder friendly, so I commend you for that."

A few exceptions
Three commonly held BDCs -- Prospect Capital , Fifth Street Finance , and Medley Capital -- have already reported their latest quarterly earnings. Each one trades at a substantial discount to book value. Only Medley Capital has approved a repurchase plan and committed to actually using it. Most BDCs approve buybacks, only to never repurchase any meaningful amount of stock.

Repurchases at current valuations are the easiest money a BDC could ever make. If at any point you believe you can buy back stock for less than net asset value, it is a very obvious choice to make. After all, buying dollar bills for $0.70 or $0.80 is a fantastically good business.

Yet, business development companies rarely repurchase stock, because doing so shrinks their balance sheets, along with the fees their asset managers can charge for managing their portfolios.

A buyback policy to match a dividend policy
Business development companies generally have a dividend policy that includes a consistent monthly or quarterly dividend, with occasional special payouts when they realize gains on their investments. To my knowledge, none have an explicit repurchase policy.

The industry owes it to its investors to have a buyback policy. Such a policy might look something like this: "If our shares trade at a 20% discount to net asset value, we will seek to match new investments with equal amounts of share repurchases."

It's pretty simple. A BDC can continue to underwrite new investments when its shares are cheap, but it will have to match these new investments with stock repurchases dollar for dollar. It's a balancing act that ensures owners and their managers can have a healthy middle ground.

The industry still has a lot of growing up to do. Only recently have BDCs become competitive on fees for managing investors' money. In due time, and with enough pressure from shareholders, they'll have to become competitive on their capital allocation decisions.

Any manager that issues new shares at a small premium to book value while refusing to buy back stock at a massive discount simply does not have the best interests of its shareholders in mind.

The article These High-Yield Stocks Should Be Buying Back Stock By the Billions originally appeared on Fool.com.

Jordan Wathenhas no position in any stocks mentioned, but he has a soft spot for BDC investors who are poorly treated by greedy management teams.The Motley Fool has no position in any of the stocks mentioned. 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.