3 Half-Truths These High-Yield Stocks Love

By Markets Fool.com

When it comes to analyzing a business, what matters isn't what management will tell you. What matters is what they don't tell you.

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Over time, I've realized that corporate doublespeak is the worst in industries where individual investors constitute the majority of the investor base. After all, it's simply easier to tell tall tales when your investors have day jobs that consume the majority of their time.

One industry stands out for frequently repeating tall tales to investors. That's the business-development company, or BDC, industry, an industry that attracts individual investors because it offers dividend yields to the tune of 8%-13% per year, generated by lending and investing in small private businesses across the United States.

In the last year, I've heard a few common, but dubious, phrases repeated over and over again across the industry. Here are three of the worst, and some additional context for each.

1. "Our assets are valued by an independent third party"
Allied Capital served as a powerful reminder that BDCs are "black-box" companies. Allied overstated the value of its assets for years, ultimately succumbing to reality when the 2008 financial crisis made it difficult for the company to raise more capital to hide its losses.

BDCs primarily hold debt and equity investments in private businesses which outsiders know little about. These assets are so-called "Level 3 assets" for which there is no liquid market to determine their value. Thus, managers basically get to pick how to value their investments, and outsiders have to simply trust them at their word.

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To give an air of accuracy and legitimacy to their balance sheet marks, many BDCs now hire outside firms to assist them with valuing their portfolios. The idea is that a third party, not the management team, decides the value for its assets.

It sounds good in theory, but it's simply nonsense. As Ernst & Young explains in a brief paperon asset valuation, valuations rest in the hands of a company's board of directors.(Emphasis mine.)

From a regulatory perspective, BDCs are not required to use external valuation agents, but there is a reason many entities do: it gives the BDC's Board of Directors much more useful information when they are approving final valuations.

It is important to note that even if a BDC utilizes outside valuation experts, the Board -- and the Board alone -- has the ultimate responsibility for the final approval of the investment valuations. This is a statutory requirement. When a BDC obtains outside valuations, the Board should ask: are there differences between the findings of the independent agents and valuation information provided by management? If so, how can these differences be reconciled? The Board should never simply accept the valuation agent's numbers at face value. There is an important distinction between abdicating a Board's valuation responsibilities to a third party versus using the findings of an external specialist in good faith to help formulate a Board's final decisions.

A little logic can go a long way in finding the truth of the matter. BDCs pay around $5,000 to $10,000 per year, per portfolio company, for third-party valuation services. That's practically nothing. Off the top of my head, I can think of at least one BDC that has operating costs to the tune of more than $200 million per year, of which less than $2 million is spent on valuation services.

If the valuation consultants were doing deep and detailed due diligence into a BDC's portfolio, this BDC could fire all the investment professionals it has on staff. When a new deal comes across its desk, it could just send the documents to its valuation company, and let it decide if it's a good deal or not.

Of course, not one BDC sends a deal to a third-party valuation service to make the call on a new investment. They know a few thousand dollars won't buy the kind of due diligence necessary to sniff out a good deal from a bad one. Why we're supposed to believe that a third party will do a thorough job after the investment is made, but not before, is beyond me.

But in case you had any doubt about the importance of third-party valuations, remember that Allied Capital, the BDC which fraudulently overstated the value of its assets, also hired the help of third-party valuation consultants. The use of a third-party valuation company gives me no added confidence that the marks are accurate. Compare the prices at which a BDC sells its assets to the valuation it ascribed to the asset in prior periods; that's much more telling of whether it errs on the side of conservatism, or aggressiveness.

2. "We're more efficient than the banking industry"
Efficiency can have many meanings. It's true that BDCs can generally close on a loan much faster than a bank, so they are more efficient in that respect. It's also true that, as a percentage of total investment income, BDCs spend less on expenses.

Banks spent 61% of their revenue on non-interest expenses in the first quarter of 2015. BDCs, by contrast, generally spend about 35% of their revenue on non-interest expenses.

Taken at face value, BDCs are much more efficient than banks. But the banking industry's high operating expenses result in very low interest expenses. Their costly branches and customer services bring in piles of low-cost deposits -- the 11thDistrict Cost of Funds Index stood at 0.68% in April, meaning that banks paid, on average, 0.68% per year to fund their balance sheets.

BDCs don't and can't take deposits. They borrow from Wall Street through bond offerings, and from banks via credit facilities. Some borrow with the government's help through the Small Business Administration.

The cheapest money a BDC will ever find comes from the very industry they characterize as being inefficient -- the banking industry. One of the largest BDCs, FS Investment, currently has one of the cheapest credit facilities in the industry, which carries a rate of 1.79% per year. Its weighted average cost-of-debt financing -- which includes all of its high- and low-cost debt -- came in at 3.5% as of the most recent quarter.

In other words, banks are financing themselves with funding that costs 0.68% per year. One of the most creditworthy BDCs pays five times more (3.5%) for its funding.

You can't compare non-interest expenses without including interest expenses. BDCs that want to compare themselves to banks likely do so to deflect from the fact that a comparison to their real peers -- other business development companies, not banks -- would result in a less-than-favorable comparison.

3. "We benefit from rising interest rates"
Like all lenders, BDCs can be defined as being in the "spread" business. Their profit is the spread between their funding costs and their investment yields. When that spread widens, their profits should grow.

BDCs tend to lock in most of their financing with fixed-rate debt, and invest the capital in floating-rate debt. Thus, one would conclude that rising rates would push up their investment yields with no impact to their borrowing costs.

Again, this is mostly true. Mostly.

The missing detail is exactly how much rates would have to rise before positively affecting income. In general, that threshold is about 1%. Short-term rates, as measured by one- and three-month LIBOR, would have to jump higher than 1% before the industry starts to post better earnings.

Getting to an environment where LIBOR is 1% from where we are today -- three-month LIBOR sits at 0.29% -- is a massive leap. The 17 members of the Federal Open Market Committee don't see short-term rates rising above 1% until 2016. And that's probably the best-case scenario.

After all, several supposed dates for a rate increase have already come and gone. A headline from June 2009 reads, "Interest-rate futures price in Fed hike by end of 2009." It's now 2015, and rates are broadly lower, not higher. Forecasting rate increases is hard -- but that's not the point.

The point is that, as rates rise from current rates to 1% and beyond, most BDCs will actually see their incomes fall. That's because the floating-rate loans BDCs invest in have what's called a floor, or an alternative minimum interest rate to use when LIBOR is really low, like it is now.

A typical loan might yield 8%, plus LIBOR, or a floor of 1%, whichever is greater. Until LIBOR crosses 1%, the typical loan will yield 9% per year (8% plus the LIBOR floor of 1%). If LIBOR were 1.5%, the loan would pay based on LIBOR, and thus yield 9.5% (8% plus LIBOR of 1.5%). Rate increases only matter when LIBOR is already higher than the floor of the loan.

While the floating-rate assets have floors, most of a BDC's floating-rate liabilities do not. Thus, in between now and when LIBOR crosses 1%, the BDC industry will generally experience tightening spreads as their borrowing costs rise with little or no offsetting increase in their investment yields.

Beyond 1%, though, many BDCs will begin to post higher earnings. The worst-case scenario would be that rates rise only modestly and sit there for a very long time, dragging down the industry's income across the board.

It's not all bad
I don't mean to suggest that the industry is full of bad actors and liars. You could write similar criticisms of every industry. In all reality, my opinion is that a well-run BDC can, and should, be able to generate higher returns for shareholders than a regulated bank over a full market cycle. As the industry matures, it's attracting top-flight managers who are coming to market with better structures to protect investors. Progress is being made, albeit slowly.

What I do want to suggest, however, is that a little due diligence and cynicism can go a long way in deciphering what information is actionable, and what is simply fluff. And when it comes to finding the best BDCs to invest in, the companies that tell the fewest of the three aforementioned little white lies are probably the best places to start.

The article 3 Half-Truths These High-Yield Stocks Love originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. 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.