Income investors are always on the lookout for investments that will produce ample income, and it's hard to find companies that do better right now than business development companies. BDCs like Main Street Capital (NYSE: MAIN) and Apollo Investment (NASDAQ: AINV) make investments in different types of businesses, often providing capital through either debt or equity financing. Because BDCs often elect the favorable tax status of regulated investment companies, they have to distribute the vast majority of their taxable income to their shareholders, and that produces the impressive yields that both Main Street and Apollo give their investors.
With rates on the rise, BDCs both have new opportunities and face some new challenges. If you're looking at BDCs right now, it's reasonable to wonder which ones are best-positioned to take full advantage of a rising-rate environment. Below, we'll look at Main Street and Apollo based on some simple performance metrics to see which one looks more favorable right now.
Stock performance and valuation
Based solely on share-price movements, neither Main Street nor Apollo looks particularly good. Apollo has seen its stock drop 10% in the past year, while Main Street has only managed to post a gain of less than 1% since May 2017.
However, looking only at share prices ignores the impact of dividends. When you incorporate their high yields, Apollo's total return approaches the break-even level, while Main Street presses out to a 7% gain.
Trying to compare BDCs using earnings-based valuation methods is often an exercise in futility. That's because earnings are driven to such a large extent by accounting distortions that play a particularly important role in the types of financing that Main Street and Apollo use. Tax reform has made the two companies' trailing earnings almost impossible to put side by side, and even readings that suggest forward earnings multiples of about 15 for Main Street and nine for Apollo are suspect.
Book value is a more common way to draw comparisons, and there, Apollo has an edge. It currently trades at just 0.82 times its book value, compared to almost double that for Main Street at 1.60. That arguably gives Apollo a valuation edge, but as we'll see below, the different approaches the two companies take can also explain that disparity to some extent.
Both Apollo and Main Street pay healthy dividends, but Apollo's is more generous. The company currently pays $0.15 per share quarterly, and that works out to a yield of almost 11% at current levels. That compares quite favorably to the solid yet less impressive 6% dividend yield that Main Street sports.
However, when you look at dividend growth, the two BDCs have been going in opposite directions. Apollo has seen a big fall from glory, slashing its payout in half in the immediate aftermath of the financial crisis in 2009 and then making two additional cuts that took the quarterly payment down from $0.28 per share as recently as late 2011. By contrast, the financial crisis was just a pause in Main Street's dividend growth, and its total distributions have very close to doubled on an annual basis compared to what the BDC paid during 2008 and 2009. If you value consistency over current yield, then Main Street has put together the more impressive track record of dividend performance.
Growth prospects and risks
Business development companies have had to deal with adverse trends in the industry, including rising credit-related issues and falling earnings. For Apollo, massive restructuring promises to change the way the company interacts with shareholders, with CEO Howard Widra announcing permanent reductions in base management fees from 2% to 1.5%, with further reductions for leveraged investments for which debt exceeds the amount of corporate equity. Incentive fees will now include a total return requirement with lookbacks, and Apollo seems committed to use increased capacity for leverage prudently. The middle-market loan environment remains extremely competitive, however, and that will put Apollo's lending discipline to the test as the BDC aims to concentrate on the most lucrative opportunities it can find. With the industry in constant flux, it'll be interesting to see how Apollo's moves pan out.
For Main Street, smart moves have been rewarded lately. The BDC saw its dividend income soar during the first quarter of 2018, showing the success of its equity portfolio, and the company's asset management business caters to an outside fund that results in Main Street receiving additional revenue from fee income. Yet Main Street's most important strategic moves involve additional investments in portfolio businesses. Given its prominent position in Houston, Main Street also stands to benefit from the recent recovery in energy prices, which will be necessary to help the region recover from the tragedy of Hurricane Harvey last fall. If it can keep succeeding with its investments in relatively small companies, Main Street Capital will be in good position to keep up its favorable track record.
Main Street Capital looks like the better buy between these two business development companies. Although its dividend yield is lower and its valuation levels are higher, the portfolio of quality assets seems more reliable and could better foster future growth. That's something that BDC investors can value in a rising-rate environment.
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