This month, we are going off the beaten path a little.
Main Street Capital (MAIN) is not your average dividend growth company. It is in an unusual niche business: It provides financing for small and mid-size private companies that might otherwise find it difficult to access capital.
Introduction: Business Development Companies
MAIN is a Business Development Company (BDC). That is a unique business structure under a 1980 amendment to the Investment Company Act of 1940 designed to create private investment companies.
There are about 50 BDCs, many created within the past 15 years. MAIN is the 5th-largest.
The majority of BDCs, including MAIN, elect to be treated as a regulated investment company (RIC) for tax purposes. BDC/RICs must comply with several requirements:
• Distributions. If they distribute at least 90% of their taxable income to shareholders every year, they avoid corporate income taxes. This also allows them to offer high yields to shareholders. Thus they are called “pass-through” entities.
• Diversification: To reduce risk, BDCs may not invest more than 5% of their assets in any single security, nor own more than 10% of a given security’s total voting assets, nor invest more than 25% into businesses they control or businesses within the same industry.
• Constraints on leverage: A BDC’s ratio of total debt to total equity cannot surpass 1:1. BDCs employ much lower leverage than some banks and REITs, where leverage ratios often far exceed 1:1.
• Managerial assistance. BDCs must make significant managerial assistance available to the companies in their portfolios.
BDCs have similarities to venture capital and private equity funds. However, those are often closed to all but “accredited” investors. BDCs, on the other hand, can be purchased by anyone.
We will get into Main Street Capital’s business operations later, but for now, just understand that it qualifies under the law as a BDC/RIC, its stock trades under the ticker MAIN like any other stock, and anyone can buy or sell shares.
With that background out of the way, let’s examine Main Street Capital in the same way that we have analyzed other dividend growth stocks.
MAIN’s Dividend Characteristics
MAIN’s dividend resume is good, especially if you like high-yield stocks.
As a pass-through entity, most of MAIN’s profits flow directly through to its shareholders. That accounts for both the high yield and the high payout ratio.
The slight negative to pass-through companies is that the dividends are taxed to shareholders as ordinary income rather than receiving the favorable 15% tax rate on “qualified” dividends.
Of course, if the stock is held in a tax-deferred account like an IRA, this makes no difference.
The biggest downside to MAIN’s dividend record is that they only have a 5-year streak of increasing dividends.
Their annual payout habits require a little interpretation.
So far in 2015, MAIN’s regular monthly dividend has increased from $0.17 to $0.18 per share.
That’s how the 5.9% increase was calculated for the chart above.
But since 2013, MAIN has paid out special dividends in addition to their regular monthly dividends. If the special dividends were included in the calculation of yield, MAIN’s yield would be close to 9%. (Stock yields usually are calculated on “regular” dividends only. The 6.7% yield shown in the chart reflects regular dividends only, not the supplemental dividends.)
Below is a chart of MAIN’s quarterly total dividend payouts going back to when it went public in 2007. You can see they had a rocky time year during the Great Recession, freezing their dividend for more than 2 years. But they never cut it, which is impressive considering the economy at the time.
On this chart, the special dividends appear as the cross-hatched bars.
Since 2011, the annual increase in the regular dividend has come in the 2nd quarter. With the 2 special dividends per year, assuming they maintain that practice, MAIN’s payment schedule will be 12 monthly + 2 supplemental = 14 payments per year.
This is just an OK resume, although again remember that we are talking about a company with a yield of nearly 7%.
The best parts of the resume are the 5-year earnings growth rate – 14% per year – and the reasonable debt/equity ratio. At 0.8, the latter is well below the average for all 753 Dividend Champions, Contenders, and Challengers, which is 1.2. Of course, as we saw earlier a BDC by law is required to maintain a D/E ratio of 1.0 or below.
MAIN’s return on equity (ROE), at 11%, is below the 14% that I like to see. MAIN has managed to deliver higher ROEs in some years. BDCs sometimes have variable earnings, because they are dealing with loans and equity stakes that are constantly changing.
The projected earnings growth rate – 7% per year – is fine for a dividend growth company.
MAIN’s credit rating is considered investment grade at BBB. However, there are several grades above it on S&P’s scale (from AAA to BBB+), so it is at the lower end of the investment-grade range.
Neither Morningstar or S&P Capital IQ rate the company, so there are blanks where normally we would see a moat rating and a quality rating.
How Does Main Street Capital Make Money?
Main Street Capital was founded in the late-1990s and became public in 2007.
MAIN’s business model is to provide long-term debt and equity capital to lower middle-market companies (companies with revenues between $10 million and $150 million) and loans to middle-market companies. It has more than $3 Billion in capital under management: $2.2 B internally and $0.9 B as a sub-advisor to a non-public BDC.
MAIN’s investments are typically made to support management buyouts, recapitalizations, financing for growth projects, and acquisitions of other companies. Its portfolio has grown from 27 companies in 2007 to 206 today.
Management feels that it offers a 3-prong opportunity to its own investors:
• Sustainable and growing monthly dividends
• Semi-annual supplemental dividends
• Meaningful growth in net asset value (NAV) per share
MAIN is internally managed. That means that no external management fees or expenses are paid, which helps hold down costs. MAIN targets total operating and administrative costs at 2% of assets or below, and they have been achieving that target. They state that they have the lowest operating costs in the BDC industry.
MAIN is invested in a diversified portfolio of companies, whether diversification is measured by industry, type of financing, or geography.
Because it distributes most of its profits, MAIN must borrow money or issue new shares to grow.
On the borrowing side, according to a recent investor presentation, Main Street is well positioned for increasing interest rates when they happen. This comes from a combination of having fixed rates on much of the money it borrows combined with floating rates on much of the money it lends.
A long-term rising trend in interest rates should not hurt the company and may actually help it if rates rise more than 1% or so.
MAIN recently improved its borrowing position by amending its 5-year lending agreement. Under the new arrangement, they gained a reduced interest rate so long as they maintain their investment grade rating and an extension of the final maturity by one year to September 2020.
The amended agreement includes the participation of fourteen banks with total commitments of $555.0 million plus an accordion feature that allows for an increase up to $750.0 million.
As to issuing new shares, this is a normal financing activity that MAIN does regularly.
Quite often in analyzing dividend growth stocks, we see share repurchase programs that reduce the number of outstanding shares over time. MAIN presents the opposite picture: The company makes secondary offerings routinely, as a way to gather money to finance its own investment opportunities.
In addition to lending money to small businesses, MAIN also usually acquires an equity stake in the lower-middle-market businesses that they lend to. The company holds about 36% equity in their lower middle market companies.
When those “bets” pay off, it creates another source of returns for MAIN. Management regards their equity stakes as an advantage: They call it an ability to become a partner rather than a commoditized vendor of capital.
There is risk in this business model, and it comes mostly from risks presented by the companies that MAIN invests in. Thus it requires a careful approach to selecting those companies while rejecting others.
Per its own literature, MAIN seeks out strong management teams with established track records, entrenched industry knowledge, strong competitive advantages, and stable, positive cash flows. Their past record of success suggests that they have been skillful in selecting the companies that they work with.
Overall, I give MAIN’s business model a positive grade, but not a real high one in light of the inherent risks in financing small businesses.
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value. The default estimate is based on an average price-to-earnings ratio (P/E) of 15 shown by the orange line.
As you can see, MAIN’s actual price (black line) is right at the fair-value price.
Step 2: FASTGraphs Normalized. The second valuation step is to compare MAIN’s price to its “normal” long-term average P/E ratio, shown by the blue line.
As it happens, based on 6 years of data, MAIN’s long-term average P/E ratio is 14.5 (see the blue box in the right-hand panel), which is almost the same as the default P/E ratio of 15 used earlier.
So again by this measure, MAIN is fairly valued.
Step 3: Morningstar Star Rating.
Morningstar uses a comprehensive NPV (net present value) technique for valuation. Many investors consider this approach to be superior to using P/E ratios as we just did with FASTGraphs.
Unfortunately, Morningstar does not have an analysis of MAIN. So we cannot draw a conclusion about valuation from this step.
Step 4: Current Yield vs. Historical Yield.
Finally, we compare the stock’s current yield to its historical yield. It is better to be near the top of that range than the bottom.
According to Morningstar, MAIN’s 5-year average dividend yield is 6.8%. Its current yield is 6.7%. Again, we have a near-match and therefore a fair value rating.
The valuation summary for IBM looks like this:
By my methods, MAIN is fairly valued right now. It is neither a great bargain nor overpriced.
There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.
Beta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them when their price drops.
Main Street’s stock has a beta of 0.8 over the past 5 years, meaning that it has been less volatile than the market. That is a plus for the company.
The second miscellaneous factor is analysts’ recommendations. I normally get this information from S&P Capital IQ or alternatively from Morningstar. Unfortunately, neither source has a record of analyst recommendations for MAIN.
Main is an intriguing dividend growth company. Here are its positives:
• High yield at 7% + recurring special dividends that bring the effective yield close to 9%.
• Held its dividend steady during the Great Recession, then began an increase streak that has reached 5 years.
• 5-year dividend growth rate is good for such a high yielder.
• Careful, conservative approach to selecting portfolio businesses. The company seems to make good choices.
• Low operating cost structure.
• Company literature repeatedly emphasizes dividends, a “plus factor” that I like to see.
MAIN’s negative is the inherently risky nature of what it does: It invests in small companies. Presumably, many of the companies turn to MAIN because they cannot get the financing they need from commercial banks, where it would be cheaper.
That risk is reflected in MAIN’s high yield. The stock market does not normally allow the yield of a great business to get anywhere near 7%, let alone 9%. Investors would price the stock higher if they had more confidence in it. That would bring the yield down.
I do not own MAIN, but after researching and writing this article, I am tempted to buy some.
During my research, I read comments from owners and wannabe owners that they would like to see the price fall to $28 or $29 from its current $32 before buying shares. I would too, but on the other hand, my analysis tells me that MAIN is fairly priced now.
Here is MAIN’s 5-year price performance. You can see that it is nearly at its all-time highs. Nevertheless, I am tempted.
— Dave Van Knapp
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