The Most Dangerous Double-Digit Yields

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Most income investors find their way to business development companies (BDCs) by screening or searching for big yields. And there&a;rsquo;s no doubt these listed payouts do appear impressive!

A first-level look may have you wondering why &l;i&g;anyone&l;/i&g; would buy Main Street Capital when they could nearly double their dividend by choosing another ticker. Well, there&a;rsquo;s a good reason that we&a;rsquo;ll get to in a minute. First, let&a;rsquo;s talk about what BDCs actually &l;i&g;do&l;/i&g; so that we can understand what is driving these big dividends.

It all started in 1940, when Congress passed the Investment Company Act. It created a new form of lending with tax benefits similar to those currently enjoyed by REITs (real estate investment trusts). To put it simply, firms that lend to certain types of small companies get a pass on their tax bill if they pay out most (at least 90%) of their income to shareholders as dividends. Hence the big yields you see above.

Also many of these loans have floating rate kickers, so BDCs are positioned to make money in any rate environment. Really, they have a sweet setup. The problem is, their setup may be a little &l;i&g;too&l;/i&g; sweet for the small niche they are all trying to serve. What&a;rsquo;s to stop a small company from shopping around for their capital?

Over the long haul, very few BDCs deliver their dividends without &a;ldquo;tapping&a;rdquo; their investors&a;rsquo; pockets. In some cases, they fund their payouts partly from the income they derive from their loans (which is good) and partly by selling investors&a;rsquo; assets (which of course is bad).

Except for Main Street Capital, the other four BDCs delivered &l;i&g;lower&l;/i&g; returns than their dividends promised. Two actually cut their payouts (more on these dogs in a minute). A big dividend doesn&a;rsquo;t do us much good if we lose some (or all) of it in stock price depreciation!

Not MAIN however. Two simple yet important things set it apart:

&l;/p&g;&l;ol&g;&l;li&g;The firm increases its investment income annually, and&l;/li&g;

&l;li&g;It conservatively pays its dividend so that it never has to cut it.&l;/li&g;

&l;/ol&g;

Since its IPO in 2007, Main Street Capital has raised its dividend (which is paid monthly) is up 77%. It&a;rsquo;s never been cut, which is rare for a BDC. The company smartly keeps a cash buffer and pays out extra income as a year-end special dividend to make sure its investors (who depend on its monthly dividend to pay the bills) are never short.

What&a;rsquo;s so hard about this? Apparently, a lot. Two of Main Street Capital&a;rsquo;s four competitors mentioned above are paying lower dividends today than they were five years ago!

This shows that &l;i&g;their&l;/i&g; lending businesses actually become &l;i&g;less and less&l;/i&g; valuable over time. These stocks, always living on borrowed time, are &l;i&g;not&l;/i&g; the types of investments we want in our No Withdrawal Portfolio!

So should we buy Main Street Capital and call it a day? It&a;rsquo;s not that easy. As always, the price we pay matters. While most BDCs trade at a discount to their book value (or NAV, the value of the loans in their portfolio) Main Street Capital consistently trades at a premium. Not surprising, considering that it stands out from the BDC crowd in every respect!

The trick with Main Street Capital is to pay as little a premium as possible, because dips in price-to-book (below 1.3 or so) tend to indicate bargains in the stock price.

MAIN isn&a;rsquo;t quite there today, but it&a;rsquo;s a good income stock to keep on your watch list. Other BDCs, however, tend to be yield traps. Always check the long-term track record and, unless you see one that is shaping up like Main Street Capital&a;rsquo;s, you should probably stay away.

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