Get Private Equity-Caliber Returns in Your Own Portfolio
Niche, High-Yield Investments
Three Top Candidates
Sometimes the stock market feels rigged against the little guy. Yesterday the news was that a “cyber espionage ring” had tricked hundreds of executives into revealing confidential information that was then used to make profitable stock trades. Earlier this year, America was shocked by revelations of “dark pools” and other tools that high frequency traders use to front-run ordinary investors.
Sometimes it feels like you just can’t win.
However, there are a few Wall Street-style tricks you can use yourself, even if you don’t own a supercomputer located next door to the NYSE.
My colleague Jacob Mintz, Chief Analyst for Cabot Options Trader, tracks unusual options volume and uses it to follow insiders into profitable trades.
That doesn’t work with the stocks I recommend for Cabot Dividend Investor-most of these stocks trade millions of shares a day, every day. But that doesn’t mean we income investors can’t take advantage of some of Wall Street’s tricks too.
My latest recommendation in Cabot Dividend Investor, for example, is a stock that gives individual investors a way to participate in the rarified world of private equity, something you normally need millions of dollars to do. However, we’re getting in through a little-known but growing kind of income investment that you can buy shares in with less than $100. This investment and its peers go by the un-sexy name of business development companies.
Like private equity firms, business development companies, or BDCs, invest in private (or public but thinly traded) small businesses, and provide resources to help them grow. In addition to funding, they will often provide consulting or managerial guidance, or even take seats on the company’s board.
And while BDCs primarily exist to make loans to their portfolio companies, many also make equity investments, which can translate into big payoffs when they exit the position.
Successful BDCs will look to invest in companies that have good growth potential, and where their investment and guidance can be helpful.
The big difference between BDCs and private equity firms is that BDCs are publicly traded, so you can buy shares-and, by extension, own a part of all the little companies they invest in.
That means BDCs have to play by some special rules the government has set out to help protect you, the investor. For one thing, they’re limited in how much leverage they can take on: the government says they have to cover every dollar x2028of debt with two dollars of assets.
And second, and even better for you as an investor, they have to distribute at least 90% of their taxable income to shareholders as dividends. That means they have fat payouts: even the most conservative BDCs pay dividends that generate yields of over 6% per year.
Some BDCs are still very risky, so you should know how to analyze their unusual financials before jumping in with both feet. I wrote an in-depth article on how to find the safest, highest-yielding, highest-potential BDCs in my most recent Cabot Dividend Investor, just published last week. If this kind of niche, high-yield investment is interesting to you, I suggest you subscribe and read it. You’ll also get the name of my favorite BDC for all investors. But if you just want a taste of the opportunities in this market, here are sneak peaks at three BDCs I considered when making my pick for Cabot Dividend Investor subscribers.
Hercules Technology Growth Capital (HTGC) focuses on technology and life sciences companies, and has a good history of increasing distributions to investors.
TCP Capital (TCPC) hasn’t been around very long, but has done an impressive job of growing revenues since its IPO in 2012.
And Main Street Capital (MAIN) invests in a diverse array of companies, from all over the U.S., and has one of the best dividend track records in the industry.
There is one more thing you should know before adding the private equity-power of BDCs to your portfolio, and that explains the sector’s lousy performance for much of this year.
In late February, Standard and Poor’s announced that it would remove business development companies from its indexes effective March 31. After the S&P decision, Russell followed suit, announcing that it would remove BDCs from all its indexes in late June.
The reasoning is not a strike against BDCs-rather, it had to do with the way that BDCs report certain fees. These fees aren’t charged directly to investors, but the way they are reported can make it look like funds that hold BDCs have higher fees than they actually do. S&P and Russell didn’t want this happening in the ETFs based on their major indexes, so they decided to eliminate the problem by removing BDCs from the indexes altogether.
Shortly after the announcements, Barron’s reported: “Since an estimated 8% of all BDC shares are held by funds benchmarked to the indexes, such as iShares Russell 2000 ETF (IWM), ‘it will take weeks’ worth of trading volume for index funds to sell those positions,’ says Bryce Rowe, an analyst at Robert W. Baird.”
Sure enough, in the 11 weeks after S&P announcement, the main ETFs tracking the BDC market both fell over 8% (the S&P 500 was up 3% over the same period). Even after they were removed from the S&P indexes March 31 and from the Russell indexes in late June, BDCs remained weak into the fall, with most hitting new lows in October. I was waiting to see some strength return to the sector before adding a BDC to our portfolio, and decided it was time this month.
Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor