In this brief post we highlight a couple of BDC allocation strategies that appear to be common but are unlikely to outperform in the longer-term in our view.
One strategy is what is commonly called a value trap strategy that allocates to BDCs primarily on the basis of valuation. For instance, a recent headline stated that the BlackRock Capital Investment Corp (BKCC) is an “average” BDC at a cheap valuation.
In fact, there is nothing average about BKCC when we look at its ability to generate wealth for investors. It is the worst performer across 3Y and 5Y horizons in total NAV return terms of the BDCs in our coverage.
Granted, gauging total NAV returns can be quite tricky in the BDC sector which is why you don’t often hear about it in BDC commentary but it’s essential to avoid value traps like BKCC.
The other strategy that is likely to underperform in our view, though to a smaller extent, is buying strong-performers without regard to valuation. The problem here isn’t that these BDCs deliver poor total NAV return – they typically outperform the sector. However, their elevated valuation is totally out of line with how much outperformance they have delivered in total NAV terms historically.
For example, BDCs like CSWC and HRZN spent much of 2021 trading at silly valuations of 150-170% which was around 40-60% above the sector average.
This is despite delivering performance that was only 0-20% above the sector average level over the past 3-5 years in total NAV terms (and lower more recently).
In short, once valuation is taken into account, these BDCs typically deliver a lower return on investor capital than the sector average. Higher-valuation BDCs also tend to be priced for perfection and see significant valuation compression in periods when not everything lines up perfectly, such as 2022.
In our view, avoiding value traps and making sure that the valuation investors pay are justified by a similarly high or even higher total NAV outperformance can increase the likelihood of investors reaching their investment goals in the sector.
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