This is an extract from an earlier article at Systematic Income Premium. When originally released to subscribers on 18-Oct CSWC was trading at $17.17 versus $20.08 pre-market today.
In this post we highlight the Business Development Company Capital Southwest (CSWC). CSWC has spent most of 2021 trading at a ridiculously high valuation which has now fully deflated. Though it remains at an above-sector average valuation (103% vs. 87%) it is much closer to fair-value given its above-average performance track record.
The company has a focus on first-lien loans – at around 10% above the sector average with sector overweights in Media, Marketing & Entertainment as well as Business Services as the following chart shows. Its allocations target primarily the lower middle-market segment. CSWC has recently hiked its dividend – a regular feature – and trades at a 12.2% regular dividend yield (15.7% total dividend yield).
No Longer Priced Beyond Perfection
We have avoided CSWC over the past year for primarily valuation reasons. The chart below shows how the stock’s valuation has traded over the past five years (blue line) against the BDC sector average (orange line). The chart shows that first, CSWC has tended to trade at a higher valuation than the sector average over the last four years or so. And second, it blew out to a ridiculous premium in 2021 that was totally unjustified either by the company’s historical valuation pattern or by its ability to generate value for investors.
The chart below makes its 2021 valuation blow-up more clear – at its peak the company was trading at a higher than 60% premium to the average BDC. In absolute terms its valuation nearly hit 180% or an 80% premium above its book value.
There are two main reasons why such excessive valuation levels are problematic. First, they tend to be totally divorced from performance. Let’s take a closer look at this. Investors who know enough about the BDC space understand that they should look to historic total NAV returns to gauge the value that a given BDC has delivered historically. As they say, past performance is not indicative of future returns, but it’s as good a place to start as any.
Drivers Of Performance
A key question for investors is what is it about CSWC that allows it to drive outpeformance in the BDC sector. A lot of BDC analysis comes down to management in the sense that strong BDCs are strong because they have “quality management” and poor BDCs are poor because they have “poor management”. This is one kind of “analysis” that should get the investors’ bullshit detector up because it typically provides no actual information content but is just reflective of the performance of the given BDC.
Clearly, management quality differs but if management quality were a determinant factor in performance then all BDCs would consistently outperform or underperform and that simply doesn’t happen. Most BDCs don’t consistently do either. Some outperform in one period and underperform in another.
What this suggests is that investors should look to “harder” structural factors that provide a tailwind or headwind to a given BDC. For CSWC we can identify several.
First, CSWC is internally-managed. Internally-managed BDCs tend to feature a lower level of operating expenses. This is true of CSWC as the following table shows – specifically in the metric Opex excluding debt interest as a function of total assets, is a full 30% below the average BDC. This goes straight to the bottom line of the company.
Second, the company has consistently sold shares at a premium to NAV which is accretive to the NAV. For instance, in calendar Q2 (called Q1 in CSWC results) the company sold $47m worth of new shares via its ATM program at a 23% premium to book. As the following chart shows this resulted in a 6.8% annualized gain to the company – as much as many BDCs generate via their normal business. At the current very small premium, this source of returns will essentially go to zero, however, it could easily come back once BDC valuations revert to their less depressed levels. The corollary here is that if we were to strip out the ATM sales from the company’s return profile, its “organic” underwriting business returns would look much less impressive. This is something that investors need to take on board. If valuations remain depressed we would also expect CSWC returns to move closer to the sector average from their previously high levels.
Positive Q3 Outlook
CSWC recently released its Q3 guidance. Its net investment income midpoint estimate is $0.515 which is above the $0.48 figure for the previous two quarters.
The Q3 NAV estimate is $16.53 or just marginally below its $16.54 Q2 level. A rise in net income and flat NAV is as good as it gets in the current environment. It shows that rising short-term rates are getting passed through to portfolio income while the quality of the portfolio is not deteriorating.
The company recently increased its dividend to $0.52 from $0.50 which itself was recently hiked from $0.48. CSWC has been a serial hiker of dividends as the following chart shows.
On this metric it compares very favorably against the broader BDC sector whose dividend profile has been fairly flat over the last 5 years.
CSWC has been a consistently strong performer in the BDC sector. However, until recently it has been “too hot to touch” as it has traded at a ridiculously high valuation which was fully divorced from its ability to generate value. Now that its valuation has collapsed, it looks a much more reasonable allocation.
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