17-Apr-2022
A subscriber asked why we don’t have Capital Southwest in our portfolios since its valuation has fallen over the last few months by around 30% to 144% as of this writing.
This raises an important question of – what should be the basis of ratings that investors often hear from the income commentariat such as “Buy” or “Strong Buy”?
There are different types of investors for whom these ratings have different meanings. Splitting them into two broad groups – for tactical investors a Buy rating very likely means price performance in the near term, i.e. buy this at 144% because it’s going to 154% in a few weeks.
For strategic / buy-and-hold investors, it probably means that something is a buy because at a given valuation it is very likely to deliver superior longer-term returns relative to other available options in a given sector.
If we focus on the latter formulation which is probably more of interest to those reading this – CSWC has delivered total NAV returns that are more-or-less in line with the median of the BDC sector over the last 3-5 years (exactly equal to the median over the last 3 years and 0.4% above the median over the last 5 years).
So far so good. CSWC has performed either in line with the median BDC over the last 3 years and a touch stronger than the median BDC over the last 5 years in generating total book value returns (i.e. including dividends). This argues for its inclusion in investor portfolios.
However, we also know that investors don’t have access to total NAV returns because BDCs don’t trade at their NAVs. For instance, holding a BDC at a valuation of 110% means you pay an additional 10% “tax” on the stock’s total NAV returns. The key point here is that if you pay an above-average tax for fairly average historic performance, the return on your capital is below average. In short what matters for performance on investor capital is not just total NAV returns but also the valuation of that return stream.
A good question to ask is if the entire sector delivers the same exact return over the next 3 years as it did over the past 3 years in total NAV terms (the absolute numbers aren’t relevant for this example – what matters is the relative returns of CSWC to the rest of the sector), how will the CSWC return on investor capital compare to the rest of the sector. To answer this question we calculate what we call the Valuation-adjusted 3Y total NAV return which is simply the historical 3Y total NAV return divided by the company’s valuation (i.e. the price / NAV ratio).
If we look at the table above, we see this metric in the rightmost column. In short, if CSWC performs in line with its 3-year trend, a position in the company’s stock at its current valuation of 144% will underperform the sector by 1.7% per annum, all because of the drag of its valuation.
What this suggests to us is that investors who are happy to hold the company at its high 144% valuation are betting that the company’s forward total NAV returns will be significantly above the sector. In other words, investors holding the company’s stock implicitly believe that, while CSWC delivered historic total NAV returns roughly in line with the sector median (a bit above the sector average), the company’s performance relative to the sector will be significantly stronger over the next few years than it has been over the last few. If that doesn’t happen, it does raise the question of whether CSWC is simply mispriced.