Main Street: This high-quality 6.9% yield is on sale (NYSE: MAIN)
Recent market volatility reminds investors that investing in high-quality business development companies that promise stability and regular dividend payments is never a bad idea.
With recent declines in tech stock valuations, business development companies such as Main Street Capital (NYSE: HAND) provide dividend investors with consistent dividend income well backed by net investment income and stability in book value.
Buy BDCs that have a demonstrable history of growth
Companies that have excelled in the past are investors’ best allies in this market in times of growing economic uncertainty and inflation. Main Street certainly ticks all the boxes in this category as the company has established itself as the benchmark in the business development company industry. Main Street’s coveted status as a premier BDC is largely the result of careful capital investments throughout the life of the company, as well as steady growth in book value.
Investors often lose appreciation for companies that steadily increase their book value while the bulk of the money is made elsewhere, especially during good times. Investors are rediscovering the importance of investing in companies with strong balance sheets and consistent earnings results over long periods as the economic outlook deteriorates.
Over a long period, Main Street has steadily increased its book value per share. The chart below illustrates the growth in Main Street’s book value since BDC’s IPO in the fourth quarter of 2007. Main Street’s book value increased 101% from $12.85 per share on December 31 2007 at $25.89 per share on March 31, 2022.
Even though BDC has consistently paid and increased its monthly dividend, Main Street’s book value has grown 5% per year on average. Dividends of any kind, regular or special, reduce the book value of a BDC, meaning Main Street was able to increase its substance value by 5% per year on average, despite producing covered and growing dividend income for shareholders.
During Main Street’s most recent quarter, 1Q-22, the company’s net asset value increased 2.4% from book value of $25.29 as of December 31, 2021.
Equity investments in the lower middle market portfolio pave the way for Main Street to increase its book value. Historically, Main Street has made significant gains in this area. Main Street has realized cumulative net gains of $157.7 million on its portfolio investments in the lower middle market since BDC’s IPO nearly 15 years ago.
Main Street’s lower middle market portfolio also posted strong gains in 1Q-22 as it contributed $21.0 million of unrealized net appreciation. Total unrealized net appreciation of all investments, including lower middle market portfolio, private loans, middle market and others, was $14.8 million.
Steady dividend growth is valuable in times of heightened uncertainty
The dividend record, in addition to the steady growth in book value as an indicator of a high-quality business development company, is a solid statement. Companies that grow their investment portfolio over time and have a shareholder orientation tend to return more cash to them.
In the case of Main Street, the company did just that. Main Street’s dividend has increased 95% since BDC’s IPO, and BDC has never cut its recurring monthly dividend. Based on the current monthly dividend of $0.215 per share, the total dividend payout before special dividends is $2.58 per share, implying a stock yield of 6.9%.
Low payout ratio, special dividend potential
Main Street net investment income in 1Q-22 was $52.2 million, or $0.73 per share, up 31% year-on-year and 26% year-on-year. The recovery in portfolio values and income following the pandemic explains why Main Street’s performance has improved significantly compared to the same period last year. Distributable net investment income, excluding stock-based compensation expense, was $55.0 million, or $0.77 per share, up 31% and 24% year-on-year.
Main Street’s payout ratio in 1Q-22 was 84% based on distributable net investment income. In March 2022, Main Street also paid a special dividend of $0.075 per share. The payout ratio was 94% when the exceptional dividend was included. Since BDC easily covers its dividend with distributable net investment income, additional windfall dividends can be expected in 2S-22.
Main Street has always sold at a significant premium to book value, as the company has performed well over its history: loan losses have been low, dividends and book value have increased, and the dividend has always been covered by distributable net investment income. Despite MAIN having the highest P/B multiple I’ve seen in the BDC industry, it’s a premium valuation I’m more than willing to pay.
Why Main Street stocks could see a lower price
The impact of a recession or stagflation scenario (high inflation and stagnant economic growth) on Main Street’s portfolio and earnings is impossible to predict. At least some companies are likely to experience financial difficulties, which could lead to loan losses and, therefore, a general decline in the value of investments. It is precisely in such a framework that I would like to own the highest quality business development companies.
Main Street is a stock worth trading at a premium to its book value. Due to growing recession fears, Main Street’s stock yield of 6.9% is selling, and I’m buying.
The long-term growth in book value on Main Street suggests that we are dealing with a strong BDC here, and the appreciation of 1Q-22 investments in the LMM portfolio once again boosted book value growth. Main Street’s 1Q-22 dividend remained very safe, with an 84% payout ratio based on distributable net investment income. In 2H-22, the BDC could pay special dividends.