Buying by the Numbers

 | Jul 02, 2014 | 3:00 PM EDT  | Comments
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arcc

The midyear prediction circus has begun. Everyone has an opinion about what the stock market will do in the second half. If you had told all the prognosticators and forecasters in January that we would see an almost 3% decline in GDP, open hostilities in the Ukraine and Iraq, and that coffee, cattle and pork bellies would all be up more than 10%, I am sure they would have guessed that the market would be a lot lower today. Instead, all of these things have happened and stock prices are up about 7% on the year. Predicting the market is a fool's errand, so I released my official second-half stock-market forecast on Twitter Tuesday.

Rather than try to guess the market, it is more productive to look for what is cheap. In 1976, Ben Graham talked about a simple approach to picking stocks. Out of his famous 10 criteria, he said that if you used three of them (earnings yield twice the AAA-bond rate but never lower than 10%, equity that is greater than long-term debt, and a dividend yield that is two thirds of the AAA-bond rate), you should beat the market over time. This morning I looked for stocks that fit the bill as safe and cheap under these guidelines.

In today's low yield environment with 10-year AAA-rated bonds yielding a whopping 3%, we will be looking for stocks trading for less than 10x earnings that yield at least 1.8% with equity-to-asset ratios greater than 0.5. While this sounds like an easy task, the screen returns very few names. The total list of qualifying stocks is just 24. The majority of them come from particular sectors, and this is worth considering.

Twelve of the stocks on my list are business development companies (BDC). These unique finance companies were not around during Graham's day, so we will never know what he would think of them as a business, but many of them are very cheap now. These companies make loans to smaller and middle market companies that cannot access the public debt markets on reasonable terms and don't qualify for bank lending. It is a higher-risk, higher-reward approach to lending, but the payouts to shareholders are quite high. Most of them yield more than 8% and many have double-digit yields.

Several private equity investors have recently made comments on the prospects for direct lending and the rich opportunities present in today's world. I believe we may be seeing a huge opportunity unfold in this sector. Banks are increasingly unwilling to take on riskier loans and BDCs will able to help fill the void at a good profit to themselves and ultimately to shareholders.

I was surprised to find that so many business development companies passed the asset-to-debt test. On one of my favorite stocks in the sector is Apollo Investment Corp. (AINV) and it easily passed the test. It currently has $2 billion of equity compared with $1.5 billion of total debt. The price-to-earnings ratio is just 8 and the stock yields a very nice 9.6%. I listened to the recent conference call and I like the direction management is taking. They have been reworking the portfolio to favor mostly senior secured debt and expanding into the North American energy sector to take advantage of the fracking boom in shale fields.

Ares Capital (ARCC) is another interesting BDC that qualifies. The shares trade at 9x earnings and yield 8.6%. It has $4.8 billion of equity and total debt is $3.3 billion, so it passes the balance-sheet test. Ares is the largest BDC as measured and has a strong record over the past decade, averaging a total return of about 14% per year. The portfolio is spread out over 15 different industry groups with health care representing the biggest percentage of its lending activities. It should be well positioned to profit from the growing need for middle-market financing.

Graham's simple criteria for selecting stocks appear to uncover a major opportunity developing in business development companies. A portfolio of these finance companies that pass the equity test used by Graham could provide solid long-term total returns, with much of that delivered in the form of dividends.

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