Capital Southwest: A Sustainable Yield Attractive To Dividend Investors

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The following is a brief introduction to the topic:

After the crash, the US banking sector has been neglected. Capital Southwest ( CSSWC) is a business development firm that has not received the same attention as other industry leaders, such as Main Street Capital.

Capital Southwest’s revenues come from flexible financing solutions provided to small and medium sized businesses, as well as distressed companies. Capital Southwest fills the gap left by larger banks such as JPMorgan and Bank of America.

The large yield of CSWC, which is currently above 11%, is what makes it so attractive. A yield of this magnitude would normally cause people to look away, but following a strong Q4 result an investment in CSWC still looks very attractive, resulting a buy from me. The company’s fair value of its investments increased by 29% to $1.2 billion. This was a solid improvement. The debt-to equity ratio decreased from 1.16x to 0.88x. These improvements reassure me that CSWC can perform despite difficult market conditions.

Company Structure

Capital Southwest is a small-medium business lending company that specializes in helping businesses grow and acquire new assets. CSWC is a company that is internally managed, meaning it hires its own management team to manage the assets of the company.

Investors tend to prefer this structure because it is clearer about the pay of the management team, and important information such as operating expenses are displayed. The company’s investment portfolio is dominated by First Lien Investments (86.6%), followed by Equity at 9%, and I-45SLF and Second Lien Investments making up the remainder. The portfolio is composed of 85 companies, and the average. The yield on the total investments is now 12.1%. It is worth mentioning that the floating-rate component stands at 98%. This supports growing interest income, even in an environment of rising interest rates. Capital Southwest can lend at higher rates in the current market. I expect that this will benefit the portfolio of the company positively and lead to steady growth.

CSWC’s top priority in the past years has been to maintain a strong dividend for its shareholders. This dividend has grown at a rate of 14.33% over the last five years and has reached a payout percentage of 89.04%. FWD’s dividend yield is currently over 11%. This yield is much higher than the average for the Financials Sector, which is only 4.16.

Recent News Fitch Ratings Inc. recently rated CSWC as BBB- with stable outlooks. CSWC was rated BBB- due to its strong portfolio of investments, which had been diversified well. Consistent operating performance also contributed to the above-average cushion for asset coverage. This recent news is yet another reason why CSWC could be a good addition to a portfolio that is divided.

Upgraded Rating

Fitch’s upgraded rating is proof that CSWC built a portfolio of investments that are very well managed and can withstand downturns, without introducing excessive risk to the company. The rating upgrade was a result of CSWC focusing on its “senior” focus in their investment portfolio. Fitch’s outlook was “consistent core earning generation”. I think this is plausible because the Tangible book value has grown by an average of 13.88% YoY over the past 5 years. This shows the rapid progress that CSWC made in the last few short years. The recent rating upgrade acknowledges this.

Fundamentals

Risk is often the deciding factor in where people draw their line when it comes to investing. A yield of CSWC of nearly 12% would put it on par with many other value traps. These companies are value traps that hide internal issues.

Capital Southwest is not a value trap. This is because the payout ratio is very high and nearing 90. The debt/equity is also 1.08 which is not a huge difference or cause for alarm. It’s also trading at historically lower multiples. CSWC’s successful growth of its investment portfolio has fueled dividend growth, not an increase in rates. First Lien Loans remain at 83%.

CSWC’s portfolio is not heavily dominated by one industry. Media & Marketing and Business Services make up 24% of the total portfolio.

CSWC, historically, has been very successful in increasing its operational efficiencies. It now has a Opex/Average Assets ratio of 1.9% which is the lowest ever. These improvements are a sign of a competent management team that has made sound investments. The portfolio generated $0.65 in pre-tax investment income. The company also raised equity. $29.2 millions in gross proceeds were received at 118% of NAV for Q4. Over the past 12 months, CSWC has significantly reduced its regulatory leverage. It went from 1.16x down to 0.88x. It should be CSWC’s ability to maintain a strong operating performance throughout the rest of the year as we wait for the FED rate increases.

Value Profile

CSWC has outperformed the SPY by 50.7% in the last three years. Capital Southwest’s dividends were also paid during this period. This is why it outperformed the SPY.

Capital Southwest’s success has been largely due to its operational momentum. The internal management structure has helped the company grow its portfolio. This structure has allowed for a lot of growth in the last five years. Assets have increased by 24.68% per year.

In terms of valuation I do not worry about paying too much for CSWC at this time. It is priced below MAIN, which many believe to be the highest-quality BDC. There is some evidence to suggest that CSWC’s valuation could be slightly higher than MAIN. CSWC does not share the same spotlight time as MAIN, but MAIN’s only BDC with whom it works is CSWC. The l45 SLF was a partnership which began in 2015. MAIN’s success will, I believe, be reflected in the future performance of CSWC. The partnerships show some similarities between the two in terms of risk management and portfolio management.

The GGM model allows us to determine the intrinsic value of an organization based on the projected dividend growth. We then calculate the rate of return that could be achieved and the price at which you can achieve it. According to the chart, CSWC would offer a 12% return if you paid under $30 for each share. I’ve applied a lower constant dividend growth rate than CSWC’s historical 14% in the last five years. The main reason I have chosen a smaller constant dividend increase rate than the historical 14% for CSWC in the last 5 years is because I do not see a 14% YoY growth to a dividend as sustainable on a long-term basis. I think a 5% increase is more reasonable. Target Price ($30), divided by D1/(12%-5%) would give you the calculation for your first year. The required rate of return would be achieved by paying less than $30 per share.

It may seem excessive to require a “required” return of 12%, but since CSWC has a high dividend yield, it is only fair that I also demand a high rate of return. Investors will receive a high return on their investment if CSWC increases its dividend. This is provided they buy under the value per share I stated for 2023, which would be $30.

Peer Comparison

Here is a comparison of CSWC with two other companies that operate in the financial sector.

TriplePoint Venture Growth () has historically been the worst performer in terms of ROE. TPVG is the company with the highest yield of the three at 14. The negative ROE raises questions about the dividend and the yield.

Here is another comparison between the same companies. MAIN is also a strong contender. I do not necessarily see CSWC as a clear winner. What type of investor are you? If you’re more risk-tolerant and don’t mind a stock with a higher yield in your portfolio, CSWC is a good option. The high yield of the company that has a lower valuation than its historic P/B is where I see the biggest benefits. This, along with a very high efficiency ratio, makes me more inclined to choose CSWC over the other options. I believe TPVG to be the most common. The company has a much higher debt to equity ratio and also the highest efficiency ratios among all companies.

Risks

CSWC’s portfolio includes companies that are vulnerable to recessions. I believe a reasonable concern about CSWC would be the value of its portfolio dropping if we entered a recession. This could lead to some losses in its credit portfolio. It is part of the nature to invest in BDCs. I believe CSWC is able to maintain a portfolio with significant risk, as the non-accrual is currently just 0.3%. A recession is more likely when interest rates rise, which puts pressures on capital. The job markets are still robust, and the prospects for a softer landing seem to have improved. The company where CSWC has invested may have to reduce dividends due to rising interest rates. This would affect the income generated by the investment portfolio. This would lead to a declining ROE, which could justify a reduced valuation of CSWC as the risks associated with its investments are increased.

Investor Takeaway

Investors could be concerned about CSWC, or any company in this sector, if a recession were to occur. This could cause the loan performance to degrade. COVID-19 is a good example of how CSWC has not been affected by previous challenges. The dividends, whether regular or supplement, were not halted by CSWC.

CSWC is a good dividend investment for those investors who are looking to increase their yields and can accept some of the risks associated with high-yielding firms. As the article has shown, CSWC’s quality and competence should not cause anyone to worry about future performance. I’d say that it won’t be like that.