One of the components of a diversified portfolio is dividend investments. While many different types of companies pay dividends, one of the more generous types is business development companies (BDCs).
BDCs are required to pay out at least 90% of taxable income to shareholders in the form of a dividend. Hercules Technology Growth Capital (HTGC 0.63%) is a leading BDC that specializes in a vehicle called venture debt for life sciences, energy, and technology businesses. The company competes with traditional banks that may not be willing to make a loan to a start-up given its risky growth profile.
Over the past decade, Hercules stock has a total return of nearly 160%. This multibagger stock could be really attractive for dividend investors. And with shares trading below their 52-week range, now could be a great opportunity to open a position.
What makes Hercules Capital Unique?
When a start-up is first getting off the ground, the founders may turn to outside investors such as venture capital (VC) or private equity firms to raise funding. In exchange for investment capital, the founders give up equity ownership in the business. Over time, this deal structure can become less attractive as founders and employees are diluted. For this reason, as the start-up matures, it may seek out alternative financing structures like debt. Debt is a non-dilutive investment vehicle and can be useful for a business that is no longer burning cash but still needs a bridge before it can become fully self-funded or tap less costly capital. This is where BDCs like Hercules come into play.
What makes Hercules unique is how it structures deals. For example, a start-up always has the option to go to a bank and fill out a loan application. However, given the newness of the business and the unpredictability of cash flow, a bank may be willing to make only a small loan -- if any at all. On the other hand, Hercules has the balance sheet strength to make larger loans to these start-ups and provide the company with adequate funding. The catch is that these loans carry much higher interest rates than a regular bank's. Nevertheless, mature start-ups are typically eager to explore these types of deals due to their nondilutive nature. Moreover, so long as the company is confident in its ability to generate sufficient cash flow to pay down the loan, these transactions can make a lot of sense.
Another aspect of Hercules' business is that its deals typically carry stock warrants, giving it the option to buy an equity stake. This provides the potential for an extra layer of return for its portfolio companies. Many of Hercules' clients either pursue an initial public offering (IPO) or end up getting acquired by a larger competitor. Not only does Hercules make money from the interest on its loans, but it can get an extra kicker from its warrants during a liquidity event.
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Should you buy Hercules Capital stock?
Data source: YCharts
As of the time of this article, Hercules trades at a price-to-book (P/B) ratio of 1.4. This is slightly above the company's 10-year average of 1.3. The company is fresh off another record-setting quarter, and the stock's total return of 34% so far this year has handily beaten the S&P 500. For these reasons, it's not entirely surprising to see the stock trading at a slight premium.
Right now, the stock trades for about $16 per share, roughly 11% off its 52-week high. My guess is that some investors are taking gains off the table before the year's end. Moreover, it's unclear when exactly the Federal Reserve could start tapering interest rates -- an event that could meaningfully affect Hercules Capital.
But after zooming out and considering the bigger picture, whether the Fed begins to reduce interest rates sometime in 2024 is somewhat irrelevant. Given its unique business model, Hercules is more than just a lender. During the company's third-quarter earnings call, management stated that "we expect several additional M&A exits over the coming quarters." This sheds a lot of light on some of the secular tailwinds pushing the growth sectors Hercules serves.
The stock has been a solid performer for the past decade, and I don't see that stopping anytime soon. At current prices, the stock offers a juicy 12% dividend yield, and now looks like a great opportunity to scoop up some shares.
