Is Fifth Street Finance the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock and then decide whether Fifth Street Finance (NYSE: FSC  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. Although past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that a company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Moneymaking opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Fifth Street Finance.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15% 107.0%* Pass
  1-Year Revenue Growth > 12% 67.4% Pass
Margins Gross Margin > 35% 100.0% Pass
  Net Margin > 15% 38.7% Pass
Balance Sheet Debt to Equity < 50% 38.3% Pass
  Current Ratio > 1.3 0.31 Fail
Opportunities Return on Equity > 15% 6.1% Fail
Valuation Normalized P/E < 20 18.67 Pass
Dividends Current Yield > 2% 9.0% Pass
  5-Year Dividend Growth > 10% NM NM
       
  Total Score   7 out of 9

Source: Capital IQ, a division of Standard and Poor's. NM = not meaningful; Fifth Street started paying a dividend in Sept. 2008. *3 1/2-year growth rate. Total score = number of passes.

With 7 points, Fifth Street Finance isn't quite perfect, but it comes fairly close on our scale. The company certainly finds itself near the top of the pack in terms of dividend yield.

Fifth Street Finance is a business-development company that focuses mezzanine financing of small companies with enterprise values in the range of $20 million to $150 million. Often, Fifth Street offers debt financing with an equity kicker to enhance potential returns.

With increased investor interest in finding investments that pay high dividend yields, business-development companies have gotten increased attention lately. Ares Capital (Nasdaq: ARCC  ) , Prospect Capital (Nasdaq: PSEC  ) , and MCG Capital (Nasdaq: MCGC  ) are all set up using the BDC structure, which are required to distribute their income to shareholders as they earn it. As a result, each of them has highly attractive payouts.

Each BDC is different, though, so you need to have a comfort level with the particular portfolio of investments each owns. In Fifth Street's case, you'll find investments in everything from oil and gas and health-care businesses to retail, business services, and technology companies. That level of diversity should give investors some comfort that Fifth Street isn't too exposed to any one sector.

Fifth Street isn't quite perfect, but for dividend investors, it has a lot going for it. If its investments pan out, then it could keep delivering solid returns for shareholders well into the future.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Add Fifth Street Finance to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our 13 Steps to Investing Foolishly.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 19, 2011, at 1:16 AM, surfgeezer wrote:

    FSC takes a bullish sentiment on the recovery, or at a minimum a slow growth belief. They get their financing 3 way1-SBA gov fixed loans,2- issue shares,3-line of credit from banks. They are well capatalized. In the BDC sector, I have FSC, PSEC, MAIN. All doing well. These companies have taken over the biz loans many banks used to do and seem to have found a profitable nitch, partly because they do much better due diligence, can and do take positions in the company and will work with the occasional company that gets in trouble, as long as they are still making money. The sector is beat up now from Greek worry contagion, but the earnings calls and reports are still performing very well.

  • Report this Comment On June 23, 2011, at 10:17 AM, clancy1951 wrote:

    Payouts are monthly now according to dividend.com and these are not qualified dividends (same source) therefor normal tax rate.

    Why is there no mention of this on MF (regarding qualified with favored 15% tax rate for now vs non-qualified with ordinary income tax rate). Most REIT's and BDC's are not considered qualified dividends.

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