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The more I invest and study the market, the more amazed I become by the variety of investment vehicles available to the typical investor. There are thousands of stocks, bonds, commodities, mutual funds, hedge funds, exchange-traded funds, and finally derivatives that relate to any and all of the preceding instruments and funds.
To make sense of all of these, I categorize them. And my favorite category includes income-paying stocks, as I discussed last week in an article about why smart investors buy dividend stocks. What I want to do now is take this categorization one step further by looking at a specific subset of high-yielding stocks.
Business development companies
If you're an income-seeking investor, you're probably familiar with master limited partnerships like Kinder Morgan Partners and mortgage real estate investments trusts like Annaly Capital Management. To qualify for preferential tax treatment, businesses like these must distribute the lion's share of their earnings to shareholders via dividends -- typically along the lines of 90% thereof. As a result, their dividend yields are generally higher than the broader market; Kinder Morgan's is 5.4% and Annaly Capital's is 13.5%.
In addition to these, there is a lesser-known though related entity known as a business development company. BDCs are closed-end investment firms that invest in privately held middle-market businesses, that is, businesses with revenues between $10 million and $1 billion per year. They are an outgrowth of the Small Business Investment Incentive Act of 1980, and were created by Congress to facilitate the flow of public capital to private companies. BDCs accomplish this primarily through debt financing, and secondarily through the provision of equity.
Because BDCs are entitled to the same type of preferential tax treatment as REITs and MLPs, they too are incentivized to pay out the lion's share of their earnings via dividends. A cursory review of the biggest BDCs demonstrates the impact of this on their yields. Apollo Investment (Nasdaq: AINV ) yields 14.2%, Prospect Capital (Nasdaq: PSEC ) yields 11.6%, and Main Street Capital (NYSE: MAIN ) yields 7.3%.
One side effect of these large dividend payouts is the failure of BDC shares to markedly appreciate in value, as they don't retain earnings. Unlike shares in McDonald's, for example, which pay a dividend and appreciate in value, the only opportunity for return from an investment in a BDC typically comes in the form of the dividends, which also helps to explain why investors demand such a high yield.
Another downfall is their susceptibility to financial stocks. As such, the Great Recession has been tough for many BDCs. For example, American Capital (Nasdaq: ACAS ) lost 75% of its value, was forced to suspend its dividend, and is now being sued by shareholders for misrepresentation. And things got so bad for the one-time industry leader, Allied Capital, that it was forced to sell itself to competitor Ares Capital (Nasdaq: ARCC ) at a discount.
As late as last year, in fact, the situation remained somewhat dismal for BDCs, as Fool analyst Anand Chokkavelu discussed in an article about the 10 worst investment companies of 2011. Both Apollo and American Capital made the list, with annual dividend-adjusted returns at the time he wrote the article of negative 33.7% and negative 9%, respectively.
Foolish bottom line
These caveats aside, the right BDC remains a potent vehicle for yield-hungry investors. Not to mention, many of these stocks have performed well since the beginning of the year: Apollo is up 21%, Prospect Capital is up 15%, and Main Street Capital is up 5%.
To discover the identity of more potentially lucrative financial stocks, check out our recently released free report about stocks only the smartest investors are buying. It includes an industry giant that recently came to Warren Buffett's attention, as well as a smaller bank that we believe he would have liked in his early days. To access this free report while it's still available, click here now.