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How These Investors Filter Good and Bad Investments

At the 1999 Berkshire Hathaway shareholders' meeting, Warren Buffett dropped one of his most popular quotes:

The stock market is a no-called-strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, "Swing, you bum!"

As my colleague John Maxfield points out, making good loans is "the most important thing" that separates good banks and bad banks. John's article and Buffett's quote encouraged me to review my coverage list to see how various investment companies sort through thousands of potential investments.

Making loans on Fifth Street
As a middle-market business development company, Fifth Street Capital  (NASDAQ: FSC  ) reported relationships with 240 private equity firms in the United States in its 2012 annual report. This network allows it to source deals and participate in debt and equity investments across the United States.

The company has a three-stage process. It initially screens deals as they come in to determine whether the deal fits within its most basic investment criteria. Deals that pass initial inspection are then sent to an investment committee, which delves deeply into the economics of a potential middle-market investment. Some 80% of all investments do not make it through the first review by the investment team.

Deals that survive this process then proceed to the final stage, where terms are drawn up, negotiated, and reevaluated by the investment committee. Fifth Street Finance approves roughly half of the deals that make it to this stage. Thus, from beginning to end, only 10% of all investment opportunities that pass first muster result in a portfolio investment.

Prospecting for lending gold
Prospect Capital  (NASDAQ: PSEC  ) provides capital to non-public companies via debt and equity investments. In the company overview, Prospect Capital notes that it sources more than 3,000 new investments each year, but only 2% go from opportunity to investment.

The company is one of the most active in new deal generation. It first originates 2,000-3,000 opportunities from its call center, trade shows, broker networks, email lists, banks, and private equity groups. From there, only 2-6% of opportunities (150-300 investments) make it to basic due diligence. By closing, only 30-50 investments survive for a final round of investigation to a completed deal.

Management stakes a significant amount of its own money on its investment selection. Managers have never sold a single share of stock, and currently own more than $35 million of the company's shares.

The Foolish bottom line
It's important to remember that business development companies such as Fifth Street Capital and Prospect Capital invest primarily in unrated companies. Most don't even have a basic debt rating from Moody's, Standard & Poor's, or Fitch. That means they're making investments in companies that aren't in the public spotlight.

Knowing how an investment manager makes investment decisions ensures that investors making decisions on your behalf are philosophically aligned with your own investment framework. But the proof is in the pudding -- tracking a company's historical performance is one of the best ways to see whether its investment policy is central to the business, or just another piece of paper.

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Have you missed out on the massive gains in bank stocks over the past few years? There's good news: It's not too late. Bargains of a lifetime are still available, but you need to know where to look. The Motley Fool's new report "Finding the Next Bank Stock Home Run" will show you how and where to find these deals. It's completely free -- click here to get started.

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9/27/2016 4:00 PM
FSC $5.77 Up +0.04 +0.70%
Fifth Street Finan… CAPS Rating: ****
PSEC $8.26 Up +0.01 +0.12%
Prospect Capital CAPS Rating: ***