In this week's Financials episode of Industry Focus, Gaby Lapera and Jordan Wathen go over which of Jordan's predictions for BDCs panned out and which didn't, how the BDC industry changed in 2016, and a few predictions for what 2017 (and the upcoming presidential administration) might hold for BDCs.

Also, the hosts talk about their New Year's' resolutions, some perks of index funds as opposed to individual stock picking, what CLOs are and why investors should be wary of companies that invest in them, and much more.

A full transcript follows the video.

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This podcast was recorded on Jan. 9, 2017.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, January 9th, 2017. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, one of our top analysts here at The Motley Fool. Hey, Jordan! How's it going?

Jordan Wathen: Hey, Gaby! It's going alright. 2017 looks OK so far. How's yours?

Lapera: (laughs) What a resounding endorsement for 2017. Mine has been pretty good so far. This is actually my first Industry Focus of the year, because we had the first Monday off because it was New Year's Day. Well, New Year's Day observed.

Wathen: Right.

Lapera: But, I really love New Year's. It's one of my all-time favorite holidays. It goes Thanksgiving, New Year's, 4th of July, and then St. Patrick's Day, but that's mostly because it's my birthday. I feel bad for my brother, he really did not luck out, his birthday is on Valentine's Day, so every year he's always celebrating with his wife and it's like, "Here honey, I did all this stuff for you because it's Valentine's Day!" I mean, she gets him stuff, too, it's his birthday, but still, I think I definitely got the better end of the deal.

Wathen: That's really rough for a guy, actually.

Lapera: (laughs) I know. St. Patrick's Day is great, because you can always encourage people to go out with you, because you're like, "It's St. Patrick's Day! Don't be lame! Let's go party!" (laughs) All right. On that note, this is actually New Year's Resolution week on Industry Focus, so you can expect to hear from all of us about our financial resolutions for 2017. If you want to check them out in one place, head to New Year's resolutions. Do you have any, Jordan?

Wathen: I actually didn't make a New Year's resolution this year. I haven't in a long time. But one thing that I did do, and this is kind of an ongoing resolution, so I'm just going to claim it for this year. In college I decided that my New Year's resolution, one year, was to do something that someone wanted me to do, like go to a social event that I didn't particularly care for, or try a new food, and I would not say no to it. And actually, it turned out alright, and I learned that I liked a lot more foods than I thought I did.

Lapera: Like what?

Wathen: I've always had this weird thing with cheese, certain cheeses, I don't like. So that throws out some foods. But it turns out I like a lot of cheeses that I hadn't run into before.

Lapera:I feel like it's pretty rare for people to dislike cheese, except for the super stinky ones, which I love.

Wathen: Oh, see, I don't like the stinky cheeses, no no no.

Lapera: I love them. My mom always says that I'm a trucker trapped in a girl's body because I love onions and mustard and stinky cheese and all this stuff that makes your breath smell really bad. (laughs) I was talking to a friend of a friend, and she had a really interesting New Year's resolution. She was going to take 20 book recommendations from friends and family, and then read all of the books over the course of the year. I think you really have to trust your friends and family if you're going to do that, because her group of people have all been trolling her. They gave her books like The BibleMoby Dick, Atlas Shrugged. So it might take her a while to finish them. I gave her The Martian because I felt bad for her. I was like, "This is a short, fun book! It'll be easy for you to read!" I had all these other books I wanted to recommend, but I was just like, "I can't give you anything hard after hearing your list."

Wathen: Yeah, that's really unfortunately. You could totally bomb her with a very long book. 20 books from other people, hmm.

Lapera: Yeah, 20 books. Maybe you should consider that one. Think about it. (laughs) 

Wathen: I don't know, I would have to ask certain friends. I would game it. So I don't think I could do it honestly.

Lapera: (laughs) So, my New Year's resolutions, I don't know if you know this, but in Venezuela, there are a bunch of New Year's traditions that you have to do every year. The first one is you have a glass of champagne and you put silver coins in it, and you toast with that, and that's for lots of money. So obviously, I did that, because who doesn't want lots of money? And the second one is that you eat 12 grapes as quickly as possible after you toast with your champagne, and you try not to choke to death, and each grape is a wish. The choking to death part is really key. I've almost done that two years. (laughs) It was pretty scary. Grapes really go down, pretty easily, the wrong pipe. Then, the third thing that you're supposed to do is, if you want to travel a lot, you're supposed to take your luggage and run around the block as fast as you can, which I also do every year, and it clearly worked last year because I went to Asia and Louisville, Kentucky. 

Wathen: Right, and that's a good one because it teaches you not to carry so much luggage when you travel, right? Just carry-ons for that part of the New Year's resolution.

Lapera: Exactly. I know some people who do it with full-on suitcases, like the rolling luggage, or the big old Samsonite ones. That's what my parents do it with. And I'm just like, "No, I'm just going to take a backpack. This will be representative of my journey, my very lightly packed journey." But because I want to travel a lot in 2017, I made a few different New Year's resolutions. The first one is that I am going to look for a side job, some part-time work for Gaby Lapera. That is because I want to travel and spend money, and that's a little bit of luxury, but I also -- this brings me to my second resolution -- want to max out my Roth IRA in 2017. Contribution limits for people who are under 50 is $5,500 for the whole year, and it's $6,500 if you're over 50. I still have to pay rent and stuff like that, so in order to do everything I want to do, I'd like to pick up a side job so I don't feel panicked about my money situation. This is not a new thing for me. I've worked plenty of second jobs before. Although, this one is nice, because I don't have to commit 30 hours a week. I'm only going to be working like 45 to 50 hours a week, which is totally cool. It's not like back in the day when it was 80 hours a week. That was rough. 

So, that should be fun. It's really easy to find a side job, too. I don't know if you've ever done this, Jordan, but I always try and find something that already fits into my life. So, I've given horseback riding lessons in exchange for money and a break on my horse boarding, or lessons for myself. Or, I've made friends with bartenders and bartended on weekends every once in awhile. Stuff like that, stuff that I'm already doing anyway, so it's easy to fit into my life.

And then my third resolution. I don't know if you guys read my resolutions last year. It was to start an emergency fund, which I accomplished. I completed my emergency fund, go me. And, to buy 20 stocks. Literally, I don't know what I was thinking. 20 stocks is so many stocks. Jordan?

Wathen: Yeah, that's a lot. Academic research says 30 basically gets you the market returns, so with 20, you're well on your way.

Lapera: Yeah, it was insane. I didn't even buy one. Not even one, unless you want to count the 8 million that I bought by buying a ton of index funds, because I was basically like, "You know what I like way better than researching stocks? Buying index funds." (laughs) 

Wathen: Well, it's understandable. To a certain degree, to buy 20 with the contributions from one year, you would pay a fortune in commissions. So, it makes sense.

Lapera: Yeah. So, this year, I decided to tone it down a little bit. I'm only going to buy five stocks, one in each sector of Industry Focus. I figure this is way more doable, because I can ask the other hosts of Industry Focus who are experts in their sector, and they can be like, "Oh, yeah, consumer goods, everyone knows XYZ!" And I'll be like, "I didn't know X or Z, but I did know Y, so thanks for the other two." (laughs) So, that's the plan. Those are my financial New Year's resolutions. I love resolutions. I write so many every year.

Wathen: I think they're good, I just have a hard time with it. One thing I do do, for financial purposes this time of year, is I like to take a look at everything I'm spending money on automatically. It seems like there's so many stupid little things that cost $10 a month or $20 a month or whatever that just slowly eat away. And I like to review those and be like, "Do I really need this? And if I really need it, can I reduce it?"

Lapera: Yeah, it's like a new year cleaning. It's like spring cleaning but earlier.

Wathen: Right, exactly. Like, I don't even have cable anymore, because that died one year, and my review, I was like, I don't even watch TV as much as I should if I'm going to spend this much on it. So, over time, I just have killed so many expenses that way, just looking at it.

Lapera: Yeah, that's a good resolution. Also, if anyone is curious about any of my non-financial resolutions, feel free to write to [email protected], I'll send you a whole list. It's like eight or nine resolutions. I go resolution crazy. But, to be fair, one of them has been the same since I was in high school, and it's to drink more water. I don't really drink that much water. I drink a heap ton of tea. And I read an article a couple years ago about this guy who gave himself a kidney disorder from drinking way too much tea, and it freaked me out.

So, Jordan, this is the part of the show where we turn to you. Listeners, Jordan wrote an article last year about his predictions, 12 predictions, one for each month, just like my grapes, for high-yield BDCs. And we are going to ask Jordan how he did with those predictions.

Wathen: I think I actually did pretty well, but we'll let readers judge. The article is still online, you can search for it, it's "12 Predictions for High Yield BDCs."

Lapera: And I can send it to you if you want it, [email protected]. We really like emails. That's why I keep plugging our email.

Wathen: Also, too, on every article I ever write, my email is in my profile, you can send me an email. A lot of people do. It's interesting. I actually enjoy it, because then I know what people want to hear about. So, definitely send some emails.

Lapera: Yes. So, your first one was "Activism will flourish." Did that happen?

Wathen: Yeah, that was a big theme in 2016. Let's step back and talk about what a BDC is really quickly.

Lapera: Good idea.

Wathen: A business development company, or BDC, lends money, generally, to smaller businesses in the United States. So, companies that are too small to list on Wall Street that don't have any access to money in that fashion will borrow money from a BDC, typically at very high interest rates. It's usually part of something like a private equity buyout. So, a private equity identifies this company, they want to buy it out, they will borrow money from a BDC to do that and leverage their equity investment in a company. That's what a BDC does. What had happened in the second half of 2015 is that a lot of these BDCs were selling for less than book value. That'd be the equivalent to owning an index fund and it selling for way less than what all the stocks in it are worth. So, activists basically said, "Hey, that's not right. If the market isn't valuing every dollar of assets that you own at a dollar, why are we letting you run it? Let's just shut this down, liquidate it, and cash out." And for a lot of BDCs, they attracted this activist attention. 

Whether or not they were successful, I'm going to give myself a failure on this one, I said that activism would flourish. There were a couple of activist targets. Some of them basically didn't pan out so well. There were two BDCs managed by Fifth Street Asset Management. They went after them. Fifth Street Asset Management bought them off. That didn't turn out so well. The one success story was that American Capital was sold to Ares Capital this year. That was the one activist success this year.

Lapera: OK. Also, for listeners, we're talking about high-yield BDCs. In general, when you see high-yield anything, just assume there's something hinky going on. When companies have high yields like that, it generally means that there's something very risky happening, because high yields don't appear out of nowhere. And when we're talking high yields, we're talking 2X-3X the S&P 500 average.

Wathen: Easily. More like 5X, even. Looking at 10-12%.

Lapera: Yeah, that's a lot. If you see anything in the double digits -- really, anything above 5% -- start asking yourself, "What's wrong with this company? Should I really be trusting them?" This is the exact type of BDC we're talking about. Was there a "BDC takeover" in 2016?

Wathen: There wasn't. Jordan's wrong again. There's not really a reason to spend much time here. What happened was, in early 2016, oil prices crashed. A lot of people thought a lot of these debt investments in oil companies would immediately go to 0. Some did, some didn't. But no, there was no troubled BDC takeover, so mark that as a wrong, too.

Lapera: "Congress will support BDCs?"

Wathen: Also wrong. Everyone has thought this would happen for a long time. One of the protections that investors have in BDCs is that they're limited to one-to-one leverage. So, their debt-to-equity ratio must be less than one-to-one. For a long time, they've talked about increasing that to two-to-one, so you could have $2 of debt for every $1 in equity. For years, I think I've heard about this since 2012, it's been one of the things that would give BDCs a massive lift, if they could use more leverage. To date, it seems to always get stuck with regulators, which I'm not sure is a bad thing, actually.

Lapera: Yeah, I don't think it's a bad thing at all. But we both know how I feel about BDCs. Listeners, if you don't, we have plenty of episodes. Just search Industry Focus BDCs on Google, I'm sure they'll pop up. Do you think that might happen in 2017? A lot of people are gambling on deregulation with the new administration.

Wathen: That's an interesting thing. Someone by the name of Mick Mulvaney -- I don't think I pronounced that right, but that's OK -- he was Trump's pick for the Office of Management and Budget. And he sponsored this bill, and a lot of people think he'll be a birdie in Trump's ear, saying, "Hey, sign this if it comes through." I don't know. I'm not so certain it's such a good thing anyway. I think the good BDCs would use it wisely, and a lot of them would use it in very charitable ways. But when you're making a risky investment, I'm not sure you need more leverage.

Lapera: Yeah. OK. So, the rest of them, I believe, you said you got right.

Wathen: Yeah. For the most part, I think the rest of them I nailed.

Lapera: There were "Fewer new listings."

Wathen: There wasn't a single IPO this year. The last one to go public, I believe, was Goldman Sachs(NYSE: GS) BDC, and it really told the story of how out of favor these stocks were, because when Goldman Sachs took its BDC public, they actually said, "Hey, if this sells for less than book value, we'll buy back stock," which is something that never happens in BDC-land whatsoever.

Lapera: Right. And there was also, you said that "Portfolio quality will generally deteriorate."

Wathen: Yeah, I think we can definitely mark that as a yes, but that's an easy one. Time is going on now since the great financial crisis. So the credits you're seeing now that the BDCs are underwriting aren't nearly as good as the credits they saw in, say, 2010 or 2011, when there was more borrowers than money. Now, it seems like there's more money than borrowers.

Lapera: "BDCs will dose up on activist repellent."

Wathen: Oh, so many. This actually happened before I wrote the article, but Medley Capital reduced their fees. Then, after that, you had Fifth Street Finance, they reduced their fees. You have PennantPark Investments, they reduced their fees.

Lapera: And this is activist repellent because it makes activists less interested in trying to take over the BDCs because they're being more responsible.

Wathen: Right. The idea is, by reducing fees, it makes you less of a target. Typically, BDCs with lower fees or expenses will trade at higher prices relative to book value.

Lapera: CLOs -- "BDCs will stop investing in CLOs."

Wathen: Definitely. I think that happened for the most part. This was kind of a continuation of a trend, this wasn't a bold prediction. Investors, for the most part, have priced BDCs that invest in CLOs at less than book value. So, you can invest in them all you want, but as a manager of a BDC, you would prefer your BDC to trade above book value, so you can raise more money, raise more assets under management, and generate more fee income. So, when the investor community says, "Hey, we don't want to invest in BDCs that own CLOs," you say, "OK, we shouldn't hold CLOs." It's not in your interest to do so.

Lapera: Right. For listeners, a CLO is a collateralized loan obligation, which is basically a security that is made up of a bunch of debt, and it's often not very good debt, it's low-rated stuff. It's no good. Imagine how the mortgage-backed securities were right before the financial crisis -- that's basically CLOs.

Wathen: Yeah. CLOs have performed well through the crisis. The thing is, there's just so much leverage with them. Typical disclosure will be 8X-15X leverage with these vehicles. So, it only takes a fairly low default rate and a fairly low loss on default for a CLO to go close to zero, the bottom tranche of the CLO that BDCs invest in.

Lapera: Yeah. I'm going to quickly go through the other ones because we're running a little bit short on time. You said that "Not one BDC will liquidate."

Wathen: That didn't happen. There's a small one that's in the process of it, I don't think it'll happen.

Lapera: Ah, but it didn't happen until 2017, so you were right about 2016! (laughs) 

Wathen: I'll give credit to American Capital, which sold out to Ares Capital this year. There was more cash involved in that deal than stock, but it didn't completely liquidate, so.

Lapera: Yeah. "Dividend cuts will continue," which did happen.

Wathen: Yeah, I think 25% of the industry cut their dividends last year.

Lapera: Which is very responsible of them. Good for BDCs. It's kind of like when you have a juvenile delinquent and they go to school every day for a semester and you're like, "Good job! Awesome for doing what you should have done!" (laughs) That's how I feel about BDCs. "New focus by investors" -- investors are going to focus more on BDCs' net income than net investment income, which holds the BDC more accountable to actually meet performance metrics.

Wathen: Right. It's more about underwriting quality. Anybody can generate interest income. It's whether or not you can keep it and not lose it to bad loans. I don't know if we can quantify that, so I'm going to say yes/no/maybe/I don't know if that prediction was true.

Lapera: Yeah. "Individual investors play a bigger role in governance." It looks like individual stockholders are voting more on BDC proxies this year, which is good.

Wathen: Yeah, it was awesome. In one case -- I'm just going to give one case here -- Goldman Sachs' BDC asked their shareholders for the right to issue stock below book value. And their shareholders voted no. And Goldman Sachs, to its credit, didn't fight it, they didn't push off the annual meeting or anything. They said, "OK, fine, we won't do it, we don't need to do it," and life went on. A lot of BDCs would have suspended the annual meeting, pushed back the time, and then basically gone to people and ring their necks over and go, "No, vote for this, it's terrible for your interest but do it." So I'll give them a lot of credit for that, and I'll give credit to their shareholder base for saying no.

Lapera: And then, the last one is, "There's more dispersion in performance."

Wathen: I think that's absolutely true. If you look on a price-to-book-value basis, the lowest priced BDC sells for 1/7 of the highest priced BDC on a price-to-book basis. I don't think there's any other way to say that definitely happened. The BDCs that are performing really well have traded really well, and the BDCs that have credit issues this year have just done terribly.

Lapera: Yeah. I looked at it, that means you get 9 out of 12 correct, which is 75%. Cs are for degrees, so are Ds, but you know what? You definitely passed.

Wathen: (laughs) Did I pass? And, the important thing to remember, I want to point this out, is that a lot of these predictions, if you nail one, you'll nail another. I said this before the show, but if you predict that it's going to be a very cold winter and the price of heating oil is going to go up, then you're probably going to get both of them right or both of them wrong. Balance it out.

Lapera: Definitely. Do you have any predictions for next year? Er, this year?

Wathen: Generally, first of all, activism, I think, is on hold. The median BDC trades at a 10% discount to book, so there's not really enough meat there, not enough room to make some money if you get in and mix things up. Secondly, this is really more of a warning, you really need to be very careful about this idea that rising rates will be generally good for BDCs, and you'll get all these dividend increases. I think what will happen, and what we'll see, is that over time, rising rates will lead to higher income, but it'll offset would-be dividend cuts, rather than lead to increasing dividends to investors.

Lapera: OK. So, I'm going to remember that, and I'm going to ask you about this next year, in 2018. (laughs) Be ready. Listeners, thank you very much for joining us. I know I said it would be a short episode -- or, at least I did before the episode started -- but we didn't do that because we never do that. As usual, people on the program may have interests in the stocks that they talk about and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at [email protected], or by tweeting us @MFIndustryFocus. Again, if you want to look at our resolutions in one central location, head to You can also email us your resolutions at [email protected], or by tweeting us. Wouldn't that be exciting? We'll have a little resolutions party! Thank you to Austin Morgan. Austin, do you have any New Year's resolutions this year?

Austin Morgan: I do not. I don't normally make resolutions.

Lapera: So many non-resolutioners! I'll give you one after the show.

Morgan: Alright.

Lapera: Thanks again to Austin. He's today's producer. And, thank you to you all for joining us. Everyone, have a great week!