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Buy, Sell, or Hold: Solar Capital

By Selena Maranjian – Oct 12, 2012 at 9:09AM

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Does the potential here, along with an 11% dividend, outweigh the risks?

When considering any stock for your portfolio, don't be swayed by just the positives. Examine its pros and cons, and decide whether its possible upside outweighs its risks. Let's take a look at Solar Capital (SLRC 0.07%) today and see why you might want to buy, sell, or hold it.

Founded in 2007, based in New York, and with a market capitalization north of $800 million, Solar Capital, in its own words , "is a closed-end, externally managed, non-diversified management investment company that has elected to be treated as a business development company (BDC)."

The most obvious reason to be interested in Solar Capital is for the company is its dividend, which recently yielded a whopping 10.7%. It has also been boosting its investments and revenue by double-digit figures lately.

Then there's its business. For those who wish they could participate in private-equity investments, BDCs fit the bill. Such companies offer diversification, investing in a range of companies. They may span an operational range and a geographic one as well. But in Solar Capital's favor, it has focused its money domestically  and has thereby avoided the current mess in Europe that's kept many other companies down.

The companies in which Solar Capital has invested include Weetabix, Rug Doctor, Isotoner, Earthbound Farm, Vision Holdings, Ark Real Estate, and Midcap Financial, among others. Clearly, it's not too focused on any one industry.

Management seems to be another plus, with CEO Michael Gross having already founded another successful BDC, Apollo Investment (AINV 1.44%), which recently yielded 10%. My colleague Amanda Alix has noted that, "Apollo just closed a five-year, $100 million credit facility with Miller Energy Resources, a company that's looking to develop oil fields in Alaska," and pointed out that there's been some significant insider buying lately.

One reason to avoid Solar Capital is if its business structure doesn't fit your needs. Remember that it's not a typical company, making and selling something. Instead, as a Business Development Company (BDC), it invests in other companies and is essentially a publicly traded private equity company. Like real estate investment trusts (REITs), BDCs are required to pay out at least 90% of their earnings as dividends. That can be great, offering shareholders significant income, but as dividends are so strongly tied to earnings, payouts may be rather volatile.

Consider, for example, that while Solar Capital has been paying out $2.40 per year in dividends recently, its trailing 12 months' of earnings per share total just $1.70. That suggests a smaller dividend may happen.

Keep in mind, too, that since BDCs pay out most of their income in dividends, there's not much left for the company to reinvest in growth. Thus, while their shares may appreciate in value over time, they may not do so nearly as rapidly as well-selected common stocks.

BDCs also sometimes issue more shares at below-net-asset-value prices, which isn't always a good thing for shareholders. If you're investing in Solar Capital, this is worth keeping an eye out for. In recent years, Solar Capital's share count has held steady.

Another concern is that Solar Capital's free cash flow recently turned negative, largely due to paying down debt, which has risen sharply over the past year. Cash and equivalents, meanwhile, topped $200 million a few years ago, but has been around $10 to $12 million lately. It has a short but strong history of dividend increases, as well.

Hold (off)
Given the reasons to buy or sell Solar Capital, it's not unreasonable to decide to just hold off. You might want to wait for it to return to positive free cash flow, for example, or for it to increase its dividend, which has stayed constant since 2010.

If you're taken with the idea of BDCs, you might look at other ones, too, such as Main Street Capital (MAIN -0.38%), which recently yielded 7.4%. It favors investing in "traditional or basic businesses," and late-stages ones at that, preferring to avoid start-ups, which can be riskier.

You can also pursue hefty dividend yields via master limited partnerships (MLPs) such as Energy Transfer Partners (ETP), or mortgage REITs (real estate investment trusts) such as Chimera Investment (CIM -0.18%) or American Capital Agency (NASDAQ: AGNC).

Energy Transfer Partners, recently yielding 8.3%, specializes in midstream energy services, operating thousands of miles of pipelines for oil and gas. Bulls think its performance should get a big boost soon as various projects start delivering, and especially if the price of gas rises. Read up on MLPs, though, to understand their tax quirks. They can decrease taxable income, but they're more complicated than common stocks.

Chimera, meanwhile, invests in real-estate-related securities with borrowed money and profits from interest rate spreads. It recently sported a whopping 13.7% yield. (It's not without risks, though, so read up.)

The verdict
I'm going to pass on Solar Capital at the moment. Everyone's investment calculations are different, though, so do your own digging, and see what you think. Remember that there are plenty of other compelling stocks out there.

Longtime Fool contributor Selena Maranjian, whom you can follow on Twitterhas no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Apollo Investment. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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