I'll admit it: This is a twisted question because it assumes you should invest in business development companies. Should you?
There's a strong case to be made. First, those who index to the S&P 500 (NYSEMKT:SPY) do not own BDCs. So, if you index, you specifically exclude the effect of BDCs in your portfolio. Secondly, without BDCs, you really don't have any exposure to smaller, middle-market companies that aren't publicly traded.
But here's the real question: If you should own them, how much of your portfolio should be dedicated to BDCs, and what's a "safe" level of BDC exposure?
Financial academics around the world agree that 30 stocks is a relatively optimal balance between diversification and so-called "diworsification." That is, 30 stocks is the level at which you can be broadly diversified without adding more, lesser-quality stocks just to have more stocks in your portfolio.
With that in mind, we also have to consider industry-specific risks. Owning 30 oil stocks is not diversified. Neither is owning 100 financial stocks. If all your eggs are in one industry basket, you're taking very, very big risks. Diversification isn't helping you.
So, let's get back to the idea of owning BDCs. By their nature, BDCs are diversified. Prospect Capital (NASDAQ:PSEC) is a BDC that had investments in 124 portfolio companies as of the last quarter. So it's diversified, it's just very diversified in very, very small companies.
Don't forget the financial crisis
Given that BDCs are diversified in hundreds of portfolio companies, they should fare well in times of economic crisis, right?
Well, not exactly.
It's easy to forget how BDCs perform in times of economic peril when the economy is recovering from a financial crisis. Relative to 2009, everything seems rosy, but the truth is, economic calamity will come once again. In the last century, we've experienced two world wars, countless financial meltdowns, a great depression, and extreme inflation in the 1970s. If you think the next century will be different, I want you to reconsider that position. History repeats itself.
You, as an investor, want to make sure that if financial catastrophe strikes, you're still in the market with a positive balance -- even if you're just holding on to a chip and a chair.
With all that said, I went back to look at how the BDC industry performed through the 2009 financial crisis.
Here's a chart of BDC stocks over time (dividends are excluded):
The simple reality is that there is no such thing as a BDC safe haven. Sure, some BDCs like Main Street Capital (NYSE: MAIN) and Prospect Capital fared really well. Some, like Ares Capital (NASDAQ:ARCC) and American Capital Ltd. (NASDAQ: ACAS) , performed horribly, each losing more than two-thirds of their market value.
And we have to keep in mind that looking back at what we see today is a really bad way to look at the industry. Allied Capital, a private-equity BDC, essentially went bankrupt during the financial crisis. Ares Capital bought it out. Likewise, Patriot Capital suffered significant losses only to be bought out by Prospect Capital. American Capital faced technical default on its covenants during the financial crisis, and it survived only because it liquidated investments at the bottom of the market!
So, in 2013, it's all too easy to forget the carnage of 2008. Next year, that memory will fade when the huge losses fall off the free, five-year historical financial information you find on most financial portals.
I don't want you to be the kind of investor who ignores history just because that history is no longer in investors' memories. The horrible times of 2008 and 2009 did exist. I watched the Dow tumble more than 777 points in a day. You probably did, too. Don't let that memory fade.
But there's good news
I don't mean to be a Debbie Downer; I just want to give you a realistic view of how BDCs hold up to economic weakness.
All in all, BDCs are probably as safe as a small bank in a financial crisis. You see, most banks leverage assets at anywhere between 8-10 times over. So, a 1% loss on the asset level creates an 8%-10% loss in shareholders' equity. BDCs are limited to 2 times leverage.
But even that isn't an honest way to look at leverage. Ares Capital nearly lost it all in 2008 and 2009 even though it was levered less than 2 times over because of its balance sheet composition.
Ares Capital has a huge position in a private finance vehicle with General Electric. On the balance sheet, that partnership is treated as a debt investment, but it's really an equity position. Ares gets paid last, just like a shareholder would. So, in 2009, investors essentially treated that debt investment as being worth nothing.
The "safe" level of BDCs in your stock portfolio
It all boils down to the point that a position in BDCs should be smaller than 5%-10% of your portfolio. This is a highly cyclical, highly volatile industry.
And when you think about risk, I want you to also think about risk on the balance sheet.
Main Street Capital is probably one of the safest BDCs out there because it has very limited equity investments, and it doesn't have any weird quasi-equity positions like Ares Capital. So, relative to other BDCs, it's less risky. Of course, to buy Main Street Capital today means you pay a big premium to book value -- Wall Street recognizes its balance sheet stability.
On the other hand, a company like American Capital is very risky because a substantial part of its portfolio is invested in unsecured mezzanine debt and equity, or ownership stakes in the companies in its portfolio.
Bottom line, if your BDCs are mostly equity BDCs, you should make them a smaller position in your portfolio. Debt-heavy BDCs can be larger positions.
Even though it's tempting to go all-in on BDCs paying dividends of 8%-12% or more, this industry should just be a fraction of your total portfolio. Make it no more than one-tenth of what you have invested because the best amount to invest in any industry is the amount that you can lose and still stick to the plan. It's easy to commit to a portfolio in a bull market, but build a portfolio in such a way that you can commit to it in a bear market, too.
Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. 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.