As annual reports flow in for business development companies, I can't get my eye off one particular: Main Street Capital (NYSE:MAIN).
I'm stuck on it because it is the undisputed star in the industry, delivering excellent returns for its shareholders since IPO. Naturally, as an investor, I want to know why Main Street has performed so well. Is it a "special sauce," or is it just luck?
Breaking down returns
When you look at BDCs, it's important you differentiate between stock returns and the return of the underlying portfolio. Main Street Capital has experienced some multiple expansion, meaning investors are willing to pay a higher multiple of book value today than in past periods.
What we really want to find is the returns underlying the share price. Main Street Capital is nothing more than a closed-end investment fund. The performance of its investments, not the movements of its share price, is more important to understanding whether or not Main Street is truly outperforming other BDCs.
By all indications, the stock price is just following the incredible returns of the investment portfolio.
The chart above shows the change in Main Street Capital's Net Asset Value from its operating activities. That is, growth in NAV that comes from its investments, not from simply issuing new shares at a premium.
Notice, in every year, Main Street Capital increased its net asset value per share, even during the darkest days of the Great Recession. Its strong performance was due to spectacular underwriting, as it realized losses on exited investments in only two years since its IPO -- 2009 and 2010.
Main Street Capital's investing strategy
Main Street's CEO, Vince Foster, has previously praised the company's underwriting, simplifying it to a process of "try[ing] to pick the ones that are most likely to make it through."
On the last conference call, Foster provided more detail to Main Street Capital's underwriting process.
"So what we do is we have a target leverage ratio and debt coverage ratio such that the EBITDA can get cut in half before they are unable to service their debt."
Let's cut through the finance-speak. Main Street Capital underwrites investments so that a measure of earnings can fall by 50% before its investments become troubled.
This is what Warren Buffett and Ben Graham would call a "margin of safety." By underwriting conservatively, Main Street Capital knows its portfolio companies can afford to pay them back in all but the very worst case scenarios.
Often, the projected worst case scenario never happens. In such a case, a wide margin of safety only adds to investment results, powering the bottom line.
It's not luck. It's a good process of careful and calculated underwriting.