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Outlook for SBIC & Commercial Finance Stocks Looks Gloomy

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The Zacks SBIC & Commercial Finance industry consists of companies that provide finance to small and mid-sized privately held developing firms, which are generally underserved by traditional banks and other lenders. Firms suffering from financial distress are the primary target clients of these lenders.

Products of these companies also includes mezzanine loans that typically pay high interest rates and could be converted into equity in the target firm.

Here are the three major themes in the industry:

  • Continued growth in domestic economy is expected to boost demand for small business loans. While higher interest rates are helping SBIC & commercial finance stocks to earn better investment income, it could reduce demand as borrowing is becoming expensive for clients. So, the net benefit is not expected to be significant.
     
  • Regulatory changes are expected to work in favor of SBIC & commercial finance stocks. In March 2018, an amendment in the Investment Company Act of 1940 by the Small Business Credit Availability Act eased the leverage limits for such companies, allowing them to increase their debt-to-equity leverage to 2:1 from 1:1. This has been helping these companies to lower portfolio risk by investing in higher capital structures without foregoing current returns. In other words, it has given extra funding flexibility to these companies and will continue to provide more growth opportunities.
     
  • SBIC & commercial finance companies are structured in such a way that they are required to pay nearly nothing in terms of corporate income taxes. Instead, these companies pay out nearly 90% of their annual investment income and capital gains to shareholders as dividends.

Zacks Industry Rank Indicates Dismal Prospects

The Zacks SBIC & Commercial Finance industry is a 37-stock group within the broader Zacks Finance sector. The industry currently carries a Zacks Industry Rank #168, which places it at the bottom 35% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates underperformance in the near term. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of dismal earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are gradually losing confidence in this group’s earnings growth potential.

Despite this disappointing picture for the near-term, we will present a few stocks that are well positioned to outperform the market based on a strong earnings outlook. Before doing this, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Underperforms Sector and S&P 500

The Zacks SBIC & Commercial Finance Industry has underperformed both the S&P 500 composite and its own sector over the past two years.

While the stocks in this industry have collectively lost 10.6% over this period, the Zacks S&P 500 composite has rallied 14.1% and the Zacks Finance sector 0.3%.

Two-Year Price Performance

 

Industry’s Valuation

One might get a good sense of the industry’s relative valuation by looking at its price-to-tangible book ratio (P/TBV), which is commonly used for valuing loan providers because of large variations in their earnings results from one quarter to the next.

The industry currently has a trailing 12-month P/TBV of 0.87X. This compares to the highest level of 1.13X, lowest level of 0.78X and median of 0.95X over the past five years. Additionally, the industry is trading at a significant discount when compared to the market at large, as the trailing 12-month P/TBV for the S&P 500 composite is 9.75X, as the chart below shows.

Price-to-Tangible Book Ratio (TTM)

 

As finance stocks typically have a low P/TBV ratio, comparing SBIC & commercial loan providers with the S&P 500 may not make sense to many investors. But a comparison of the group’s P/TBV ratio with that of its broader sector ensures that the group is trading at a decent discount. The Zacks Finance sector’s trailing 12-month P/TBV of 2.80X for the same period is way above the Zacks SBIC & Commercial Finance industry’s ratio, as the chart below shows.

Price-to-Tangible Book Ratio (TTM)

 

Bottom Line

While higher interest rates will continue to support SBIC & commercial finance stocks’ investment income, it could lower the demand for such loans as borrowing costs rise. Nonetheless, regulatory changes and growing economy will aid the industry in the near term. So, investing in this space could be rewarding.

One should particularly consider betting on stocks that depict an upbeat earnings outlook.

We are presenting one stock with a Zacks Rank #1 (Strong Buy) and two with a Zacks Rank #2 (Buy) that investors may consider betting on.

You can see the complete list of today’s Zacks #1 Rank stocks here.

Saratoga Investment Corp. (SAR - Free Report) : The stock of New York-based company has lost 3% over the past year. The Zacks Consensus Estimate for fiscal 2020 EPS has been revised marginally upward over the past 60 days. The stock sports a Zacks Rank 1.

Price and Consensus: SAR

GSV Capital Corp (GSVC - Free Report) : The stock of this Woodside, CA-based company has declined 24.4% over the past year. The consensus for 2019 EPS has been revised 70% upward over the past 60 days. The stock currently carries a Zacks Rank #2.

Price and Consensus: GSVC

TCP Capital Corp. (TCPC - Free Report) : The consensus EPS estimate for this Santa Monica, CA-based company has moved upward slightly for 2019, over the past 60 days. This Zacks Rank #2 stock has lost 10.2% over the past year.

Price and Consensus: TCPC

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