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Prospects Look Gloomy for SBIC & Commercial Finance Industry

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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 offered by the industry participants also include 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 strong domestic economy is expected to boost demand for small business loans. However, lower interest rates are likely to hurt SBIC & commercial finance stocks, as it will result in lower investment income. Also, prepayments and refinancing are expected to rise, which may hamper profitability to some extent.
     
  • Regulatory changes are likely to work in favor of SBIC & commercial finance stocks. In 2018, an amendment to 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 (subject to board/shareholders approval). This will help these companies to reduce portfolio risk by investing in higher capital structures without foregoing current returns. In other words, the act has provided extra funding flexibility to these companies and will continue to offer 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 #161, which places it at the bottom 37% 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 disappointing 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. Over the past year, the industry’s earnings estimates for the current year have been revised 35.1% downward.

Despite this dismal near-term picture, we are presenting 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 three years.

While the stocks in this industry have collectively lost 7.6% over this period, the Zacks S&P 500 composite has rallied 44.2% and the Zacks Finance sector has grown 13.7%.

Three-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 1.14X. This compares to the highest level of 1.14X, lowest level of 0.71X and median of 0.97X 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 12.73X, 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 3.29X 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 regulatory changes and growing economy will support the industry in the near term, lower interest rates are likely to hamper SBIC & commercial finance stocks’ investment income to some extent.

Nonetheless, one can consider investing in some stocks in the industry that depict an upbeat earnings outlook.

We are presenting four stocks with a Zacks Rank #2 (Buy) that investors may consider betting on.

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

Ares Capital Corporation (ARCC - Free Report) : The stock of New York-based company has rallied 23.5% over the past two years. The Zacks Consensus Estimate for 2020 earnings has been revised marginally upward over the past 60 days.

Price and Consensus: ARCC

Gladstone Investment Corporation (GAIN - Free Report) : The stock of this McLean, VA-based company has gained 31% over the past two years. The consensus estimate for fiscal 2020 earnings has been revised 3.4% upward over the past 60 days.

Price and Consensus: GAIN

Goldman Sachs BDC, Inc. (GSBD - Free Report) : The consensus estimate for this New York-based company has moved 5.4% upward for 2020 earnings, over the past 60 days. The stock has rallied 3.3% over the past two years.

Price and Consensus: GSBD

Golub Capital BDC, Inc. (GBDC - Free Report) : The stock of this McLean, VA-based company has gained nearly 1% over the past two years. The consensus estimate for fiscal 2020 earnings has been revised 2.4% upward over the past 60 days.

Price and Consensus: GBDC

 

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