One of the greatest aspects of putting your money to work on Wall Street is that there’s no one-size-fits-all strategy to build wealth. Regardless of whether you prefer buying aggressive growth stocks or deep-discount value stocks, there’s a path to grow your nest egg over time.
But among these countless strategies, buying dividend stocks and holding them over long periods is tough to beat.
According to a report issued in 2013 by J.P. Morgan Asset Management, the wealth management division of money-center bank JPMorgan Chase, companies that initiated and grew their payouts between 1972 and 2012 averaged an annualized return of 9.5% over four decades. That compared to a meager annualized return of 1.6% for publicly traded companies with no payout over the same 40-year timeline.
With quite a few economic data points and predictive tools forecasting weakness to come for the U.S. economy (and stock market), I’ve begun gravitating toward profitable, time-tested dividend stocks. Last week, I opened a position in a high-octane stock that’s yielding nearly 13%, which, for some odd reason, Wall Street seems perfectly comfortable overlooking.
Ladies and gentlemen, say hello to an incredibly special, ultra-high-yield stock that’s flying completely under the radar: PennantPark Floating Rate Capital (PFLT 1.09%).
Higher interest rates and economic uncertainty are taking their toll
PennantPark Floating Rate Capital is a business development company (BDC). BDCs typically invest in the equity (common and preferred stock) or debt of micro-cap and small-cap companies, which are themselves commonly referred to as “middle-market companies.”
As of June 30, PennantPark’s investment portfolio totaled just over $1.1 billion, with $950.3 million in various debt investments and $154.9 million in preferred and common equity. In short, it’s predominantly a debt-focused BDC.
The concern for BDCs that hold debt in smaller businesses is that these unproven companies could fail to make their payments. As I pointed out, a number of indicators suggest the U.S. economy could weaken, including a historic yield-curve inversion, an 18-month decline in the Conference Board Leading Economic Index, the first notable drop in M2 money supply since the Great Depression, and a rare dip in commercial bank credit. Smaller businesses that aren’t yet time-tested could struggle if a U.S. recession takes shape, potentially leading to an increase in nonaccruals (delinquencies) for PennantPark.
Rapidly rising interest rates in another source of skepticism. Since March 2022, the Federal Reserve has increased the federal funds rate by 525 basis points — the fastest rate-hiking pace in more than four decades. For unproven middle-market companies subjected to variable-rate debt, the current pace of interest rate increases could be too difficult to bear.
Lastly, even though BDC’s typically offer supercharged dividend yields, three- and six-month Treasury bills are producing hearty 5.5% yields of their own. Treasuries are considerably less volatile than equities, which is clearly enticing some investors to choose the safety of short-term Treasuries over ultra-high-yield stocks like PennantPark.
This under-the-radar BDC is a hidden gem for income seekers
Every single publicly traded company has headwinds to contend with. But not every public company has the abundance of tailwinds PennantPark Floating Rate Capital has in its sails.
The first clear-cut benefit for PennantPark can be seen in the yield it receives on its debt investments. Since access to traditional debt and credit markets is often limited for micro-cap and small-cap companies, BDCs like PennantPark are able to net higher yields on the debt they hold. As of the June-ended quarter, its 12.4% weighted average yield on debt investments completely blows the yields on U.S. Treasury bills and bonds out of the water.
You might be wondering about nonaccruals, given that PennantPark focuses on unproven businesses. According to the company, just 1% of its overall portfolio was delinquent relative to the cost basis of its investments.
PennantPark’s secret sauce is its investment diversity. It’s put its money to work in 130 companies, with an average investment of $8.5 million. No single investment is critical to the success of PennantPark, nor can any one company sink the proverbial ship.
To build on this point, PennantPark’s management team has done a fantastic job of protecting its debt investments. All but $100,000 of the company’s $950.3 million debt investment portfolio is in first-lien secured debt. First-lien secured debt is first in line for repayment in the event that one of its borrowers seeks bankruptcy protection. Though this hasn’t been a problem, as evidenced by only 1% of its overall portfolio being delinquent at cost, it’s comforting to know that this protection is in place.
But the single biggest catalyst for PennantPark Floating Rate Capital is the structure of the debt it holds. Every single cent of its $950.3 million in debt investments is variable rate.
The central bank increasing interest rates at the fastest pace in decades is music to PennantPark’s ears and its income statement. Since Sept. 30, 2021, its weighted average yield on debt investments has expanded from 7.4% to 12.4%. With core inflation still elevated, the Fed won’t be in a rush to lower rates.
To sum things up, PennantPark Floating Rate Capital has a diverse, debt-focused portfolio with minimal delinquencies that’s perfectly positioned to benefit in a rising-rate environment.
The final piece of the puzzle is that PennantPark’s valuation makes sense. The company’s net asset value per share stood at $10.96 at the end of June. When my buy order executed this past Friday, Oct. 27, I paid $9.70 per share — a nearly 12% discount to book value.
The cherry on top is that PennantPark Floating Rate Capital pays its nearly 13%-yielding dividend on a monthly basis, and it’s raised its payout twice since the year began. With no rate cuts in sight, PennantPark has the look of an inexpensive money machine that’s set to reward patient shareholders.