Taking It to the Banks
This year has gotten off to a good start for stock market investors. Through the first seven weeks of this year, the S&P 500 Index was up more than 6%. Tech stocks did even better, as evinced by the 12% rise in the NASDAQ Composite Index.
To be sure, those are solid results. But those returns pale in performance to the 22% gain racked up by Hercules Capital (NYSE: HTGC) this year (circled area in chart below).
Hercules Capital is a BDC (business development company) that makes loans to small businesses. Because those loans are riskier than standard bank loans, the company can charge higher interest rates.
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You can be forgiven if you’ve never heard of Hercules Capital. As a BDC, it doesn’t get much love from Wall Street. Only 25% of its shares are owned by institutional investors. The rest are held by individual investors like you and me.
Hercules Capital is a relatively small security with a market cap of around $2 billion. That makes it less than 1/100th the size of Bank of America (NYSE: BAC), which has a market cap of $280 billion.
But since BAC is huge and lends to big companies, it is popular on Wall Street. More than 70% of its shares are owned by the same institutional investors that shun HTGC. They are satisfied with the 2.5% dividend yield paid by BAC, which is considerably less than the current yield on the 10-year Treasury Note.
Hercules Capital pays a forward annual dividend yield of 9.6%. By law, it must pay out at least 90% of its taxable net income as dividend to avoid paying corporate income tax.
On February 16, Hercules released its fiscal 2022 Q4 and full year results (ended December 31). Despite rapidly rising interest rates last year, the company produced all-time highs for net debt growth, total investment income, and net investment income.
The big banks cannot make the same claim. Last year, Bank of America’s diluted EPS (earnings per share) fell to $3.19 from $3.57 in 2021. Wells Fargo (NYSE: WFC) saw its EPS drop from $1.38 in 2021 to just $0.67 last year.
Now, big banks are even more reluctant than usual to lend to small businesses. They fear a recession may drive many of those companies into bankruptcy, with little or no money to repay their debt.
That’s good news for Hercules Capital. Without big banks competing for that business, Hercules and other BDCs are negotiating from a position of strength.
That is one reason why Hercules’ assets under management (AUM) increased by 29% last year. Its customers need money, and right now BDCs are about the only lenders that will work with them.
Hercules Capital isn’t the only BDC benefiting from that trend. Through the end of last week, the VanEck BDC Income ETF (NSYE: BIZD) was up 9% so far this year. BIZD owns shares of 25 BDCs, including Hercules Capital at 4.5% of total assets.
The fund’s biggest holding is Ares Capital (NYSE: ARCC) at nearly 20% of total assets. Even though Ares is the most valuable BDC in the world, its market cap of $10 billion is still considerably less than that of most regional banks.
As well as BDCs have performed recently, they could do even better over the remainder of this year. That’s because most of the loans they make include “equity kickers,” which are stock options paid to the lender as bonuses when the loans are terminated.
What makes Hercules Capital especially attractive is that most of its borrowers are in the tech sector. The equity kickers it receives can rapidly escalate in value when one of its borrowers is acquired or goes public.
There haven’t been many liquidity events in the tech sector since the Fed started jacking up interest rates. Through the first ten months of 2022, the number of IPOs (initial public offerings) in the United States was about 90% less than the year before.
That means there is a lot of pent-up demand for tech IPOs. And when that money starts flowing in, Hercules Capital could see its investment income surge as those equity kickers are cashed out.
That could happen sooner than most people on Wall Street think. Once the Fed stops raising interest rates, the tech sector could soar. And when that happens, the equity kickers held by Hercules Capital could be worth a lot of money.
Editor’s Note: When we’ve put inflation and rate hikes behind us, certain innovative companies will explode on the upside. That’s where our colleague Dr. Joe Duarte comes in.
Dr. Duarte has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.
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