Can you really “Grab a Government-Mandated 8.8% Yield?”

Sniffing out high-yielders teased by Bryan Perry's Cash Machine

By Travis Johnson, Stock Gumshoe, August 21, 2012

Bryan Perry runs the income-focused newsletter for Investorplace, providing the high-yield yin to the high-growth yang of Robert Hsu and Louis Navellier and others, and he aims to generate “double digit income.” It used to be, in fact that he aimed for 25% — which was lofty even in the days of higher interest rates — but the name of his newsletter changed a couple years back from the 25% Cash Machine to just Cash Machine.

And today, in his attempt to drum up new subscribers, he’s pitching that he’s got an investment idea that provides a government-mandated yield of 8.8% … along with a handful of other high-yielding ideas in the same sector. So what’s the big idea?

Well, here’s a bit from the ad to give you a wee taste:

“When this law first passed, most people didn’t even notice

“It was 1980, a much different time than today.

“There weren’t any 24/7 news channels. Most Americans didn’t concern themselves with big business or Wall Street. And they parked a lot of money in bank CDs, paying up to 19% annual interest at the time.

“Fast forward 32 years.

“The economy is slow, like it was then. Unemployment is high, like it was then. And despite what the government wants us to believe, everyday costs — for food, gas, health care and the like — are through the roof….

“… while this law was passed after intense lobbying by American businessmen, it also created a significant advantage for America savers, as well — especially in an age where Ben Bernanke has vowed to keep interest rates low seemingly “forever.”

“The company I’m writing to you about today — taking full advantage of this law for its big investors — will also pay you a luscious 8.8% annual yield.

“Not out of the goodness of their hearts — only because they must do so by law.”

So does that ring a bell for you? Yes, you in the back … correct! Perry is teasing Business Development Companies (BDCs), which are pass-through non-taxed entities that provide funding to small businesses. As far as taxes are concerned, they’re a little bit similar to Real Estate Investment Trusts (REITs), the company doesn’t have to pay any tax as long as they pass along almost all of their earnings to investors in the form of dividends — and like with REITs, you don’t get the dividend tax break on these distributions, though you can usually own them in tax-advantaged accounts if you want to.

BDC’s were set up to help provide more funding to small businesses, both by leveraging the use of small business lending programs from the government and by channeling private money to businesses that are kind of in the ignored middle — too big to be funded just by the local loan officer at the bank, too small to reasonably go public or issue bonds or to get fair treatment from the big Wall Street banks. So a Business Development Company will raise capital, lever up that capital with some debt of their own (usually modestly — they’re limited in the debt they can carry), and use that money to fund a portfolio of small businesses who need to build a factory or hire workers or get other seed or growth investment. In return, they charge pretty high interest rates on the loans to these relatively risky smaller companies and/or they get a “kicker” in the form of equity, seats on the board, options, warrants, or the like so they get some extra incentive to help the company do well. In many cases, the BDC is really an active venture capital or private equity-like investor, helping to shape strategy at their portfolio companies and helping them manage and grow their business, but some BDCs are more passive investors — there are a few BDCs and BDC-like companies that have a portfolio of just a dozen or less clients/investments, and others who have massive portfolios of hundreds of smaller loans, there’s a wide spectrum of strategies from wide diversification to active participation.

Other than the market crash, which really decimated these companies, many of them have shown some pretty good performance over the last 20 years, generating extremely high dividends for investors — they are generally quite cyclical, because the smaller companies they lend to are often very economically sensitive (small manufacturers, car dealers, etc.), but the financial crisis hurt them more than usual because they came under pressure for the debt they held as well as for the defaults and troubles of the companies they lend to — one of the big survivors of the crash, American Capital (ACAS), hasn’t even been able to resume its dividend yet, four years later. There have also been some scandals or near-scandals in this sector, particularly David Einhorn’s takedown of Allied Capital (ALD), which at the time was by far the biggest of the BDC’s and basically went out of business and was absorbed by a relative upstart competitor (though that was years after Einhorn published his accusations that ALD was defrauding the Small Business Administration and investors — ALD was able to keep churning along, raising equity more successfully and fighting back against Einhorn, for what was, at least in retrospect, a shockingly long time).

So which one is Bryan Perry teasing now? Well, he actually hints at a few … but we’ll start with that 8.8% yielder.

Here’s what he tells us about them:

“This stock’s estimated ex-dividend date is September 11. That means you must own it before that date to be entitled to its next quarterly distribution….

“This stock has done very well for subscribers to my Cash Machine service so far. In fact, we’ve enjoyed a 2-year 62% total return — in a slow economy and tough stock market….

“it lends to small and midsized companies, at premium rates, which translates into high yields for you.

“The company is extremely well-managed…models risk exceptionally well…and its stocks trades at a beta about half the S&P 500, which means it’s only half-as-volatile as the stock market as a whole.”

So … not a lot of clues. Ten years ago this would have been easy, because there were only four or five BDCs back then, but there are more than 30 publicly traded ones now so we’ll have to chuck those clues into the Thinkolator and hope for the best.

Ah … hmmm … still waiting. There we go, yes, this is very likely Ares Capital (ARCC), one of the biggest couple BDC’s and the one that bought Allied Capital a couple years ago. They do have a yield of right around 8.8% right now, which is actually on the low side for BDCs at the moment — though the many BDCs that yield between 10-12% are generally much smaller and carry much more perceived risk. This one has a long history of being teased and recommended, since it’s perceived as a big, relatively stable player and the yield has always been quite enticing — Nancy Zambell pitched it as a “fast double” back in the Spring of 2009 (and she was right, though pretty much everything that was at all risky doubled in those next six months), Ian Wyatt misleadingly pitched it as the “8.2% Manhattan Savings Account” about a year and a half ago and the shares are pretty much unchanged now from that tease (though you would have collected that rising dividend).

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So Ares is probably where most folks look first when they’re searching out a BDC, they carry a big, diversified portfolio and about 3/4 of their portfolio is either senior (first or second lien) or secured debt, so they’re not edging out into the riskier equity stuff very far or betting big on just a few companies.

I have not looked through ARCC’s filings or accounting at all, but on the surface they seem to be basically what a BDC should be — the price dipped slightly just recently because they had a secondary offering, but secondaries are quite common for BDCs … they can’t retain earnings because of the tax rules and the dividends, and their balance sheet is restricted, so they all eventually have to issue more equity if they want to grow their portfolios, but since their whole business is taking that money and investing it for gain, secondary offerings shouldn’t be particularly dilutive to earnings or dividends unless they offer them at really inopportune times when the shares trade at a steep discount. That particular offering didn’t look particularly worrisome, and the shares fell just a little bit.

Oh, and the “government mandated yield” bit? Yes, if Ares makes money they have to pass 90% or more of it along to shareholders like you … but if they don’t make money, or they make less money, the dividend can easily be cut or stopped, as we’ve seen with a couple BDCs that don’t currently make a profit or pay a dividend. They have to pass through income … but if there ain’t no income for whatever reason they don’t have anything to pass through, and the government certainly isn’t saying that they have to pay specifically an 8.8% yield.

Looks fairly reasonable right now, and Ares stands out in part because they only cut their dividend by about 15% in 2009, at a time when some BDCs went under, some cancelled dividends, and others cut them far more dramatically … but neither a rising share price nor a specific dividend is guaranteed by the gummint or anyone else. (ARCC, for what it’s worth, also saw its share price fall about 75% in the financial crisis — but by the time they cut the dividend, the price had already started it’s rapid recovery, so often these stocks react very violently on just the fear of a dividend cut or impending financial stress).

What else is being teased here? Three more BDC-type investments and … teaser of teasers, we’re out of time so I’ll tell you if I’ve found ’em all … tomorrow. If you want to start browsing around on your own, Harry Domash has the best directory of BDCs here, a good place to start your search.

Have you ever tried out Perry’s Cash Machine newsletter? We haven’t received any recent reviews or ratings of that one, so if you’ve ever subscribed or you subscribe now, please click here to let your fellow investors know what you think.


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