Most investors in their working and retirement years have probably heard of the 4% rule, which states that a retiree should aim to withdraw 4% of their investment balance each year. The question remains, however, about the types of investments to target in the first place.
For one, the S&P 500 (SPY) is still only yielding 1.6%, barely enough to meet the 4% rule without having to touch its principal, and we all know that selling the principal can be detrimental to a portfolio when the market is having a down year, as we find ourselves so far.
This brings me to Fidus Investment (NASDAQ: FDUS), which is a well-managed BDC that generates a high return that one can use to fund living expenses. This article highlights what makes the recent sale a good opportunity to layer on that name, so let’s get started.
Fidus Investment is an externally managed BDC that invests primarily in the lower middle market, as defined by US companies with annual revenues between $10M and $150M. It was founded in 2007 as a small business investment firm and went public as BDC in 2011.
Fidus targets businesses in niche markets with defensible market positioning, diversified customer and supplier bases, and strong free cash flow with deep capital buffers. Like some of its larger peers such as Main Street Capital (MAIN), FDUS primarily invests in the lower middle market space, which is highly fragmented with over 100,000 companies and offers attractive risk-adjusted returns.
Currently, it has a diversified portfolio totaling $812 million across 74 companies. 84% of Fidus’ investments are in the form of secured debt (59% first lien, 25% second lien), the remainder being higher yielding subordinated debt (7%) and equity (8.8% ) for a growth engine.
As shown below, the portfolio is primarily defensive in nature, with IT, business services, component manufacturing and specialist distribution comprising 62% of the portfolio.
Fidus maintains holdings in 82% of the companies in its portfolio. This strategy has worked well for Fidus, as equity represents 19.8% of the fair value of the portfolio, comparing favorably to the portfolio cost of 8.8% mentioned above. Since its IPO, FDUS has an impressive track record of $183 million in cumulative net realized capital gains. As shown below, FDUS has made equity gains every year since 2011 except 2013.
FDUS continued to demonstrate strong underlying fundamentals, with net asset value per share up $0.48 year-over-year to $19.91 in the first quarter. While the NII per share was down $0.03 from $0.42 year-over-year, it more than covers the regular dividend of $0.36 per quarter with a dividend coverage ratio of 1.17x. Unrecognized investments remain low at only 0.3% of the fair value of the portfolio.
Awaiting Q2 results and beyond, one would expect the NII per share to improve as Fidus maintains a very strong balance sheet, with a regulatory debt to equity ratio of just 0 .6x, well below the statutory limit of 2.0x.
Risks to FDUS include potential conflicts of interest due to external management and a slowdown in economic activity. Management, however, noted record levels of private capital on the sidelines as a potential safety net, as noted on the recent conference call:
Thus, the market today appears to be primarily focused on companies that have not been significantly impacted by COVID-19 or the supply chain issues and overall inflation dynamics that many companies are experiencing. and meet.
And, in fact, which we are, we continue to see a premium paid for businesses that operate without significant incident or concern of these issues. There is obviously good pent-up demand and plenty of cash to invest in high-quality assets.
In fact, I would say that private equity and private debt, a war chest for lack of a better word, are near record highs today. So as I would, as I sit here today, I would say activity levels are still reasonably strong in the lower middle market, but obviously a far cry from last year.
Finally, I find the current stock price of $17.83 attractive, especially after falling from the $20 level as recently as early June. This equates to a price-to-book ratio of just 0.9x, sitting at the low end of its trading range over the past year.
Analysts on the sell side have a consensus buy rating with an average price target of $20.90. This implies a potential total return of 25% over one year, including regular dividends. That could be higher given that FDUS paid out $0.24 per share of special dividends in the first half of this year alone.
Key takeaway for investors
Fidus Investment Corporation is a BDC that offers attractive risk-adjusted returns. It has a diversified portfolio in the defensive sectors of the fragmented lower middle market space and continues its strong track record by generating healthy gains on its equity investments. I find the stock and the well-hedged dividend attractive, especially after the recent decline in the share price.