Saratoga Investment Stock: Breaching Inflation with a 9% Yield (NYSE:SAR)


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Investing for dividends can be much more rewarding than simply investing for capital gains alone. In effect, cash dividend payments provide recurring flows that come directly to you as an investor and can never be recovered by society. This contrasts with growth stocks which are fun to hold when they post unrealized capital gains, but can be downright depressing when they inevitably come back down to earth.

This brings me to Saratoga Investment (New York Stock Exchange: SAR), which is a growing BDC whose share price weakness has now taken the yield to an attractive high. This article highlights what makes SAR a decent income choice for those looking for income diversity, so let’s get started.

Why SAR?

Saratoga Investment is a growing externally managed BDC that provides financing solutions to middle market businesses in the United States. Currently, it has an $818 million investment portfolio diversified across 38 distinct sectors. As shown below, SAR mainly invests in defensive industries, with education, food, HVAC and healthcare software constituting its major segments.

Composition of Saratoga's Investment Portfolio

Composition of the SAR portfolio (Investor Presentation)

The portfolio is also well structured, comprising 77% senior secured debt, 5.4% junior debt and equity making up much of the remainder at 15.4% of the fair value of the portfolio. While equity investments tend to be riskier than debt securities, they offer greater potential for capital appreciation, which translates into an increase in net asset value per share.

SAR has seen consistent growth in NAV/share since inception, and this continued into the last quarter, the fourth quarter of fiscal 2022 (ending February 2022), with a 4% sequential increase in quarter-on-quarter and an increase of 17% year-on-year.

Saratoga Investment NAV per share

SAR NAV/Stock Growth (Investor Presentation)

Meanwhile, SAR’s debt portfolio appears to be in good shape, with 98.5% of its loan investments at the highest internal rating with zero defaults. It also offers a solid return on equity, with 13.9% over the last twelve months. As shown below, the current management team has done a good job of reshaping the credit quality of the portfolio over the years.

Credit quality of Saratoga's investment portfolio

Credit quality of the SAR portfolio (Investor Presentation)

Looking ahead, the SAR is well positioned for an environment of inflation and rising rates. This takes into account that 97% of its debt investments are variable rate with floors of 1.0% or more. It also maintains low leverage, with an asset/liability coverage ratio of 209%. This translates into a leverage ratio of 0.91x, well below the regulatory limit of 2.0x.

Risks to SARs include the possibility of a recession, which could cause financial difficulties for portfolio companies. This, however, is mitigated by the defensive nature of the portfolio, as management pointed out during the recent conference call:

Our subscription bar remains high, as usual, but we continue to find opportunities to deploy capital, as we will discuss shortly. Follow-up investments in existing borrowers with a strong business model, balance sheets continued to be an important avenue of capital deployment for us, as demonstrated by the 40 follow-ups over the past year, 19 in last quarter only, including deferred drawdowns.

A strong fundraising culture remains paramount at Saratoga. We approach every investment by working directly with management and ownership to thoroughly assess the long-term strength of the company and its business model. We strive to peer as deeply as possible into a business in order to accurately understand its underlying strength and characteristics.

Meanwhile, the stock’s significant year-to-date fall from a 52-week high of $30.25 to $23.26 pushed the dividend yield up to 9.1% . The dividend also remains hedged at a payout ratio of 94.6%, based on the adjusted NII per share of $2.24 for fiscal year 22 (ending February 2022).

I see value in the stock at the current price versus book value of just 0.79x, well below the level of around 1.0x over the past 12 months. Analysts on the sell side have a strong buy consensus rating with an average price target of $30.42, implying a potential total return of 40% including dividends.

SAR stock price to book

SAR price to book (Looking for Alpha)

Key takeaway for investors

Saratoga is an attractive high yield investment option, with a diversified and defensive portfolio, strong recent credit performance, low leverage and an attractive dividend yield. It is well prepared for a rising rate environment, and recent share price weakness provides a solid margin of safety for long-term income investors.

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