Solar Capital’s Stellar Yield


While addressing the CFA Institute in May, legendary value investor Seth Klarman suggested the stock market could suffer another decade without gains. That’s not something most investors want to hear. While awfully pessimistic, you have to consider the source credible. Klarman’s Baupost Group seeks out-of-favor stocks so a down market would certainly make his job easier. However, at his annual meeting in May, Klarman suggested he might return cash (currently sitting around $6 billion in cash) to investors if it got any higher.

With that in mind, I will write a series of five articles covering some of his current holdings. At the end of March 2009, Baupost Group reported holding 42 stocks in its 13F filing. One year later, this number is down to 19. The first we’ll talk about is Solar Capital (Nasdaq:SLRC), a closed-end fund operating as a business development company. Baupost invested prior to the IPO in February and holds 6.1% of its shares.

Average Size Deal
Solar Capital’s investments generally range between $20 million and $100 million and are a combination of debt and equity. It seeks to achieve both current income and long-term capital appreciation from its investments, which focus on middle market companies. At the end of its first quarter, it had investments in 33 companies with a total fair value of $839 million. It made one new investment in the quarter and added to an existing one for a total of $44.6 million.

The biggest portion of its investments is in subordinated debt and corporate notes, which represent 77% of the portfolio. Its income-producing investments yielded an average of 13.8% during the quarter, down 100 basis points year-over-year. Although slightly lower, overall it generated $1.90 a share in earnings compared to a loss of 78 cents in the same quarter a year earlier. Most business development companies fared well in the first quarter. So what is it that Seth Klarman sees in Solar Capital that he doesn’t see in other publicly traded BDCs?  

Analysts Like It
Since Solar went public in February, no less than seven analysts have initiated coverage of the BDC with six of them rating it a “Buy” and one “neutral.” This is a unanimously positive outlook. When Citigroup initiated coverage in March, it suggested Solar was trading at a discount to its peers, giving it a 12-month price target of $23. The median is $24. Based on current prices, it’s trading 18% below its 12-month target. This puts it in the same ballpark as other business development companies such as Ares Capital (Nasdaq:ARCC), which is 17% below its 12-month target, Apollo Investment (Nasdaq:AINV) at 20%, MVC Capital (NYSE:MVC) at 18% and Pennant Park (Nasdaq:PNNT) at 17%.

So, despite the fact analysts are bullish on Solar Capital, it doesn’t appear they see any short-term catalysts to warrant a higher target. Its current 2010 earnings per share estimate is $2.30, giving it a forward P/E of 8.6, which is similar to its peers. Maybe a look at some of its individual investments will provide a clue.  

A Few Familiar Names
As mentioned earlier, the biggest portion of its $839 million portfolio is in subordinated debt and corporate notes. The single largest investment outstanding is a $103 million loan at 14% to DS Waters, one of America’s largest water-cooler delivery companies. Owned by private equity firm Kelso & Company since 2005, the loan matures in April 2012. Given Kelso’s average holding period is five-and-a-half years, I’d expect it will be repaid before then. In the meantime, it’s providing a substantial amount of income.

Other loans with companies you might be familiar with include Earthbound Farms, a California provider of organic salads and fruits and vegetables; Direct Buy, America’s largest direct-to-consumer home furnishings club; and Rug Doctor, a manufacturer of rug cleaning machines and products. Its equity investments, which include five million shares in Direct Buy, have taken a hit. Fair value at the end of March was $51 million but cost $113 million. However, its equity investments represent just 11.5% of its overall portfolio. High-yield debt is definitely where it makes its money. I suspect Klarman likes Solar because it generates a total return he doesn’t believe can be had from other equity investments. You can’t argue with his success.  

Bottom Line
Seth Klarman believes price is everything when buying stocks. He’ll accumulate cash waiting for the right opportunity. Buying into Solar Capital tells me he believes it’s a good deal at current prices. Time will tell if he’s right. (For a look a differing view, check out Why Being A Copycat Investor Can Get You Hurt.)

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