How To Buy A 12% Income Stream, With 20% Upside Potential, In A Zero Percent World

Interest rates have hovered in the 2% to 3% range for the last several years with no real end in sight.

Income investors are desperate to find decent yields for their investment dollars.

Business Development Companies (BDC’s) offer high yields and allocation diversity by their very nature.

OFS Capital Corporation’s share price would have to rise 81% just to trade with a PEG ratio of 1.

In today’s zero interest rate world income oriented investors are starved for yield and eagerly searching for ways to boost the income produced by their portfolios while minimizing their risk. Business Development Companies (BDC’s) can be an excellent way for small investors to take advantage of the opportunity to turn their money over to professional capital allocators and be well compensated for doing so while also achieving broad diversity in the number of businesses to which their capital is allocated. If this approach sounds interesting to you, then you will certainly want to consider the exceptional value currently offered in shares of OFS Capital Corporation (OFS, Financial) today.

OFS began trading as a public company in November 2012 and is an externally managed, closed-end, non-diversified investment company that is classified as a business development company under the Investment Company Act of 1940. This classification allows the company to pay no federal income tax in exchange for paying out at least 90% of its earnings as dividends to its shareholders. The shareholders are then taxed on the dividends at their nominal tax rate. Business development companies provide various sorts of assistance to small or medium size businesses that range from financing to consulting services. In exchange for this assistance, they are compensated through interest payments, consulting fees and even equity stakes in the businesses to whom they have provided services.

Due to the requirement for almost all of the income to be paid in dividends, the yield on BDC’s tends to be much higher than those paid by other classifications of businesses. The real benefit to this arrangement from the standpoint of individual investors is that good BDC’s are operated by people with significant expertise in assessing the risk/reward components of various businesses across various industries and are exceptionally adept when it comes to identifying excellent management teams. This structure allows small, passive investors to hire experts to pick exceptional management teams to whom their money can be loaned on very attractive terms and reap the majority of the benefits in the form of dividend payments equal to almost all of the operating profits.

OFS Capital's website describes their investment objective as being “to provide our shareholders with both current income and capital appreciation primarily through debt investments.”

The company focuses its investments on middle-market companies and their owners based in the U.S. Investments include asset classes in which our external manager has expertise, including in senior secured, unitranche, second-lien and mezzanine loans and equity securities. The company operates through two primary investment branches.

The senior loan fund segment of the business is comprised of senior-secured club loans to companies with an EBITDA generally in the range of $5 million to $50 million. The floating rate senior loans are match-funded through a floating rate credit facility with Wells Fargo.

The second arm of the business is the SBIC Fund and is focused on direct origination of structured debt and equity investments in companies with an EBITDA generally in the range of $3 million to $12 million. These debt instruments usually have a low-teens fixed rate of interest and, in certain instances, can include equity components. The SBIC Fund is financed through the long-term, fixed-rate SBA debenture program.

What Gives Us Downside Protection With This Business

My decided propensity toward value based investments always drives me to assess potential risk to my capital right from the start when I conduct my due diligence of a new prospect for allocation of my capital. In the case of OFS, I noticed that the share price has briefly dipped to about $11.20/share on a couple of occasions in the last of years as shown in the chart below. However, it has quickly bounced back on both of those occasions.

With the share price sitting at $11.80/share as of February 4th, there is only slightly more than 5% between the current price of the stock and what has served as a point of strong buying every time it has been reached over the past two years. That is quite attractive when it comes to assessing the potential for downside risk in a stock with the prospects of OFS. If we set a stop loss at $10.90/share on this position, we can limit our potential downside to no more than 7.63% of our allocated capital. This allows us to only exit the position in a case where the stock has fallen below its previous lowest point in the past two years. Should it fall that far, it could be an indication of some permanent impairment in the business that was missed in the original analysis. I believe it is of critical importance to understand my acceptable level of risk on each position I own before I ever own it and to thoroughly understand why that level of risk was set where it was. In some cases, the acceptable risk can be large and the reasons for it quite complex; in this case, the risk is small and the reason is simple.

Why Do I Want To Own This Business?

Peter Lynch, of Fidelty Magellan Fund fame, used to like to say that if you can’t explain your investment thesis with a crayon and a napkin, it is too complicated and you should avoid it. In the case of OFS, I believe I can meet that challenge as long as the napkin is a fairly large one.

This company and others like it fill a niche in the business market that is crucial to the overall economy and not recognized by many casual investors. It loans money to medium sized businesses that are too large for most local lenders and not quite large enough for the large national sources of capital. Having worked in small to mid-sized private business during most of my career, I have seen first-hand the struggles, even an excellent and profitable mid-sized business can have in trying to acquire needed capital.

OFS not only fits the bill in providing a necessary service to this under-served niche in the lending market it is very fairly valued in relation to its industry and its individual performance and prospects.

In regard to its current price compared to its present value, the table below reveals a very reasonable 12.5 P/E ratio based on 2014’s estimated final earnings of $0.95/share. If we look at the valuation of the shares using the projected earnings of $1.15/share for this current year, the P/E ratio falls to a very inexpensive 10.33 in a market that is trading for an average P/E of around 16 times earnings. As the table also displays, the analysts covering the stock have held their projected earnings fairly stable over the last 90 days and the only changes having been increases. This is quite encouraging.

When I find businesses filling critical functions, trading at very reasonable valuations with excellent downside protection, it is time to take a very serious look at the prospects for profit that might be present.

What Is The Upside Potential For OFS And How Do We Collect?

With Business Development Companies, we are buying for the dividend yield and then expecting modest growth in the earnings to provide us with increased dividend payments in the years to come. The dividend is the king in this sector. The table below shows the dividend payments made over the past several quarters by OFS.

The $1.36 in dividends paid over the past 4 quarters produces a yield of 11.4% against the current share price. This is a superb rate of return for something that is simply a buy and hold investment. Without consideration of any other aspect of this business, an 11.4% income stream on a passive investment is pretty attractive in today’s zero interest world.

There is, however, much more to like about OFS than just the dividend. The company’s earnings are currently experiencing tremendous growth and are projected to rise 21% in 2015 to $1.15/share and continue to grow at 22.6%/year for the next 5 years.

If the market simply continues to value the business at the current P/E multiple of 12.5 and the company meets the expected earnings of $1.15 for this year, the price of the stock would rise to $14.37 or 21.8% above its current price. With the dividend payments added to the potential capital gain, the total return in this stock over the next 12 months could easily be 33.2%. If the market were to assign an P/E multiple closer to the growth rate of the earnings to this stock, the potential gains become much, much larger.

This price target fall right in line with the average target of $14.50/share put forth by the two analysts providing 12-month price targets for the stock on Yahoo!Finance and displayed in the table below.

Why Does The Opportunity Exist?

OFS is a thinly traded stock with an average trading volume of under 25,000 shares a day. In other words, just about nobody knows it exists………..yet. Looking back at the Growth Estimate table above, you can clearly see that OFS is projected to grow faster than the industry over the next several years but is priced at a level that would require a rise of 50% in the share price to trade at a valuation on par with the other businesses in its industry. Why?

The company has only been publicly traded for just over two years and has not had time to build a strong following in the market. Only two analysts cover the stock and the company has not put a great deal of effort into preparing flashy press releases to draw attention to itself. The management team has simply gone about doing its job of returning value to the shareholders. Warren Buffet likes to say he wants share prices of the stocks he owns to stay low forever because it allows him to build huge positions at bargain prices. That is the situation we have today in OFS. Nobody knows who they are so there is nothing to drive the price higher and management is more focused on making money than generating publicity.

If OFS were to simply trade at a price to earnings growth multiple of 1, the share price would have to rise 81%. In order to trade at the same PEG ratio as the overall industry, the share price would have to triple. When the broader market figures out just how cheap this business is and how fast it is growing its earnings, you can bet the daily trading volume and the share price will both begin to rise rapidly.

Final Thoughts And Actionable Conclusions

I believe OFS Capital Corporation is one of the most undervalued stocks I have seen in a while and it certainly appears to be one of the best values in the market today. If the company does nothing more than what it is doing right now, the returns for investors will be very good. If the forward growth comes in anywhere near what the analysts covering the stock are projecting, at some point in the not too distant future, the share price is going to explode and reward those who invest now with exceptional returns. This stock is a bargain today and presents an exceptional buying opportunity all the way up to $13/share.