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Pair Trade: Sell Small-Cap Bank Stocks, Buy Higher-Quality BDCs

Pair Trade: Sell Small-Cap Bank Stocks, Buy Higher-Quality BDCs - New Mountain Finance Corporation NYSE:NMFC, SCM

Banks and BDCs are becoming “increasingly less compelling,” following recent run-ups and the lack of profitability catalysts to support further valuation multiple expansion, Baird’s Bryce Rowe said in a report. He added, however, that investors should focus on higher-quality BDCs, which are likely to outperform, “given modest valuations and business models best suited to withstand the environment.”

Year-to-date, the BDC sector has gained 10.7 percent, versus 3.5 percent for the SNL Small Cap US Bank index. While the current BDC valuations do not offer many investment ideas, they do have longer-term upside potential, Rowe commented.

“For meaningful multiple expansion to take place in the BDC space, the market needs to further bifurcate between higher and lower quality names; we define higher quality BDCs as those names that are preserving capital and earning their cost of capital,” Rowe wrote.

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On the other hand, bank valuations appear “fair to full,” the analyst stated. In recent years, banks have been preserving their profitability mainly through expense management and funding cost reduction. These could reach a bottom going ahead and lowering the opportunities for further expense reduction.

Investment Ideas

Fidus Investment Corp FDUS 0.45%, Main Street Capital Corporation MAIN 0.18%, Monroe Capital Corp MRCC 0.38% and Triangle Capital Corporation TCAP 0.45% were cited by Rowe as the highest quality names and as being “among the top tier performers in the sector.”

“We continue to believe these four names are among the best long-term positions in any BDC portfolio given investing and operating models that have preserved capital while generating superior profitability levels,” the Baird report noted.

Citing valuation, the analyst downgraded the ratings on Stellus Capital Investment Corp SCM and New Mountain Finance Corp. NMFC 0.68% from Outperform to Neutral, with price targets of $11 and $13, respectively.

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