NEW YORK (TheStreet) -- Double-digit yields are a double-edged sword. That kind of income is hard to beat -- until it gets cut.
So goes the opportunity to buy THL Credit, Inc. (TCRD) - Get Report before this Tuesday's earnings report. THL Credit has paid out $0.34 per share for seven quarters in a row and never had a dividend cut since going public on April 21, 2010.
Will this be THL's first ever cut? Or, might it be the fourth time the company has declared an additional special dividend of $0.05 to $0.08? Or, might it be the 10th time the company has raised its dividend?
At Baton Investing, we believe that the odds of a positive or neutral announcement on the Tuesday, March 10 earnings call outweigh the negative possibilities. For the three months ended September 30, 2014 and 2013, net investment income totaled $12.2 million and $11.6 million, respectively, or $0.36 and $0.34 per share.
That growth is important because THL Credit is a business development company and must pay out 98% of its investment income and capital gains to shareholders.
Business Development Companies
Created by the U.S. Congress in 1980, business development companies, also known as BDCs, have grown in popularity with individual investors over the last few years. There are now more than 50 BDC's traded publicly.
BDCs are essentially closed-end funds that provide financing to small and mid-sized businesses via short-term, unsecured loans. They give unaccredited investors a way to invest like venture capitalists but with much greater liquidity.
BDCs are similar to real estate investment trusts in that they are pass-through entities which generally do not pay corporate income tax. But there are a few criteria a BDC must meet in order to qualify as a "regulated investment company":
1. Invest at least 70% of its assets in U.S. companies which are either private or have less than $250 million of common equity.
2. Distribute at least 90% of its taxable income annually. (They must distribute at least 98% to avoid all corporate income taxes, and most do.)
3. Provide significant management oversight to the companies they invest in.
BDCs typically charge more than 10% interest on loans to their portfolio companies. And given that they must then payout 98% of that income to shareholders, it's easy to see why BDCs offer such great yields.
A High-Yielder That's Also 20% Undervalued
The S&P BDC Index includes 40 stocks and is down 10.6% over the past 12 months. Similarly, THL Credit has lost 21.5% of its value over the past 12 months, but has gained 8.1% in just the last month.
Despite the recent jump, the Baton algorithm, which takes into account the investing styles of great investors like Warret Buffett and Peter Lynch, rates THL as a strong buy. Our Martin Zweig model gives THL a 92% score while our Peter Lynch model gives it a 93%, meaning that our algorithms that are based on the investing styles of those two great investors rate THL Credit a strong buy.
Before frantically hitting the buy button, know that the Baton model is only right 56% of the time. But, that's been enough to beat the S&P 500 by more than 300% since 2003.
Let's see why Peter Lynch and his Growth at A Reasonable Price (GARP) methodology would buy THL Credit now. Here are three of Lynch's eight criteria that we evaluate every day on more than 6,000 stocks:
-- PEG Ratio: This is the calculation that put Lynch on the map and helped him deliver 29.2% annual returns for more than a decade at the helm of the Fidelity Magellan fund. The Price/Earnings/Growth (PEG) ratio is simply the price-to-earnings ratio divided by the three and five year average earnings-per-share growth rate for a company. For THL, the current price-to-earnings ratio of 9.63 divided by the growth rate of 23.65% yields a PEG ratio of 0.41. That's well below Lynch's limit of 1.0 and indicates that THL should be able to sustain its growth rate.
-- Equity/Assets Ratio: This measurement is used for financial intermediaries like BDC's instead of the Debt/Equity ratio. THL's ratio of 61% is well in excess of Lynch's minimum requirement of 5% and shows that THL (and most BDC's) are not over-leveraged.
-- Return on Assets: This is simply the earnings of a company divided by its total assets. ROA tells us how effectively a management team is using its assets to produce earnings. In the case of THL Credit, the ROA of 6.38% is greater than Lynch's minimum of 1%.
(You can watch Baton's chief investment officer, Jim Pearce, quickly explain why Martin Zweig would buy THL Credit now.)
Barring a dividend cut or other bad news on the March 10 after-the-bell earnings call, Baton recommends that investors buy THL Credit up to $14. It currently trades around $12.
If you're a bit of a gambler, you may want to buy THL before the earnings call. THL has no history of dividend cuts and the company seems to be able to continue paying out $0.34 a share, at a minimum. Even if the dividend does get cut, we expect it to still be north of 8%.
Or, you may want to just wait until Wednesday, March 11, to make your decision. Shareholders of record on March 16 will collect this double-digit yield on March 31.
Note: Baton Investing members and Baton management have seen a 2.4% gain since purchasing THL Credit on February 13, 2015 and will likely sell on March 13 when our 10-stock portfolio re-balances. Any sale would likely be due to the Baton algorithm identifying better opportunities rather than the downgrading of THL. All 12 years of trades are fully disclosed on our site.
This article is commentary by an independent contributor. At the time of publication, the author held TCRD.