Main Street Capital: 1 Stock to Buy-and-Hold?

Main Street Capital is one of the most expensive business development companies on the market, leading many to ask whether the company is just too pricey at 1.6 times net asset value.

But valuation is relative. Expensive stocks aren't expensive if their performance makes up for a higher price.

Here are three reasons why I believe Main Street Capital deserves a premium to book value, and other business development companies.

1. It's better at what it does
Main Street Capital makes great loans, as it noted that only one loan on nonaccrual (not current on payments) and one fully impaired (worthless) investment together accounted for just 0.7% of its portfolio as of its latest quarterly report.

Main Street Capital's default rate is one of the lowest in the BDC universe. Only Prospect Capital has better performance, but that is partially due to how quickly it rectified problems with one of its poor performers, Wolf Energy, later taking it off nonaccrual. Prospect Capital reported nonperforming assets equal to just 0.3% of its total assets as of the last quarter.

Making great loans is paramount to generating returns for shareholders. If a BDC writes down 1% of its equity on a single investment, that single loss could remove as much as 10% of its return for the full year. There is small room for error when a BDC makes a new investment in a portfolio company.

2. Industry-leading returns on equity
Making high-quality loans is one thing. Making high-quality loans at high rates of return is another. This company is doing both.

Main Street Capital proves time and time again that it can write loans with double-digit rates that its borrowers can repay. In the last 12 months, Main Street Capital rewarded investors with 17.5% returns on equity, only slightly lower than the 20.6%, 19.3%, and 19.9% returns on equity it achieved in 2010, 2011, and 2012, respectively.

Behind these meteoric returns are three factors: leverage, which has averaged about 1.8 times equity; high unlevered returns on loans (15.1% from its lower middle market lending segment); and low operating costs equal to 1.7% of assets under management in the last year. Most BDCs have much higher operating costs due to the fact they are externally managed; Main Street Capital is internally managed. Its larger rival, Prospect Capital, operates on a 2-and-20 fee schedule, charging investors 2% of assets and 20% of returns.

3. Fewer "bubbly" investments
With rates at record lows, and private-equity funds awash with cash to invest, valuations for middle-market companies are surging. However, it's worth noting that in the lower middle market, where Main Street Capital makes the bulk of its investments, valuations haven't followed.

The lower middle market is ordinarily defined as including businesses that generate less than $10 million in annual earnings before interest, taxes, depreciation, and amortization. At that size, loans and equity investments aren't broadly shopped between investment firms. Thus, the market is less efficient, leading to better pricing.

Main Street Capital reported that its median lower middle market credit was levered at only 2.3 times EBITDA. Data from S&P Capital IQ shows multiples are much higher in the larger middle market, with firms levered up to 5.3 times EBITDA. Lower leverage means a better chance that Main Street Capital recoups its investment with interest on top.

Worth the price
Over the long haul, high returns on equity allow a company to boost its book value, lowering its valuation at a given market price. Main Street Capital may be priced higher than other BDCs, but given its excellent track record, high returns on equity, and lower-risk lending portfolio, the book-value premium may be worth it for investors who think in terms of decades, not days or weeks.

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The article Main Street Capital: 1 Stock to Buy-and-Hold? originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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