This article was coproduced with The Dividend Collectuh.

Introduction

With the Fed all but confirming that interest rates will likely be cut this month, I have to admit I was expecting a larger pullback within the business development company sector. However, many of the higher-quality BDCs and their share prices have held up well since the July CPI report showed inflation to be cooling, paving the way for interest rate cuts.

Although the BDC sector has seen a slight retraction over the past two months, insiders are still loading up on some business development companies. In this article I list two BDCs that have seen significant insider buying since the beginning of 2024.

One of the greatest investors to ever live once said,

“Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise.”

For me, when stocks I own or would consider owning see significant insider buying, it increases my confidence about my investment selections. And during the past nine months insiders have been buying BDCs, signaling their prices could go higher. Two, Golub Capital BDC (GBDC) and Capital Southwest (CSWC), have seen just that since January of this year.

Insider Buying Could Mean Higher Share Prices

In July I wrote an article: 2 REITs With Significant Insider Buying That Could See Further Upside pertaining to Agree Realty (ADC) and Armada Hoffler Properties (AHH).

Since then, Agree Realty is up 11.31% from $67 to nearly $75 where they trade at the time of writing. Armada Hoffler is up 4.2% from $11.60 to $12.10 over the same period. REITs have outperformed as a result of anticipated lower interest rates which lowers their cost of capital and opens the door for investment activity to pick up.

BDC No. 1: Golub Capital BDC

GBDC is a BDC that I don’t currently own but have been a big fan of for quite some time. One reason is the company lowered their incentive fee from 20% to 15% with the announcement of the merger with GBDC III that closed back in June.

This was expected to be accretive to their net investment income and was good news for shareholders. Management expected this to contribute $0.13 to their bottom line on an annualized basis.

During their latest quarterly earnings last month, the merger contributed to their NAV growth, with this up 1.3% from the prior quarter. NAV was $15.32. Additionally, this was up year-over-year 3.3% from $14.83 in Q3’23.

Net investment income of $0.48 was also up from the prior year, as well as total investment income. This came in at $171.3 million, up double digits from $154.7 million in Q3 from the prior year. During the quarter, the BDC also made 10 investments, adding two new ones for a total of $435 million. This was a significant increase from the $111 million in Q3’23.

Their overall portfolio performance was doing well, with 89.2% of their investments rated either 4 or 5, with 5 being the highest. This was a slight increase from 87.2% in the prior quarter. Moreover, with the merger complete, GBDC presents an attractive investment opportunity, especially since they trade at a current discount of 2.5% to their NAV.

GBDC’s balance sheet and dividend coverage was strong with coverage of 109%. Additionally, the BDC has no debt maturing until 2026 and had a leverage ratio below the sector median’s 1.17x at 1.05x.

In the chart below, you can see over the first nine months of 2024 insiders have been buying a substantial amount of shares in the company. Especially in the months of August and June.

Here are the transactions (open market buys) since the beginning of 2024:

Click to enlarge

However, since the beginning of June, Golub Capital BDC is down more than 10%, signaling now could be a great time to buy the stock while it’s trading at a discount to NAV.

Below, you can see GBDC trades at a slight discount in comparison to its peer group, further signaling now may be a good time to buy. As a result of them trading near their three-year discount of 3.1% and the recent merger, I rate Golub Capital BDC a buy.

BDC #2: Capital Southwest

The second BDC is one that I have owned for quite some time and one that has been my best performer in my portfolio during the high-interest rate environment. Although they’re the opposite of Golub Capital BDC and trade at a premium to their NAV, insiders have still been buying the stock, indicating it could see further upside.

During their fiscal year Q1 earnings back in August, the BDC posted a large beat on net investment income, beating analyst estimates by $0.19. Total investment income also beat by $2.26 million, coming in at $51.35 million. This was driven by higher interest income and new investments made. CSWC invested in three new companies and 11 existing ones for $108.1 million.

This was down slightly from $111.9 million in Q1’24. Pre-tax NII was $0.69, up $0.02 from $0.67 in the prior year’s quarter. TII also rose from $40.4 million over the same period. Their overall portfolio performance declined slightly from the prior year but was still performing well with 92.4% of investments rated 1 or 2. CSWC uses a different scale from GBDC, with 1 being rated highest and 4 rated lowest.

Their balance sheet and dividend coverage were also strong. In June, management raised the base dividend by 1.8% to $0.58 and paid a supplemental of $0.06. This still gave CSWC dividend coverage of 108% using pre-tax net investment income.

They also have no debt maturing until January 2026 with a low leverage ratio of just 0.75x, well below the sector median of 1.17x. This puts them in a favorable position to make investments in the future as well as continue to cover the dividend.

For the first nine months of 2024, insiders have been buying Capital Southwest despite their seemingly overvaluation. At the time of writing, the BDC trades at a premium of 51.4% above its NAV of $16.60.

Below you can see the amount of insider buying since the beginning of 2024 with a significant amount coming during the last quarter.

Below are the transactions (open market buys) since the beginning of 2024. Compared to Golub Capital, CSWC saw less significantly less insider buying than their peer, but that’s understandable as the BDC trades at a large premium to NAV compared to GBDC who currently trades at a discount.

Click to enlarge

Similarly, the stock is also down since the beginning of June, although less at nearly 3% compared to 10.13% for Golub Capital.

Below, you can see the large premium Capital Southwest trades at in comparison to its peer group. But due to the BDC’s performance during the high-interest rate environment with dividend increases and capital appreciation, it’s no surprise they command a large premium currently. However, due to the premium still significantly above their three-year historical average, I rate them a hold.

Investment Risks

As a result of their business structures, acting as banks (lenders) for small, sometimes distressed companies, a slowdown in the economy would likely cause an increase in non-accruals, or non-performing loans. At the end of their latest quarters, both BDCs had non-accruals accounting for 1% and 1.9%, respectively.

Moreover, with the Fed signaling the first rate cut may come in September, this could be due to an uptick in recession chances. It’s apparent the economy is somewhat slowing, with job openings falling more than anticipated for the month of July.

If the economy does slip into a recession, BDCs could see an uptick in non-performing loans as well as Payment-In-Kind income, and this is something investors looking to buy BDCs should pay close attention to going forward.

Bottom Line

Although insider buying is no clear indication that a stock may be undervalued, it could be a signal that they expect the share price to rise further in the future. Additionally, investors looking to buy BDCs due to their higher-than-normal yields should consider buying them at the right price, preferably at a discount to their NAV.

However, higher-quality BDCs could require lots of patience, as many normally trade at premiums above their NAV. But as expressed in this article, Golub Capital BDC is one of the few quality ones trading at a small discount currently.

Moreover, with interest rates likely to be much lower over the next 12 months, investors could see many BDC share prices retract further, giving them a better entry point in the future.