Saratoga Investment Stock: Lock In A 10% Yield At A Discount (NYSE:SAR)

It’s good to have a basket of high yielding stocks to help offset sticker shock when it comes to buying goods and services during times of inflation. But building an income stream takes time and patience, and the methodology that I advocate for is to have an income ladder of lower yielding C-Corps combined with higher yield REITs and BDCS. This helps to balance out risk while providing a steady and diverse source of recurring income.

This brings me to Saratoga Investment (NYSE:SAR), which is well positioned in a rising rate environment. It recently raised its dividend by a double-digit amount, and in this article, I highlight why the stock looks appealing for income investors, so let’s get started.

Why SAR?

Saratoga Investment is a growing externally-managed BDC that provides financing solutions to middle-market companies in the U.S. It’s one of the fastest growing BDCs on the market, having expanded its asset base by 10x over the past 10.5 years. At present, SAR has $955 million in assets under management that’s diversified across 42 industries.

As shown below, no one industry makes up more than 10% of SAR’s portfolio fair value and the majority of investments are spread across defensive industries like Healthcare Software, IT Services, HVAC, and Education.

Moreover, management maintains an overall safe investment profile, with 83% of the portfolio being dedicated to first lien secured loans, 2.5% second lien, 3.4% structured finance securities, and 9.3% common equity for bigger NAV per share appreciation potential.

This structure appears to have worked well for SAR, as it’s increased its NAV per share by 29% since FY 2017, with increases in 17 of the last 21 quarters. It’s worth noting that NAV per share did decline by $0.42 sequentially to $28.27. However, that has more to do with debt extinguishment and unrealized depreciation on investments than material weakness on existing investments, as shown below.

Meanwhile SAR’s overall portfolio remains healthy, with 95.6% of investments holding its highest internal rating (on a scale of performing, underperforming, and expected loss of principal), up by 0.6% sequentially, and with just one investment on non-accrual.

Plus, SAR is well positioned to benefit from interest rate spreads, as 98% of its interest-bearing portfolio is floating rate, while 95% of its own borrowings are at fixed rates. SAR is already seeing the benefit of higher rates, as its core BDC portfolio yield increased by 140 basis points to 9.9% in the last reported quarter.

SAR also maintains a safe regulatory asset coverage ratio of 184% (assets divided by liabilities), which translates to a debt to equity ratio of 119%, sitting well below the 200% regulatory limit. Management estimated at the time of the last earnings release that it has the ability to grow assets under management by 15% without the need for new external financing. This is due in part to SAR gaining its third SBIC license, providing valuable growth capital as management highlighted during the recent conference call:

We also announced the approval of our third SBIC license. This will allow us to continue to expand upon our existing investments in support of the SBA’s mission to provide growth capital to small businesses, which are so important to our economy. Our SBA guaranteed debentures are a great benefit to our capital structure, further enabling us to provide innovative and cost-effective solutions to the many smaller and middle-market companies we finance.

Notably, SAR recently increased its dividend by 26% to $0.68, and it now sits well above its pre-pandemic rate. While the dividend exceeds SAR’s GAAP NII per share of $0.64, it is a clear signal that management expects higher NII per share due additional investments and the benefit from higher interest rates.

Also encouraging, SAR’s external management has demonstrated a willingness to repurchases shares where they see value, as that contributed $0.03 to the aforementioned GAAP NII per share last quarter.

Lastly, I see value in SAR at the current price of $26.79 which equates to a 5% discount to NAV per share of $28.27. Given the strong portfolio fundamentals, I believe SAR deserves to trade at least at NAV, which potentially translates to a one-year total return in the mid-teens including the dividend.

Investor Takeaway

Saratoga Investment has a solid investment profile and is benefitting from higher interest rates. It recently raised its dividend by a substantial amount, signaling the potential for stronger earnings in its next quarterly results. With a 10% dividend yield and a 5% discount to NAV per share, SAR presents a good opportunity for income investors.