Updated on March 25th, 2019 by Josh Arnold
As the saying goes, if something looks too good to be true, it usually is just that. This can often be applied to unusually high-yielding dividend stocks.
For example, Stellus Capital Investment Corp. (SCM) has a 9.7% dividend yield, which is very attractive on the surface. The S&P 500 Index, on average, has a dividend yield of just 2%.
Stellus is one of only about 400 stocks with a 5%+ dividend yield. You can see the full list of established 5%+ yielding stocks here.
Not only that, but Stellus pays its dividend each month, rather than each quarter, like most companies. This helps to make Stellus stand out, as there are currently just ~40 monthly dividend stocks.
You can download the full list of monthly dividend stocks from our database below:
However, while double-digit dividend yields are very appealing in a relatively low-rate environment, investors must make sure the dividend is sustainable.
Stellus has a very high payout ratio, which is very near 100%. As a BDC, Stellus is required to distribute essentially all of its income, so its payout ratio will always be high.
However, it is in investors’ best interests to carefully monitor the company’s earnings performance for signs a cut in the distribution may be coming.
This article will discuss Stellus’ fundamentals as they pertain to supporting its nearly-10% yield.
Business Overview
Stellus is a Business Development Company, or BDC. It makes investments in small, predominantly private companies that are usually at an early stage in their growth cycles.
Stellus is a middle-market investment firm, and makes equity and debt investments in private middle-market companies.
Source: Investor presentation, page 4
The company’s portfolio is approaching $500 million. It typically invests relatively small amounts of $10 million to $30 million in each company, and underwrites to companies with positive EBITDA.
It also has a highly diversified investment portfolio, both geographically and in terms of industry concentration.
Source: Investor presentation, page 13
Stellus will make a variety of debt investments including first lien, second lien, uni-tranche, and mezzanine financing.
The investments are placed in a variety of industries, including business services, industrial, healthcare, technology, energy, consumer products, and finance.
Invested capital is used for a wide range of purposes, including acquisitions, growth investments, and more.
Stellus is externally-managed, by Stellus Capital Management LLC, a registered investment advisor.
The company follows a disciplined investment strategy. It has closed less than 2% of deals reviewed. Its relative selectiveness allows the company to focus on the highest-quality investments.
It also means the company has far more investment opportunities than it needs, enhancing its ability to select only the best investments.
Stellus generates particularly high yields from its first lien, second lien, and unsecured debt investments.
Source: Investor presentation, page 16
Stellus has originated more 1st lien debt in the last four quarters than its current portfolio composition, indicating it is lowering its risk profile.
This will, over time, slightly reduce its average portfolio yield, however, lower risk is something investors surely will not lament.
Next, we’ll take a look at the company’s growth prospects.
Growth Prospects
A strong catalyst for Stellus is its growing investment portfolio. In 2018, Stellus initiated $278 million in new investments.
It also received $148 million in proceeds from exits, for net new activity of $130 million. We see continued growth as the primary growth catalyst in the coming years.
Stellus has seen its investment portfolio rise at a rapid pace over the past five years, which has allowed the company to earn higher investment income.
Source: Investor presentation, page 15
The company saw sizable amounts of growth in 2018 thanks to the portfolio activity mentioned above. The company now has 57 different companies in its portfolio as of the end of the year.
The good news is, that the investment portfolio continues to grow, as does the company’s net asset value. At the end of 2018, NAV was $14.09, which is essentially the same as the current share price. Continued growth could help expand dividend coverage.
Another potential catalyst for Stellus could be higher interest rates. As a primary debt investor, Stellus could benefit from higher yields on its future investments.
The company is already adept at reaping high yields from its investments. The overall portfolio held a weighted average yield of 10.9% as of the end of 2018.
Source: Investor presentation, page 14
In addition, the company’s portfolio is almost entirely floating rate. This is a positive in a rising rate environment, but this leverage works both ways.
On the plus side, Stellus’ portfolio is risk-averse, with 90% coming from the top two levels of credit risk. This means Stellus accepts slightly lower yields but has a more stable platform from which it can generate income.
Given recent portfolio activity, we expect credit risk to improve over time.
Dividend Analysis
As far as dividend stocks go, Stellus is not a typical choice. It has only paid a dividend for six years, which means it has not yet developed a long track record of consistency.
Stellus currently pays a monthly dividend of $0.1133 per share, which equates to an annualized payout of $1.36 per share. This hasn’t changed since the very early days of the stock trading publicly as Stellus has neither increased or cut its dividend yet.
Net investment income was $1.42 per share for all of 2018, indicating a dividend payout ratio of 96%. This means the current dividend payout is sustainable, but just barely. Keep in mind BDCs are required to distribute virtually all of their income, so Stellus’ payout ratio will always be high.
Even so, the company does not have much wiggle room. Even a modest decline in investment income could cause the payout ratio to rise above 100%, which signals a potentially unsustainable dividend.
It is very important that Stellus continue to increase its investment, as its recent results indicate.
Stellus is a high-risk, high-reward dividend stock. If the company’s growth stays on track, investors will receive a ~10% return just from the dividend, plus any capital appreciation from a rising share price.
Even if the company does maintain its dividend, investors should not expect much in terms of dividend growth going forward. Net investment growth has been sluggish and given that the payout has been the same for six years, we don’t see any catalysts for a higher payout in the near future.
As a result, Stellus is not an attractive investment for dividend growth investors. It has appeal to investors looking for income right now, but only investors with a fairly high tolerance for risk should consider buying the stock.
As with any BDC, there is a significant potential for a dividend cut should the company’s results experience a downturn.
Final Thoughts
Stellus could be an attractive pick as it has a nearly-10% dividend yield and some measure of growth potential.
Plus, Stellus pays its dividend each month, which helps boost the compounding effect of reinvested dividends and enhances the attractiveness of the stock for those relying upon dividends for living expenses.
Of course, there is no guarantee the company’s growth plans will be successful and with a payout ratio nearing 100%, there is not much room for error.
As a result, investors must accept the risk of a future dividend cut if financial results deteriorate. Only investors willing to take this risk should consider buying the stock.