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Bank-Beating Alt-Financials Take Charge

July 03, 2019

A lot has changed in the market for banking and finance over the past decade. Let’s review…

The financial crisis was largely caused by bankers that forgot to “know thy customer” firsthand. So instead of burning shoe leather visiting businesses to originate loans, they bought wholesale loans and mortgages. And instead of welcoming customers in bank lobbies, they sold wholesale deposits to raise cash for loans.

Congress stepped in with a series of legislative actions, including the Dodd-Frank Act of 2010, which placed a massive list of rules and regulations to curtail bankers from prior mistakes. And regulators adopted various policies and rule interpretations that hoisted prohibitive costs on banks.

This meant that there was so much additional work that had to go into making loans and gathering deposits that the cost to earn each dollar of revenue soared, and that was reflected in banks’ rising efficiency ratios.

While efficiency ratios might have been in the 25% range pre-crisis, they have since risen into the 60%-70% range or higher for many banks, meaning operating margins became prohibitive.

Then came the Federal Reserve, with its zero or near-zero interest rate monetary policy. While stimulative for companies and households, for traditional banks it meant that there was little to no room to price loans against deposits that would leave them with profitable net interest margins (NIMs).

Then, last year, Congress passed a series of regulatory reforms, including rolling back parts of Dodd-Frank, and regulatory agencies eased up on their rules and enforcement. With the Fed moving to get interest rates to more normalized levels, NIMs began to improve in better-run regional banks.

In addition, with the US economy on the upswing, demand for loans was set to lead banks to more business.

But now, there are two recent developments. First in conversations with my banker friends, I’ve learned that the Fed and other bank regulators have been dragging their feet on implementing Congressional relief legislation.

And second, as we’ve seen in shorter order, the market is shoving interest rates lower, and the FOMC is helping. So, improvements in efficiencies aren’t as big as they were legislated to be, and NIMs are now threatened.

But there is another threat that is really at odds with banks, and it provides an opportunity for you to earn more dividends along the way.

Alternative Financiers

Over the past decade, as banks were choked, alternative financial companies came into the market for lending and other banking services. These companies were not as burdened by bank regulation, particularly for business and corporate lending. And one of the leading groups includes business

development companies (BDCs).

BDCs have thrived this decade, which you can see in the chart below, as their stocks delivered 252.15% during this period.

Business Development Companies Thrive

US Business Development Companies Total Return Index—Source: MVIS & Bloomberg Finance, L.P.

One of the best BDCs focused on lending to technology companies is Hercules Capital (HTGC). It has been building up its revenue growth over the past year. And it does so with an efficiency ratio of 52.50%, much better than its traditional banking peers. Its NIM is running at a whopping 9.30%.

Hercules Capital (HTGC)—Source: Bloomberg Finance, L.P.

It pays a dividend yielding 9.96% and has generated a return so far this year of 21.86%. HTGC is a buy in a taxable account, as it issues K-1 tax information.

Another favorite, Main Street Capital (MAIN), is a leading BDC in the middle-market company segment. It has an efficiency ratio of 8.20%, which along with its whopping operating margin of 81.40%, delivers a return on equity of 12.00%.

Main Street Capital (MAIN)—Source: Bloomberg Finance, L.P.

It yields 6.96% on an annual basis, including regular bonus dividend payments, and it has returned 26.91% year to date. While it is a bit pricey here, it’s far and away cheaper than banks with this sort of financial performance. MAIN is also a buy in a taxable account.

All My Best,

Neil George

PS—While I’ve made the case for alternative financial companies with higher dividend yields in this Digest, I have even more specific opportunities for higher dividend payments in my Profitable Investing advisory.

Click here now to learn more.