Capital Southwest: What Recession? Outperforming BDC Trumps Wall Street's Fears

Lower middle market specialist Capital Southwest (NASDAQ:CSWC) stock has outperformed the S&P 500 (SPX) (SPY) and its peers represented in the VanEck BDC Income ETF (BIZD) over the past year. The business development company, or BDC, has attracted robust support from investors, trading well above its net asset value or NAV per share. CSWC has also outperformed since my initial Buy coverage in September 2022. I noted that “CSWC’s valuations have been de-risked substantially,” bolstering its risk/reward profile for investors willing to tolerate short-term volatility.

The market’s confidence in supporting CSWC’s valuation over the past year has allowed the company to execute highly accretive ATM equity offerings while reducing leverage accordingly. As such, it has helped Capital Southwest to improve its balance sheet significantly, as it reported a leverage ratio of 0.87x in the June quarter, down from 1.1x over the past year.

Despite being one of the smaller BDCs (by market cap) in my coverage, CSWC’s outperformance against its peers isn’t surprising. I gleaned that CSWC underperformed BIZD from its highs in November 2021 through its lows in October 2022 before bottoming out. Given its exposure to lower middle market companies as a focus, the market’s more pessimistic positioning makes sense, reflecting higher execution risks, as more speculative companies were hammered in last year’s bear market collapse.

There was also a transitory scare in March 2023 as the regional banking crisis erupted, throwing weak CSWC into disarray as they sold off in a hurry. As such, CSWC was hammered back toward its October 2022 lows, but buyers returned aggressively, stemming a further decline. As such, the financial doom and gloom reported in the media didn’t gain traction with market operators, as they correctly bet that the hard landing proposition of the bearish prognosticators wouldn’t pan out.

Accordingly, recent inflation and economic data have provided a stronger basis for demonstrating the economy’s resilience, while providing a stronger foundation for the higher-for-longer positioning of the Fed.

Capital Southwest has also capitalized on the rapid rate hikes over the past year, as its weighted average yield on all investments reached 12.6% in the recently reported quarter (FQ1’24), lifting its total investment income by 9% sequentially to $40.4M.

However, I anticipate the tailwinds from the Fed’s unprecedented rate hikes are likely petering out, suggesting NII per share growth could slow. However, the company’s significant improvement in its balance sheet should help mitigate the expected growth normalization. Furthermore, the ongoing lending challenges from the traditional banks to the lower middle market segment could provide an earnings boost to Capital Southwest as its deal activity remains robust.

Hence, I believe holders who added CSWC at its lows in late 2022 or early this year should continue holding on to their positions, riding the recovery further.

CSWC’s valuation is still attractive despite the market outperformance, as the broad industry valuations have not re-rated significantly toward their previous highs. Seeking Alpha Quant’s “B+” valuation grade corroborates my observation.

As seen above, CSWC has returned to a medium-term uptrend with no red flags or sell signals. The robust bottoming signals in October 2022 and March 2023 were astute bear traps (false downside breakdowns), “spooking” weak holders into letting go of their shares at the lows before buyers returned with conviction.

I gleaned that a possible resistance zone at the $24.5 level could hinder a further advance. Therefore, investors looking to buy at the current levels should anticipate volatility as CSWC closes in against that level.

However, CSWC’s attractive valuation and price action (lack of sell signals) suggest that a further medium-term rally could continue, outperforming its peers. CSWC’s price action indicates a consolidation over the past four to five weeks, which could lead to a near-term pullback.

As such, investors should be prepared to add in phases to capitalize on such possible volatility and improve their risk/reward.

Rating: Maintain Buy. Please note that a Buy rating is equivalent to a Bullish or Market Outperform rating.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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