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Has Fifth Street Finance become the perfect stock?

Friday - 6/15/2012, 11:36am  ET

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Fifth Street Finance fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Fifth Street Finance.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15%95.7%Pass
 1-Year Revenue Growth > 12%60.6%Pass
MarginsGross Margin > 35%100.0%Pass
 Net Margin > 15%18.0%Pass
Balance SheetDebt to Equity < 50%44.4%Pass
 Current Ratio > 1.36.60Pass
OpportunitiesReturn on Equity > 15%3.6% Fail
ValuationNormalized P/E < 2016.52 Pass
DividendsCurrent Yield > 2%12.0% Pass
 5-Year Dividend Growth > 10% (1.8%)*Fail
     
 Total Score 8 out of 10

Source: S&P Capital IQ. Total score = number of passes. *Four-year growth rate.

Since we looked at Fifth Street Finance last year, the company has picked up a point. But shares haven't been as fortunate, falling nearly 20% as investors dealt with a dividend cut and concerns about the future.

Fifth Street Finance is a business development company, a tax-favored corporate structure that has gained a lot of popularity in recent years because they tend to provide high dividend payouts. But while many BDCs share similar traits, they aren't exactly alike. Apollo Investment , one of the biggest BDCs, has a broadly diversified portfolio of mid-market businesses that it supports from a wide variety of industries. But Prospect Capital tends to focus on energy investments, while Main Street Capital primarily sticks to companies in the southern U.S. For its part, Fifth Street is fairly broadly diversified in its small and mid-market company exposure.

But concerns about Fifth Street's ability to maintain its dividend have been around for a while. When 2012 began, the company dropped its monthly payout by about 10%, and shares have traded in a pretty tight range ever since.

Fifth Street has thus far been able to avoid one controversial practice that some BDCs use. Prospect Capital, Ares Capital , and many other BDCs have sometimes gone to shareholders requesting authority to issue new shares at prices below the net asset value of their holdings, thereby diluting existing shareholders. Fifth Street's proxies haven't had those provisions, and in recent offerings, Fifth Street has been able to sell shares at prices favorable to net asset value -- albeit sometimes at a discount to the then-prevailing market price of the shares. Moreover, the company actually announced a share buyback recently when shares went below net asset value.

For Fifth Street to improve, the real key is making sure that it can continue to pay its lucrative dividends. Anything that jeopardizes those payouts could send Fifth Street plummeting away from perfection.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

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This article was originally published as Has Fifth Street Finance Become the Perfect Stock?on Fool.com

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