Collect a 14% Dividend... But Watch Out for This Fraudulent Company

Yesterday, I finished the new book by David Einhorn. Einhorn manages a hedge fund named Greenlight Capital. The book is about the fraud committed by a company called Allied Capital. The title of the book is Fooling Some of the People All of the Time.

Allied Capital's is a "Business Development Company" or BDC. Twenty-six BDCs trade in the stock market. Allied Capital is the oldest and one of the largest.

All BDCs do is provide money to very small businesses and receive high interest rates in return.

BDCs are not subject to many of the rules that govern traditional lending institutions, so they can be more flexible than banks and close deals quickly.
While terms on the loans vary, they all have one thing in common: The companies BDCs lend to are always small, private, growing fast, and desperate for cash.

The size of the borrowers is the most important factor. First, tiny companies grow fastest... Not only are small businesses the most desperate for cash, but they have the most to gain from a loan. So they'll pay any price to get it... sometimes as much as 20% in annual interest payments, plus an ownership stake in their business.

Secondly, by financing only small companies, BDCs spread their portfolio over a large number of companies, sectors, industries, and locations. Collecting loans and bundling them all together is one of the secrets to finance. Diversification eliminates the risk without hurting the return.

Finally, taxes are the best reason for investing in small companies. The U.S. government thinks small businesses are vital to the economy and gives huge tax breaks to companies that lend money to them. BDCs never have to pay tax on their profits... as long as they distribute their gains to shareholders every quarter in dividends.

BDCs don't use a lot of leverage, so they're low-risk investments. (The government doesn't let them take on more debt than equity. Compare that to most banks and financial institutions in America, which frequently take on debt that totals more than 20 times equity.)

I think the BDC industry is a fantastic investment right now. On average, BDC stock prices have fallen 38% this year. They pay an average 14% dividend yield. Allied Capital is down 61%, and is yielding nearly 19%.

But don't buy Allied Capital. As David Einhorn proves in his book, Allied's senior managers are dishonest. They covered up several frauds, they lied on conference calls, and they even stole Einhorn's telephone records.

Even though the SEC has officially recognized Allied's fraudulent behavior, they haven't punished the crooks. And Allied's bent management is still running the business.

If you like income stocks, you should consider investing in a basket of BDCs. They're cheap right now, and they'll pay you an average 14% dividend yield.Fortunately, Allied Capital is the exception. Properly run, BDCs make excellent returns on their investments and pay the most stable, high dividend streams you'll find anywhere in the stock market.

Good investing,