Capital Southwest trades at $25.05 per share and has stayed right on track with the overall market, gaining 8.6% over the last six months. At the same time, the S&P 500 has returned 13.5%.
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Why Do We Think Capital Southwest Will Underperform?
We’re sitting this one out for now. Here are three reasons why CSWC doesn’t excite us, plus one stock we’d rather own.
1. EPS Barely Growing
Analyzing the long-term change in earnings per share (EPS) shows whether a company’s incremental sales were profitable — for example, revenue could be inflated through excessive spending on advertising and promotions.
Capital Southwest’s EPS grew at an unimpressive 6.5% compounded annual growth rate over the last five years, lower than its 27.1% annualized revenue growth. This tells us the company became less profitable on a per-share basis as it expanded.
2. Previous Growth Initiatives Haven’t Impressed
Return on equity, or ROE, tells us how much profit a company generates for each dollar of shareholder equity, a key funding source for financial firms. Over a long period, financial firms with high ROE tend to compound shareholder wealth faster through retained earnings, buybacks, and dividends.
Over the last five years, Capital Southwest has averaged an ROE of 9.8%, uninspiring for a company operating in a sector where the average shakes out around 10%.
3. High Debt Levels Increase Risk
Capital Southwest reported $58.46 million of cash and $1.22 billion of debt on its balance sheet in the most recent quarter.
As investors in high-quality companies, we primarily focus on whether a company’s profits can support its debt.
With $151.2 million of EBITDA over the last 12 months, we view Capital Southwest’s 7.7× net-debt-to-EBITDA ratio as inadequate. The company’s lacking profits relative to its borrowings give it little breathing room, raising red flags.
Final Judgment
Capital Southwest falls short of our quality standards. That said, the stock currently trades at 11× forward P/E (or $25.05 per share). This valuation tells us a lot of optimism is priced in – we think there are better opportunities elsewhere. We’d suggest looking at one of our top digital advertising picks.
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