I read a lot of articles analyzing the stocks of business development companies (BDCs). The article authors invariably classify BDCs trading at a premium to book value as too expensive, and the “deals” are the BDCs that trade at a discount to book value or NAV. There are two reasons I believe this is the wrong way to look at what BDCs you want to own. (Before we begin, please note: I use the terms “book value” and “NAV” interchangeably in this article.)

My first reason is logical. Any stock, including a BDC, that has provided superior returns will be attractive to investors, and the best-performing BDCs almost always trade for a premium to their NAV. This line was in a recent Seeking Alpha article: “Ares Capital Corporation (ARCC) is a business development company with a phenomenal track record of delivering long-term total return outperformance.” The author, Samuel Smith, declared that ARCC is overrated because it trades at a premium to book value. I am a fan of “a phenomenal track record of delivering long-term total return outperformance.”

Furthering this logic, BDCs trading at a discount to their book value or NAV have probably consistently underperformed. These BDCs have disappointed investors and are priced at a discount to at least provide an above-average yield. However, investors should not expect these stocks to appreciate due to NAV appreciation or the closing of the discount to book value spread.

The second reason to look for BDCs trading at a premium is strategic. The law limits BDCs, in terms of how much debt they can carry. A BDC’s capital structure will be close to an equal weight of equity and debt. Equity consists of the shares that trade in the market. For a BDC to grow, it must do secondary share offerings. Let’s look at the difference between a BDC trading at a discount and one at a premium to NAV.

If a BDC with a 0.90 price to NAV discount sells new shares, it receives just $90 for every $100 of new shares issued. It is starting in the hole with those shares. Besides, some BDC charters don’t allow selling shares at a discount to book, so growth would be impossible.

Then we have a hot BDC, trading at 1.2 times book. That BDC sells $100 worth of shares in the market and receives $120 for those shares. Secondary stock offerings for a BDC at a premium are immediately accretive to all shareholders. Nice!

I want to own BDCs that grow their book value and dividends. That leads me to quality companies trading at a premium. One favorite is Hercules Capital (HTGC), which is currently trading at 1.80 times its book value. Over the last three years, the HTGC share price has appreciated by 23%, and investors have earned a total return of 75%.