A Well Diversified Portfolio And An 8% Dividend Yield

Ares Capital (NASDAQ:ARCC) is the world’s largest business development company, with a market cap of roughly $14 billion that surpassed that of Blackstone Secured Lending (BXSL) and FS KKR Capital (FSK). Over the past ten years, its total return performance has been among the highest of BDCs. For example, ARCC achieved a ten-year total return of 254%, superior to FSK and BXSL at 111% and 54%, respectively, but inferior to the 312% of Main Street Capital (MAIN).

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Indeed, an investment in a BDC is not suitable for every investor. Inherently, these are a portfolio of predominantly debt instruments packed into public equities. However, yield-seeking investors tend to be interested in these instruments due to the high dividend yields and dividend growth they offer.

BDCs pay a high dividend because they are obligated to pay out 90% of their taxable income as a dividend to avoid corporate tax, just like a REIT. Therefore, the leveraged free cash flow and distributions are higher with a tax benefit. For someone close to retirement or retired, BDCs are great because they offer a generous dividend, and the stock price volatility tends to be lower compared to equity blue-chips, for example.

Based on a stock price of $21.75 and adding the last four dividends of 48 cents paid in 2024, ARCC’s dividend yield is 8.82%. The regular dividend has been relatively stable throughout the years and was only cut in 2019 during the financial crisis. At the same time, Ares Capital has occasionally distributed special dividends, as was the case in 2022 and 2019. Overall, the attractiveness of ARCC’s dividend lies not solely in its yieldsince FSK and BXSL offer higher yieldsbut in its superior five-year CAGR of 4%.

Source: ARCC Investor Relations

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In essence, ARCC’s asset allocation consists of first-lien secured loans, which account for more than half of the portfolio. After that, they hold more risky asset types, such as subordinated loans and equities. Nonetheless, the issuer concentration is pretty insignificant, with an average position size of 0.2% and moderate portfolio leverage. Simultaneously, the diversification among industries is robust and consists predominantly of non-cyclical industries with attractive growth prospects and high free cash flows.

Source: YCharts

From a volatility perspective, net asset value per share proxied by book value per share is a proper metric for analyzing the ups and downs of the financials of a business development company. Overall, pre-covid, the book value of Ares Capital was stable. Of course, it was affected during Covid and mid-2022 due to high inflation, which caused credit instruments to drop, but generally, the book value per share has been on a solid rising trend.

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Source: ARCC Investor Relations

Ares Capital’s investments are mainly financed with borrowed funds in revolving credits, securitizations, and unsecured loans. Here, ARCC has a competitive edge over other BDCs as it has the highest credit ratings among the three leading raters. Simultaneously, S&P Global increased its long-term debt to BBB from BBB- in Q3. On the other hand, Fitch maintained the BBB rating, and Moody’s maintained the Baa2 rating.

For the most part, ARCC’s debt portfolio is floating, meaning that the quarterly interest received combines the previous period’s SOFR rate and a fixed credit spread. The SOFR rate is highly correlated with the federal funds rate, and technically, the time in which the company would receive the most interest is when rates are high. With the ongoing rate cut environment (although the FED has hinted at lower rate cut expectations), Ares is exposed to receiving a lower income from its investments and simultaneously re-investing them at less attractive rates.

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Nonetheless, the dividend’s safety is more than covered by the $5.407 billion excess borrowing capacity from revolving credit and a spillover income that was 2x higher than the quarterly dividend in Q3.

“Should market interest rates decline, we believe the value of our attractive dividend yield that is well covered by core earnings and supported by a strong level of spillover income will become even more valued by equity investors.” Kipp DeVeer CEO

ARCC Data by GuruFocus

Unlike most American banks, business development companies report their investments at fair value. Therefore, book value per share is a reasonable indicator of the company’s fair value or net asset value. With a price-to-book of 1.1x, the stock price seems slightly above compared to the average level of 1.03x. Despite this, it is a low-volatility stock as most of the core assets are first-lien debt, and waiting for the stock price to drop is a missed opportunity for accruing the dividend payments.

Ares Capital has had a tremendous total return of approximately 254% over the last decade. The company owns a well-diversified portfolio with predominantly middle-market companies that generate higher yields and dividend payments than traditional public investments. These investment characteristics are attractive for an investor close to retirement looking for a high dividend payment. Simultaneously, the company has a strong capital position and credit ratings on their debt.

Although the interest rate cuts are a headwind to the portfolio, the yields received would most likely still be higher than the historical average of the past 15 years. Finally, the valuation at 1.1x book value is still decent for an investor not to be concerned about overvaluation.

This article first appeared on GuruFocus.