Ares Capital Stock: A Strong Downside Buy Opportunity (NASDAQ:ARCC)

panida wijitpanya/iStock via Getty Images

Market corrections often translate into bargain opportunities. While I wouldn’t go so far as to say Ares Capital Corporation (ARCC) is currently undervalued, the recent 10% correction creates a buying opportunity for one of the top business development companies in the industry. Due to the falling share price, ARCC’s stock yield increased to 7.9%.

Ares Capital’s core competency is to invest in secured debt and build a conservative portfolio.

Ares Capital, for example, invests primarily in secured debt securities to generate recurring portfolio income that is used to pay investors a large quarterly dividend. The primary focus of Ares Capital is capital investment in senior and second lien secured loans.

In the fourth quarter, first liens made up 47% of Ares Capital’s portfolio, while second liens made up 23% of debt investments. Ares Capital also invests in (preferred) equities, but senior secured loans make up the majority of BDC’s investment activity, accounting for 75% of all investments in Ares Capital’s portfolio.

Ares Capital Portfolio Summary

Portfolio Summary (Ares Capital Corp)

Ares Capital’s investment strategy avoids volatile industries with volatile earnings patterns. Oil and gas, hospitality and transportation are cyclical industries with very little representation in Ares Capital’s portfolio.

Ares Capital’s portfolio includes larger allocations to sectors with more predictable revenue and earnings models, such as software and services, healthcare and insurance. The goal of this diversification is to steer the portfolio toward industries that can make loan and interest payments even during a recession.

As a result, Ares Capital’s credit portfolio construction improves cash flow predictability and reduces risk for investors who rely on Ares Capital’s generous quarterly dividend.

Ares Capital investment strategy

Investment strategy (Ares Capital Corp)

Ares Capital’s diversification is undeniably a strength, due to the size of BDC. In December, Ares Capital’s investment portfolio had a fair value of $20.0 billion. The more money an investment firm has to invest, the more it can diversify and reduce its dependence on a single borrower.

Ares Capital’s average investment size is 0.3% of portfolio value, compared to 0.8% for the average business development company. Additionally, Ares Capital’s top ten investments represent only 10.9% of total investments, while the industry average BDC has a much higher exposure to the top ten borrowers (25.7%). Diversification across asset classes, industries and borrowers results in a credit-focused portfolio with predictable, recurring income.

Ares Capital portfolio diversity

Portfolio diversity (Ares Capital Corp)

Ares Capital is Ready to benefit from interest rate hikes

In January, inflation hit 7.5%, the highest level since February 1982. Record inflation rates force the hand of the central bank, which must fight inflation by raising interest rates in the economy. Ares Capital should benefit from the Fed’s aggressive rate hike cycle, as a large portion of the company’s portfolio (88%) is tied to floating rates. Higher economic interest rates would bring lending rates back up, increasing Ares Capital’s profit outlook.

The ARCC will benefit from the increase in tariffs

Take advantage of increased rates (Ares Capital Corp)

Dividend securely covered

Ares Capital earned $0.52 per share in net investment income in 4Q-21, outperforming the dividend of $0.41 per share by 11 cents. Net investment income of $1.66 per share covered the entire 2021 payout of $1.62 per share.

Dividends payable ARCC

Dividends payable (Ares Capital Corp)

When net realized gains are factored in, Ares Capital’s dividend coverage improves. The net gains made from successful investments do exist, and Ares Capital has consistently recorded such profits in the past. Since 2011, Ares Capital’s dividend has been well hedged, and the degree of hedging has improved over the past two years as asset prices have recovered from the Covid-19 crash.

Net Realized Gains from ARCC

Net realized gains (Ares Capital Corp)

10% fix In stock ARCC Create a buying opportunity

Shares of Ares Capital have recently fallen as geopolitical risks have increased. The 10% decline in Ares Capital’s valuation creates a buying opportunity as BDC’s portfolio earnings are unaffected by current geopolitical events.

10% correction in ARCC stock creates a buying opportunity

ARCC share price (Finviz)

The premium to book value is well deserved

There aren’t many business development companies that deserve to trade at a premium to book value, but Ares Capital is one of them. The company has a long track record of superior dividend coverage and strong credit performance. Ares Capital’s defensive credit portfolio and stable portfolio earnings currently impose an 11% premium to book value.

ARCC price at book value
Data by YCharts

My conclusion

Given that Ares Capital has a large and diversified credit-focused investment portfolio that will continue to reward shareholders with a high dividend, ARCC’s 10% correction is a buying opportunity.

Ares Capital has long traded at a premium to its book value. The dividend is well covered by net investment income and the equity yield increased to 7.9% in an increasingly volatile market environment.

Sallie R. Loera