Ares Capital Stock: BDC’s best-in-class 7.4% yield is a buy

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Ares Capital Corporation (ARCC) offers investors book value per share and dividend growth. Ares Capital is a leader in the credit market, backed by a capable outside investment manager, and can continue to outperform its dividend as long as the credit portfolio performs as well as it does now.

Ares Capital: an undisputed leader in the world of BDC

Ares Capital is a business development firm specializing in middle market lending. Ares Capital, with a market capitalization of over $10 billion, is one of the largest business development companies in the United States. It’s also one of the oldest BDCs on the market, with a 17-year track record of success.

Ares Capital originated from the Ares family of companies. Ares Management is an investment manager with assets under management approaching $300 billion, and it has demonstrated significant prowess in raising investment capital for its various investment strategies around the world. Ares Capital’s external manager is Ares Management Corporation.

Ares Management Overview

Introducing Ares Management (Ares Management Corporation)

Construction of a conservative debt portfolio and industry-leading credit performance

Ares Capital, as a business development company, has primarily focused on credit solutions for companies in the upper middle market segment. These companies are generally well-established in their industry, with strong revenue and cash flow, as well as above-average credit metrics. The weighted average EBITDA of a company to which Ares Capital extended credit was $157 million during the quarter ended September 30, 2021.

Ares Capital’s portfolio is focused on senior, senior secured loans, with an investment allocation of 49% in 3Q’21. Second lien senior secured loans come second with 23% representation. These highly secured loans represented 72% of Ares Capital’s loan portfolio investments.

Additionally, Ares Capital invests in subordinated loans and equity, but at a much lower percentage than in secured debt. In September, Ares Capital’s portfolio was valued at $17.7 billion, with 371 portfolio companies. The average loan position size was only 0.3% of Ares Capital’s loan portfolio.

Ares Capital Secured Loans

Guaranteed loans (Ares Capital)

Ares Capital has built a reputation as a good credit risk insurer over the past 17 years. Default or loss rates on first lien and second lien secured loans have historically been well below those of the company’s peers.

Ares Capital’s loss rate in the senior loan category has historically been less than 0.1%, and the loss rate in the second lien and subordinated loan categories, which are subprime loans higher, was less than 0.2%. The loss rate for first liens is more than six times higher in the middle market industry, and it is fourteen times higher for subordinated unsecured loans.

Ares Capital Loss Rate

Loss rate (Ares Capital)

ARCC has a telling record of earnings on its dividend

The ultimate reason to invest in Ares Capital, or any other business development company, is to earn consistent dividend income from a diversified portfolio of credit investments. Ares Capital delivers on its promise by paying out $0.41 per share in dividends every quarter. Over the past ten years, the company has paid consistent dividends and consistently exceeded its dividend payout.

Historical dividends on ARCC shares

Historical dividends (Ares Capital)

However, I would not expect regular increases in dividends as Ares Capital reinvests portfolio cash flows into new interest-bearing credit instruments. ARCC stock yields a safe yield of 7.4% based on a stable dividend payout of $0.41.

Investors pay a 20% premium on book value

Due to Ares Capital’s superior credit performance and strong dividend coverage, ARCC shares are trading at a significant premium to book value. The current ARCC premium is close to 20%, which is high for the BDC industry, where the majority of companies trade at or below book value.

Book value bonuses are generally reserved for BDCs that are perceived to be of high quality, rightly or wrongly. Ares Capital is undoubtedly one of the best BDCs to invest in due to the outstanding performance of its portfolio. The book value of Ares Capital is also increasing, which cannot be said for all BDCs.

Book value of Ares Capital and price-to-book ratio
Data by YCharts

Long-term returns and volatility

ARCC stock has outperformed the industry since the company’s IPO. Since 2004, the annualized return has been 11.9%, based on dividend payouts and accretive changes in book value. BDC’s average stock in the market was fortunate to achieve just over half of ARCC’s annualized total return.

What makes an investment in ARCC particularly attractive is that the alpha has been achieved with less volatility, which is most likely due to the strong performance of Ares Capital’s credit portfolio and portfolio cash flows highly predictable.

Ares Capital Annualized Returns

Annualized returns (Ares Capital)

My conclusion

The business development company has a well-diversified portfolio and a proven track record of making strong credit investments. Ares Capital’s extensive experience in originating loans has given it a significant competitive advantage. Unless credit performance deteriorates, it’s hard to see how buying Ares Capital could go wrong.

Sallie R. Loera