Ares Capital: Every drop is a solid buying opportunity (ARCC)

Oatawa

As economic risks mount and the United States potentially stands on the brink of a deeper recession, Ares Capital (NASDAQ: ARCC) is one of the best business development companies high-quality, dividend-seeking income investors can buy right now, in my opinion.

In addition to Ares Capital covering its dividend with net investment income, BDC has special dividend potential, and the stock price recently fell below NAV, implying that investors can now buy the shares. from BDC with a discount of 5% on the net asset value.

High quality investment portfolio sold at a discount to net asset value

Ares Capital is a high quality business development firm led by an experienced team of investment professionals. BDC has developed an investment strategy focused on high-quality, senior secured loans, which represent 69% of the debt portfolio.

First Liens, the safest type of debt, accounted for 45% of Ares Capital’s investment in the second quarter, with Second Liens accounting for 19% of BDC’s portfolio.

Portfolio overview

Portfolio Snapshot (Ares Capital Corp)

Ares Capital Competitive Advantage: Credit Management Experience

Ares Capital brings decades of credit management experience to a firm that manages $21.2 billion in debt investments.

Ares Capital’s loss rate on senior debt was less than 0.1%, which is significantly lower than the market average.

Since a recession is likely to increase borrowers’ financial stress, savvy debt investors with relevant credit experience have a distinct advantage over other firms in the sector.

Credit management experience

Experience in credit management (Ares Capital Corp)

Floating rate exposure

Interest rates are currently a major topic in the BDC industry. Since June, the central bank has raised interest rates by 75 basis points three times, and persistently high inflation could lead to another rate hike in the near future.

Ares Capital benefits from rising interest rates because management has positioned BDC accordingly. 87% of the company’s investments are in floating rate debt investments, which brings significant positive interest rate sensitivity to Ares Capital’s net interest income potential. An increase in interest rates of 100 basis points, for example, should increase basic annual EPS by $0.17 per share.

Exposure to interest rates

Exposure to interest rates (Ares Capital Corp)

Dividend payment covered by net investment income

Ares Capital paid 90% of its dividends the previous year, so the business development company covered its regular dividend of $0.41-0.42 per share per quarter and a special dividend of $0.03 per share and per quarter.

The dividend is extremely safe, and given Ares Capital’s long track record of managing debt portfolios with extremely low loss rates, I expect Ares Capital to continue paying its regular dividend even in times of recession.

Dividend and payout ratio

Dividend and payout ratio (table created by author using information from BDC)

5% discount on book value

Quality BDCs rarely sell for less than book value, but it does happen. ARCC is currently trading at 0.95x book value, making it an attractive opportunity for income investors.

Chart
Data by YCharts

Why Ares Capital could see a lower valuation

Ares Capital, like most business development firms, will face a lower valuation multiple if the quality of its loan portfolio deteriorates.

I’m not concerned about a reduction in dividends or portfolio losses because BDC is well managed and its managers have extensive experience managing debt investments through difficult credit cycles.

That said, all business development companies run the risk of trading at a lower valuation multiple if the market anticipates a decline in credit quality.

My conclusion

Ares Capital is a must buy. The quarterly dividend of $0.43 per share is easily covered by net investment income, as is the special dividend of $0.03 per share.

Also, Ares Capital is one of the best BDCs to invest in if the markets consolidate, in my opinion, because management has the experience to deal with difficult debt markets, and its First Lien objective is definitely useful.

Ares Capital has demonstrated its ability to manage credit instruments by maintaining a low loan loss ratio in the past.

Additionally, Ares Capital shares are trading at a 5% discount to net asset value, making the business development company even more attractive from a margin of safety perspective.