Ares Capital Stock: A Strong Buy-The-Dip Opportunity (NASDAQ:ARCC)

Market corrections frequently result in bargain opportunities. While I wouldn’t go so far as to say Ares Capital Corporation (ARCC) is currently undervalued, the recent 10% correction does create a buying opportunity for one of the industry’s best business development companies. Because of the falling stock price, the yield on ARCC stock has increased to 7.9%.

Ares Capital’s core competency is investing in secured debt and building a conservative portfolio.

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

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

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

Ares Capital’s portfolio includes larger allocations to industries with more predictable revenue and earnings patterns, such as software and services, healthcare, and insurance. The goal of this diversification is to direct 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’s diversification is undeniably a strength, owing to the BDC’s size. 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 lessen its reliance on a single borrower.

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

Ares Capital Is Set To Benefit From Interest Rates Raises

In January, inflation reached 7.5%, the highest level since February 1982. Record inflation rates are forcing the central bank’s hand, which needs to combat inflation by raising interest rates in the economy. Ares Capital stands to benefit from the Fed’s aggressive rate hike cycle because a large portion of the company’s portfolio (88%) is linked to floating rates. Higher economic interest rates would reset loan rates to the upside, increasing Ares Capital’s profit prospects.

Solidly Covered Dividend

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

When net realized gains are factored in, Ares Capital’s dividend coverage improves. Net realized gains 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-covered, and the degree of coverage has improved in the last two years as asset prices have recovered from the Covid-19 crash.

10% Correction In ARCC Stock Creates A Buying Opportunity

Ares Capital’s stock has been declining recently as geopolitical risks have increased. The 10% drop in Ares Capital’s valuation creates a buying opportunity because the BDC’s portfolio income is unaffected by current geopolitical events.

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 corporation has a long track record of superior dividend coverage and strong credit performance. Ares Capital’s defensive credit portfolio and stable portfolio income currently command a 11% premium over book value.

My Conclusion

Because Ares Capital has a large, diverse credit-focused investment portfolio that will continue to reward shareholders with a high dividend, the 10% correction in ARCC is a buying opportunity.

Ares Capital has been trading at a premium to book value for a long time. The dividend is well-covered by net investment income, and the stock yield has risen to 7.9% in an increasingly volatile market environment.