3 Reasons To Own Ares Capital

By Will Ashworth | May 19, 2011 AAA

Maybe you've heard of Booze Allen Hamilton (NYSE:BAH)? It's a management consultancy that went public in November 2010. Perhaps you've heard about Adam & Eve fruit juices or Gilchrist & Soames skin care products? All three have senior secured loans with business development company Ares Capital (Nasdaq:ARCC). Ares is one of the largest specialty finance companies in America, with $13 billion in committed capital to the middle-market. (If you're interested in learning more about business development companies (BDCs), read Big Dividends In BDCs.)

TUTORIAL: Money Market

Here are three reasons to own ARCC stock:

Good Dividend
The 10-year U.S.Treasury note currently pays around 3.13% annual interest. Income investors needing more are limited in their options. Ares has paid a quarterly dividend of at least 35 cents since Q1 2006 (excluding one, 10-cent dividend) and $9.80 cumulatively from its IPO in October 2004 to today. Its 8% yield is attractive for anyone looking for above-average income with an appropriate amount of risk. Conservatively managed, it lowered its quarterly dividend from 42 cents to 35 cents in the second quarter of 2009 in order to maintain greater financial flexibility. This was necessary because Ares and its competitors are facing a situation where clients are looking to refinance their loans at lower rates, resulting in a reduced level of investment income. Fortunately, the fair market values of its portfolios are increasing, with the net result being a minimal effect. Nonetheless, it's something to keep an eye on. (The DDM is one of the most fundamental financial theories, but it's only as good as its assumptions, check out Digging Into The Dividend Discount Model.)

Size and Strength
The top-25 actively traded BDCs have assets under management of $24.4 billion. Its largest competitors include American Capital Strategies (Nasdaq:ACAS), Apollo Investment (Nasdaq:AINV), Solar Capital (Nasdaq:SLRC) and BlackRock Kelso Capital (Nasdaq:BKCC). As I mentioned in the opening, Ares has $13 billion in committed capital as of December 31, 2010, including $5.1 billion it co-manages with GE Capital. Since its IPO, Ares invested over $6.7 billion in capital, making it one of the largest BDCs in the country. Its senior managers all have 15-plus years leveraged finance experience and the results are indicative of this. Its acquisition of Allied Capital in 2010 is a perfect example of how effectively it manages its assets. Over the past year, the Allied portfolio has generated $927 million in cash from repayments and exits. By repositioning those assets slightly, in just one year it was able to reduce the amount of debt and equity investments, yielding less than 10% from $769 million to $449 million, increasing the aggregate yield on those assets from 1.2 to 2.0%. That's tremendous. Most importantly, between July 2007 and June 2010, in what the company refers to as the "credit dislocation period," it was able to keep its debt levels between 0.45 and 0.85 times equity. It's conservative to the core.

Excellent Performance
If you invested $10,000 in Ares' IPO back in 2004, today it would be worth approximately $23,000. That's $10,000 more than both the S&P 500 and the Asset Management industry. In 2007 and 2008, its stock lost 15 and 45% respectively. Things got so desperate at the 2008 bottom that its yield was 27%. Since then, it's been nothing but clear sailing, and while it might hit a few speed bumps in the coming months and years, there is plenty of business up for grabs as $360 billion in middle-market debt matures by 2015. Now, granted, some of this maturing debt will be its own clients running for the doors, but management sees no reason why it can't pick up a decent-sized chunk of that refinancing business. (Find out what it takes to win a spot in one of the most coveted financial careers, read Preparing For A Career As A Portfolio Manager.)

Bottom Line
In the past, I've recommended two BDCs: Golub Capital (Nasdaq:GBDC) and Solar Capital. You can make it three. An 8% dividend yield, conservative management style and superior performance to the S&P make Ares Capital worth investing in.

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