There are many different types of investment vehicles that are capable of building wealth for patient investors. Since their inception in the 1980s by an act of Congress, business development companies (BDCs) have often delivered market-beating total returns for shareholders.
Turning a $10,000 investment made in 2018 into $18,000 with dividends reinvested, Ares Capital (ARCC 0.73%) has outperformed the market. This was slightly more than the $17,000 that the same amount put into the S&P 500 index would have become with dividends reinvested.
Looking ahead, the BDC seems poised to extend its track record of strong performance. Here are three reasons.
1. A favorable environment for a proven BDC
Ares Capital, the U.S.'s biggest BDC, lends to larger middle-market companies or makes equity investments in them. These companies are often caught in limbo. They're reasonably well established compared to startups. But middle-market companies in recent decade have had more difficulty securing loans from banks, which prefer larger companies with stronger balance sheets and higher credit ratings.
Fortunately, Ares Capital is willing to take on the risks associated with lending to the middle market -- in exchange for higher interest rates, of course. The BDC boasts an investment portfolio valued at $21.1 billion as of March 31. As you'd expect from the dominant BDC in the country, Ares Capital's portfolio is incredibly diversified: The company's investment portfolio consists of 466 companies across 32 different industries, with its top 10 investments accounting for just 12.3% of its portfolio. For context, that is much more diversified than the BDC peer average of 23.4%.
Ares Capital is in a great position to cash in on the higher interest rates that have resulted from elevated inflation. This is because the company can leverage its investment-grade balance sheet to take out loans at reasonably low interest rates. Ares Capital then lends to clients at much higher interest rates, which builds in a strong spread.
So long as the economy remains relatively intact, most of its clients won't default on their payments. The company's business model has allowed it to post a 10-year annualized net asset value based total return of 11.3%, which is the highest among its selected peers.
Image source: Getty Images.
2. The mountainous dividend isn't a yield trap
At first glance, Ares Capital's 10.4% dividend yield wouldn't seem to be sustainable compared to the S&P 500 index's 1.6% yield. This dividend yield is made quite high by the fact that as a BDC, Ares Capital must pay at least 90% of its taxable net income to shareholders to avoid corporate taxation. Upon examining its dividend payout ratio, the dividend looks to be one of the safest among ultra-high-yielding peers.
Ares Capital's dividend payout ratio was just 85% in 2022. For the sake of clarity, this is based on its net investment income per share of $2.19 and dividends per share paid of $1.87 during the year. Because of its manageable payout ratio, Ares Capital has delivered 13-plus years of stable-to-growing dividends to its shareholders, including during the COVID-19 recession.
3. Ares Capital could be reasonably valued
Shares of Ares Capital are up less than 4% in the past year, yet the stock is arguably priced within reason: Ares Capital's price-to-book (P/B) ratio of 1 is in line with its 10-year median. That's why I rate the shares a buy for investors seeking reliable income coupled with modest capital appreciation.
