Ares Capital Corporation (ARCC -0.05%) is an interesting choice for income investors in business development companies, or BDCs. Strong growth in its revenue base and diversified investment portfolio, a consistently high net interest and dividend margin throughout the recession, and an impressive shareholder remuneration record all support an investment in Ares Capital.
Ares Capital's 9.9% dividend yield (per S&P Capital IQ) is attractive, but the underlying growth of this specialty finance company is where the real story is.
1. Explosive portfolio growth
Being a BDC means that Ares Capital needs to pay out at least 90% of its earnings to avoid corporate taxation.
Ares Capital concentrates on middle-market companies with an annual EBITDA of $10 million-$250 million and an enterprise value of between $100 million and $1.0 billion.
BDCs shot to popularity during the financial crisis because of their high dividend payouts. Their rise has a lot to do with the reluctance of large financial institutions to fund middle market-companies during a period of economic distress, a time in which bank lending is usually cut back.
BDCs like Ares Capital, however, gladly swooped in and benefited from strong demand for alternative finance solutions, which has been reflected in the enormous rise in investment portfolio values over the past couple of years.
Ares Capital's investment portfolio, for example, has grown by more than 270% to a massive $8.1 billion from 2009 to Q2 2014.
The increase in its investment portfolio size had a remarkable effect on Ares Capital's revenues as well, which largely consist of interest and dividend income paid by its portfolio companies.
Since the company invested heavily across the capital structure (that is, into both debt and equity layers), its revenues went through the roof and mirrored Ares Capital's portfolio growth.
2. Stable net interest margins
An investment in an income vehicle such as Ares Capital is largely driven by investors' desire for recurring income. While the yield of an income investment is certainly a key metric to consider, the sustainability of a potential dividend stream is even more important.
Income investors, who are often retirees, rely on constant cash flow from their income stocks just as much as Ares Capital depends on its portfolio investments to deliver steady cash.
Consequently, it is paramount that investors look at how volatile a BDC's past profitability has been to determine whether the company can sustain its profitability in challenging operating environments. Evaluating Ares Capital's net interest and dividend margin accomplishes just that: It stood at a healthy 8.7% in the third quarter of 2009 and has remained more or less stable around 8% ever since. In the second quarter of 2014, the margin was reported at 8.1%.
3. Outstanding shareholder remuneration
Ares Capital hasn't held back in letting shareholders participate in its strong underlying portfolio growth.
Total cumulative dividends have increased every year since 2004. While Ares Capital started out in 2004 with just $3 million in core earnings plus net realized gains and paid $0 in dividends, these figures have grown consistently over the past decade and throughout the financial crisis to $2.3 billion in core earnings and $2.0 billion in cumulative dividends.
This track record of increasing earnings and dividends certainly attests to Ares Capital's shareholder friendliness, and investors are likely to see further earnings and dividend growth in the years ahead.
The Foolish takeaway
Income investors depend on a reliable cash flow stream independent of the state of the overall economy. Ares Capital is a dependable dividend payer that has proved repeatedly that it can deliver value and dividends for shareholders throughout the business cycle.
Ares Capital's portfolio growth record, stable net interest margin, and focus on shareholder remuneration make this BDC a quality choice for income investors who are looking for strong fundamentals. Ares has just that, along with a 9% dividend yield.