Ares Capital

01/05/2015 2:15 pm EST

Focus: STOCKS

Adrian Day

Chairman and CEO, Adrian Day Asset Management

Business Development Companies (BDCs) couldn't get any respect in 2014 and the sector well-underperformed the averages, explains Adrian Day, editor of Global Analyst.

What are BDCs? They lend money to small- and middle-market companies, usually for expansions, acquisitions, or management buyouts. Structured as Registered Investment Companies (like REITs), they pay no corporate tax if they distribute virtually all net income.

A series of developments hurt the BDCs; fears of rising interest rates, their removal (for arcane reasons) from the S&P and Russell indices, a high-profile BDC slashing its dividend, and the collapse of oil prices. For astute investors, this represents a buying opportunity.

Ares Capital (ARCC) is the largest BDC, as well as one of the better-run and more conservative. In recent quarters, it has been moving more towards senior lending, which carries lower yields as well as a lower risk of default.

There is a misguided concern that rising rates would hurt the BDCs. Since over 80% of Ares's loans are floating, it will receive more income as rates rise.

Ares has a strong balance sheet, with a debt-to-equity ratio of just 0.6 times. The company has carry-forward income, about 77 cents per share, very significant given a regular annual payout of $1.52.

This regular dividend is covered by recurring income, while the undistributed income enabled Ares to pay four special dividends over the past two years.

Under $16, it is trading below book and yielding over 9.5% just from its regular dividends. BDC shares tend to be very volatile, but if a steady 9%+ yield sounds attractive to you, Ares is a strong buy at these levels.

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