Following dividend cuts at a couple of Business Development Companies (BDCs), prices have dropped, partly on realization as quarterly financials came out that the sector was ahead of itself, notes Adrian Day, editor of Global Analyst.

Ares Capital (ARCC) fell sharply after missing estimates for Net Investment Income, which came in at 32 cents, well below the dividend of 38 cents.

This shortfall was due to lower-than-expected fee income (because of fewer new investments), as well as from the impact of the great number of shares outstanding from the acquisition of American Capital.

Though Ares has the capital, and a strong backlog of potential deals, it chose to close fewer because of the high valuations, hence the shortfall on fee income. Credit quality remains good and stable, with non-accruals at just under 3% (at cost). NAV inched up.

Overall, in our view, the “bad” part of the financial report was understandable, while the fundamentals remain good. While we are not expecting any dramatic increase in income in the coming quarter or two, the potential for gains is strong, given the opportunities presented by the American Capital portfolio.

ACAS brought $1.1 billion in assets with average yields of 6.7%, so we expect Ares to sell down these high-quality assets and move into higher yielding opportunities.

Such moves would also generate origination fees which would help to offset the remaining lower-yielding assets on a quarterly basis.

That Ares chose not to buy more so far this year is a sign of their discipline, we think. I suspect that had they been more aggressive to achieve Net Investment Income that covered the dividend, the market would have rewarded them; opting not to chase high valuations and yields is a positive for the long term.

Trading at just under NAV—below its post credit crisis average—and yielding almost 9.4%--above its average, though below its highs—makes it attractive.

Earning over 9% from a solid company with a strong balance and stable NAV is not so bad! At its lowest price of the year, Ares is a buy for more conservative or income-oriented investors.

Subscribe to Adrian Day's Global Analyst here…