Ares Capital Is Great. Here's Why You Shouldn't Buy the Stock.
If you are an income investor then you have probably seen Ares Capital (NASDAQ: ARCC) pop up on a stock screen or two. Its huge 9.8% dividend yield would probably be as attractive to a dividend investor as candy is to most children. That's normal.
But it's probably best that you try to understand what this company does before you just step aboard with your investing dollars.
Ares is not a regular company
Ares is what is known as a business development company, or BDC. Basically, that means that it makes loans to other companies. This business model involves being something of a specialty lender, stepping into a space in which banks would have historically operated. That's actually a fairly important distinction.
After the Great Recession banks pulled back dramatically with regard to their lending practices. Simply put, they focused on safer lending and increasingly began to avoid riskier lending. Ares is one of the companies that stepped into the void left behind. But that means its portfolio of loans tends to be in higher-risk investments.
These are typically smaller companies that either can't get a loan from a bank or the cost of such a loan would be so high that it isn't feasible. The weighted average yield on Ares' portfolio is 11.2%. That's a huge number and suggests that the company is working with borrowers who are not exactly of the AAA variety. This isn't a bad thing, per se, but it does mean there is more risk here than meets the eye.
In fairness, Ares has a good track record of building a strong portfolio. The number of loans that have gone bad here are modest relative to peers. And it has a fairly well-diversified portfolio with lower exposure to some of the riskiest industries relative to its peers. So, relatively speaking, it could be viewed as a lower-risk option in the BDC space.
You just have to make sure you want to take on the risk of a BDC before you consider buying it.
What could go wrong?
Over the past decade, Ares has had a very strong dividend history. Even after factoring in the economic downturn during the early days of the coronavirus pandemic, the dividend has trended steadily higher over the past 10 years. That said, during the 2007-09 Great Recession, Ares ended up cutting its dividend.
That's an important period to consider. As noted, banks have been pulling back on lending to the types of companies that work with Ares because they tend to be riskier. That risk can come from being small, financially weak, and highly concentrated, or some combination of the three. During economic downturns, these are the types of companies that can run into financial trouble fairly quickly. With a portfolio filled with loans to higher-risk companies, Ares is materially exposed to recession risk. That is a big part of the reason why the deep recession from 2007 to 2009 resulted in Ares trimming its dividend.
Then there's the double-edged sword of interest rates. Many loans that BDCs like Ares make have variable interest rates. When rates go up, the payments the companies make go up, too, and vice versa. While that means Areas makes more money in a rising rate environment, which is good, it can also put more financial strain on the companies in which it has invested. Indeed, paying more in interest isn't usually a good thing for the borrower. That can lead to risk rising just as Ares appears to be doing better.
Ares stock is not for the risk-averse
There's nothing inherently wrong with Ares. It has a pretty good track record in the BDC space. However, that doesn't mean that investors should be lining up to own its huge 9.8% dividend yield. It is a complex investment that requires a great deal of monitoring. And when economic risks rise, such as during recessions, investors have to be prepared for the potential of a dividend cut. For more aggressive investors the puts and takes here will probably be acceptable, but conservative dividend investors should probably err on the side of caution and look elsewhere.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Ares Capital Is Great. Here's Why You Shouldn't Buy the Stock. was originally published by The Motley Fool
