Why Investors Can Trust This “Alternative Bank’s” 8% Payout
February 17, 2020
Can You Really Trust This High-Yield Stock?
Investing in high-yield stocks is often like cooking chicken two days past the expiry date. You just can’t trust either of them.
And like the expired meat in my fridge, I throw most of the high-yield stocks that cross my desk in the wastebasket. These often represent struggling businesses with declining cash flows or big debt loads—hence why other investors skipped over them.
But today’s company could inspire confidence, at least as far as the dividend is concerned.
This High-Yield Stock’s an “Alternative Bank”
Ares Capital Corporation (NASDAQ:ARCC) is a business development corporation, or BDC, which earns interest from lending to mid-sized companies. My colleague Jing Pan dubbed these outfits “Alternative Banks,” because they resemble traditional financial institutions.
But can investors really count on Ares Capital Corporation’s eight-percent payout?
Anytime you see such a high-yield stock, you really want to do your homework. So, let’s dive into the financials.
First off, Ares Capital Corporation has avoided one of the biggest problems in the BDC space: chasing yield.
In an effort to boost returns, some BDCs have started lending to less-than-stellar companies. Over the past year or so, lower-tier companies have increased their exposure to cyclical industries or borrowers with lower credit ratings.
Ares Capital Corporation, in contrast, has stuck primarily to “prime” customers. Recession-proof industries like food and beverage, health care, and power generation account for almost a third of the company’s loan book. (Source: “Ares Capital Corporation Investor Day 2019,” Ares Capital Corporation, May 21, 2019.)
Furthermore, 80% of the company’s book consists of senior secured loans. In other words, Ares stands first in line to get paid in the event that one of its portfolio companies runs into financial trouble. This positions the business well in the event of another downturn.
Shifting our attention to the income statement, management appears to be running the business in a conservative manner.
For full-year 2019, Ares paid out $1.68 per share in dividends on a net income of $1.86 per share. That comes out to a payout ratio of 90%.
Generally, I like to see companies pay out 90% or less of their profits as dividends. This leaves management with a little bit of wiggle room to keep mailing out checks in the event of a downturn.
Ares’ distribution, therefore, sits at the upper end of my comfort zone. But given the company’s conservative balance sheet, shareholders don’t have too much to worry about.
Don’t Ignore the Interest Rate Issue
So, what could go wrong here?
Interest rates.
Ares lends out a lot of money to customers on what the lending industry calls a “floating rate basis.”
This means the interest rate charged on the loan rises and falls along with the prevailing yields in the marketplace.
This strategy could backfire. In recent months, the Federal Reserve has started cutting rates in a bid to jump-start the economy. If they continue with the policy, Ares will see a dip in its interest income.
Furthermore, a recession would likely cause a spike in defaults.
Again, Ares has positioned itself better than most BDCs in the event of a downturn. But, with such a high payout ratio, executives don’t have unlimited wiggle room.
To say it another way, you can’t slap a perfect safety rating on this high-yield dividend stock. But Ares Capital Corporation should have no issue paying distributions for the time being.
Income hunters should give ARCC stock a second look.
