It’s hard to believe that the third-quarter earnings season is drawing to a close. And while many Wall Street experts and retail investors were focused on the latest developments in artificial intelligence (AI) and other trendy areas, it’s well worth remembering that portfolio growth can come from different segments of the business world.
For some investors, preserving their capital may be more important than achieving market-beating returns. This is why I often write about the passive income that dividend stocks can provide. While many dividend stocks do not carry the same allure as high-flying tech companies in terms of growth potential, their prices are usually much less volatile.
One of the best ways to generate dividend income is by investing in business development companies (BDCs). One of the leading BDCs out there is Ares Capital (ARCC 0.10%), which at its current share price and payout yields 9.7%. If you’re looking to augment your portfolio with some steady passive income streams, this could be a great time to buy Ares shares.
What is a business development company?
Ares specializes in several types of investment vehicles across debt financing and private equity. In the case of a start-up, the founders might raise funding from venture capital (VC) firms in exchange for equity in the company. However, over time, the founders may be hesitant to continue raising money from VCs and give up more shares in the business. For this reason, the start-up may seek a non-dilutive investment in the form of debt. This is how a BDC like Ares adds value.
In addition to working with small and mid-sized enterprises, Ares also works with public companies that may be going through capital restructuring. Its clients include tax software company Avalara, education company 2U, and music streaming platform SoundCloud.
From an investment perspective, perhaps the most important fact about BDCs is that they are required to distribute 90% of their taxable income to shareholders each year. Usually, those distributions come in the form of monthly or quarterly dividends.
Good enough for Buffett
Warren Buffett is one of the most impressive investors of all time. One of the features that I admire most about Buffett is his contrarian approach to investing. He often takes large positions in blue chip companies that have steady cash flows and are best-in-breed brands. Financial services businesses, such as insurance companies and large banks, are among the bedrocks of the Berkshire Hathaway portfolio.
In addition to the stakes in banking companies that Buffett owns via Berkshire Hathaway, he also is exposed to a number of high-yield dividend stocks through his subsidiary investment vehicle, New England Asset Management (NEAM). And guess what? NEAM holds a position in Ares. In fact, it has been invested in the BDC since 2013. It’s not hard to understand why Buffett may appreciate Ares. Given the company’s dividend history and its market-leading position in the world of BDCs, it fits squarely with Buffett’s desire to own top financial services brands.
Is Ares attractive at its current valuation?
The chart above compares the price-to-book (P/B) ratio for Ares against a cohort of other leading BDCs — Hercules Capital, Golub Capital, TriplePoint Venture Growth, and Trinity Capital. If you’ve read my prior articles on BDCs and dividend investing, you’ll know that I am a big fan of Hercules Capital and its consistent market-beating returns. Unsurprisingly, Hercules trades at the highest P/B ratio among this peer set. Ares’ P/B multiple of 1.04 puts it right in the middle of the pack.
This other chart illustrates the payout ratio for Ares over the last decade. Its current payout ratio of 79% is essentially in line with historical averages. To me, this implies Ares has the financial flexibility to either raise its dividend or declare a special dividend in the future, given the current payout ratio is normalized when compared to 2020 and 2021.
If you are looking to supplement your portfolio with predictable passive income while also avoiding added exposure to the type of volatility often associated with growth stocks, Ares could fit the bill. Moreover, given its valuation relative to its peers and its 10% yield, it looks like a bargain buy.
Adam Spatacco has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends 2U and Berkshire Hathaway. The Motley Fool has a disclosure policy.