Impending doom. This is what many investors conflate with a double-digit dividend yield.
To conflate isn’t necessarily wrong. When a dividend yield exceeds 10%, one can frequently find a share price that’s fallen through a metaphorical floor (a perceived support level). Investors are pricing in the worst – an impending earnings collapse or a dividend cut. And the worst can occur, as many investors in oil-and-gas-production MLPs have painfully learned.
Other times, though, conflating a double-digit yield with impending doom is necessarily wrong. Though the business outlook remains solid, business risk has been exaggerated. No earnings collapse or no dividend cut looms. Such is the case with the following two high-yield investments.
A High-Yield Lender That Deserves a lower Yield
Ares Capital Corp. (NASDAQ: ARCC) is one company with a double-digit dividend yield that’s priced with exaggerated business risk. Ares is a large business development company (BDC). Its shares yield 10.7% because its share price is down 14% over the past year.
Though not necessarily priced for impending doom, Ares shares are, nonetheless, priced irrationally. The yield should be lower – closer to the 9% historical norm. In turn, the share price should be higher.
Yes, Ares posted lackluster first quarter results, but the results were hardly ominous. Net investment income posted at $0.36 per share vs. $0.39 per share a year ago. The weighted average yield on its investment portfolio dropped 40 basis points year over year, though it was still respectable at 9.2%.
I should note that capital markets experienced heightened volatility in the first quarter. This was due in large part to the collapse in oil and commodity prices. Questions about the slowing of global economic growth and general confusion regarding the direction of interest rates around the world contributed to market volatility.
The market has since recovered. Commodity and oil prices have stabilized and trended higher; interest rates are down, and likely to stay down. Ares’ lending opportunities and net investment income should improve going forward.
Ares is the largest BDC in the market. And it’s about to get larger. In May, Ares announced it will acquire fellow BDC American Capital (NASDAQ: ACAS) in a transaction valued at $3.4 billion.
I like the acquisition. Ares is buying American Capital at a 20% discount to net asset value. The combined companies will be twice the size of the next largest competitor. By acquiring American Capital, Ares adds scale and diversification, giving it the ability to originate larger loan transactions.
Precedence is on Ares side. It has successfully assimilated large acquisitions in the past. A few years ago, Ares acquired Allied Capital, and after consolidating Allied, Ares was able to generate additional value from the acquired assets.
The playbook will be much the same with American Capital. I expect that Ares will rotate out of Allied’s no-yield equity investments and rotate into higher-yield lending assets. These assets will not only support Ares dividend, they will give it the ability to increase the dividend over time.
Death Doesn’t Take a Holiday, and Neither Does This Partnership’s Distribution
StoneMor Partners (NYSE: STON) is as equally undeserving of its high yield – at 10.3% – as Ares Capital is.
StoneMor – a cemetery and funeral home partnership – has been a High Yield Wealth recommendation for nearly five years. Experience and history have shown that when StoneMor units yield above 10%, it’s a good buying opportunity.
As with Ares, investors are too focused on the here-and-now. In the first quarter, StoneMore reported that same-store revenue dropped 7% quarter over quarter (though year over year, revenue was up). But there were mitigating factors: Death rates for the quarter dropped 4% to 6% in all of StoneMor’s regions. The drop impacted at-need sales by $1.5 million. In addition, heavy winter storms are estimated to have cost StoneMor $3.5 million in pre-need sales.
In short, the first quarter was an anomaly. The cemetery and funeral-home businesses are, if anything, bets on one of life’s few certainties: we all come with expiration dates. As the population grows and as more baby-boomers near the end of their golden years, StoneMor’s opportunity to sell cemetery plots and to book more funeral home business grows.
Ares Capital and StoneMor are themselves anomalies: they offer double-digit yields. But more important, they offer double-digit yields that allow you to sleep at night.
Stephen Mauzy, CFA