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By Adam Spatacco, The Motley Fool
Investors who are looking for growth in their portfolio may be captivated by technology stocks, especially given all of the recent hoopla around artificial intelligence (AI). But portfolio construction requires balance, and one of the pillars of a well-diversified portfolio is dividend stocks.
Business development companies (BDCs) can be a great source of dividend income, in part because they are required to pay out at least 90% of their taxable income each year as dividends.
One leading BDC that has consistently outperformed the S&P 500 is Ares Capital (ARCC 0.13%). With the shares trading at about $20, its dividend yield is now 9.5%, making this an opportune time to open a position and set yourself up to reap the passive income rewards.
What makes Ares Capital different?
Ares Capital sits in a unique position in the BDC world. BDCs typically compete with banks and even venture capital or private equity funds depending on the deal structure. However, most investment banks typically seek out high-profile companies and offer them a variety of solutions pertaining to mergers and acquisitions, raising capital through the equity markets, or borrowing money via the debt markets.
In contrast to many large financial institutions, Ares works with a lot of middle-market companies that may be underserved by traditional capital providers. Even among its peers, this approach is unusual. Leading BDCs such as Hercules Technology Growth Capital or Horizon Technology Finance tend to partner with the best start-ups in growth industries such as energy, life sciences, and technology.
By taking a different approach, Ares is not only carving out a niche in the world of BDCs, but it has found a way to tap into the types of activities usually handled by traditional investment banks.
An under-the-radar Warren Buffett stock
One of the core principles of Warren Buffett's investment philosophy is to seek out dividend income. Within the Berkshire Hathaway portfolio, some of the largest dividend generators include Apple, Coca-Cola, and Bank of America. But did you know Buffett has a little-known portfolio outside of Berkshire Hathaway?
The investment firm New England Asset Management (NEAM) is a subsidiary of Berkshire Hathaway. While NEAM is much smaller than its parent in terms of total assets, its portfolio contains a larger number of stocks — one of which is none other than Ares Capital.
Given the company's steadily increasing dividend over the past 10 years and its eye-popping total returns of 195%, it's easy to understand why Buffett loves this multibagger stock.
Should you buy Ares Capital stock?
From a valuation perspective, a useful measure for assessing Ares Capital stock is the price-to-book (P/B) ratio. It's a metric commonly used in analyzing banks and other financial services businesses.
The P/B ratio for Ares Capital is currently 1.06, right in line with its 10-year average. But perhaps more interesting is that it's well below its peak of 1.47. Moreover, that valuation also pales in comparison to those of Hercules Technology Growth Capital and Horizon Technology Finance, which have P/B ratios of more than 1.2.
The chart above shows the return of Ares Capital stock relative to a number of S&P 500-themed exchange-traded funds (ETFs) over the past five years. Investors can clearly see that Ares Capital is the top-performing equity. Given its discount relative to other leading BDCs and its low valuation compared to past periods, this looks like a bargain opportunity to consider buying some shares in this market-beating dividend payer.
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