ARCC - Earn Lifelong Income From A Magnificent Dividend: Blue Owl Capital

2024-01-18 07:35:00 ET

Summary

• Quality trumps quantity when it comes to your portfolio and its income.
• Age-old investment theory focuses on the benefits of dividends.
• Financial freedom can be found when income exceeds expenses.

Co-authored by Treading Softly.

Recently, I've enjoyed a slew of videos of where an individual will place a tool that was made in the '50s and '60s underneath a press and see how much pressure it takes to crush the tool. Then they take a modern example of the same tool made in the last three years and do the same test to see which one can withstand higher pressures. The idea of using this press to crush the tool is meant to examine the quality of the materials and metal used in the production of this tool. Unfortunately, a lot of modern tools use inferior materials and inferior processes to mass produce an item at cheaper prices, that likely could have been better produced differently. The question comes down to which one is a better value, one likely cost more at the time once adjusted for inflation, but was built for more rigorous and steady use, while the other was likely inexpensively made and sold inexpensively, being designed for the occasional homeowner use.

When it comes to the market, we're not building portfolios that will be crushed under pressure. We want to build portfolios that perform consistently through decades of rigorous use; because of this, you must consider age-old methods to develop your portfolio. This is the reason why, when I developed my Income Method, I didn't look at just the last 20 years of investment philosophy. I looked further back to when dividends were the primary means of returns by many companies. Companies like the East India Company paid their shareholders with massive dividend yields for their ownership of the company. The idea was that if you owned a company that was profitable, you deserved strong money to come out of that ownership and into your pocket. One way to generate strong income from the market is by owning BDCs (Business Development Companies), which then provide capital to middle market firms – the largest subset of companies within the United States.

Today, I want to look at one of these companies that provide much-needed financing and management oversight to these middle market companies and show how it is not only producing strong income today but can produce dividends that you can rely on for decades.

Let's dive in!

A Hooting Good Company

Blue Owl Capital Corporation ( OBDC ), yielding 9.3%, is a BDC that is relatively new to the public markets but is still among the largest in terms of assets. With a portfolio of $12.9 billion, OBDC can make larger investments than many peers. One way of looking at BDCs is to consider their target borrower. Some BDCs specialize in very small businesses, others focus on startups that are funded by venture capitalists, and only a handful have the size to manage a portfolio that is dedicated to the largest private companies. OBDC's average borrower has an EBITA of $196 million: Source .

This is comparable to one of my favorite all-time BDCs, Ares Capital ( ARCC ), which also targets the upper middle market.

We have been arguing for years that OBDC is a high-quality BDC that should be trading at a premium to NAV.

OBDC is the third largest publicly traded BDC. It has an investment-grade balance sheet , carries a modest leverage of 1.13x debt to equity, and has healthy diversification across 187 portfolio companies.

This adds up to a BDC that we believe is capable of trading at a 10% premium to NAV. OBDC has been out-earning its dividends, which has helped drive NAV higher.

BDCs have benefited greatly from rising interest rates, and OBDC is no exception. The loans that BDCs make are floating rate, so higher rates drive higher earnings. This has been a major driver of OBDC's earnings and is responsible for OBC's "supplemental" dividends.

One question I am frequently asked is the impact of declining rates on BDCs. As interest rates decline, we should expect that the size of supplemental dividends could decline.

Here is a look at OBDC's current interest rate sensitivity: Source .

For every 100 bps change in rates, OBDC would expect approximately a $72.4 million change in net investment income. This assumes that everything remains "as is" and OBDC does nothing to mitigate the impact. That works out to be about $0.046/quarter impact to NII.

In Q3, NII was $0.49, compared to $0.41 in total dividends.

The first thing we can see is that even with a 300 bps decline in rates, the regular dividend is still easily covered since it would result in approximately a $0.138/quarter decline in NII. The supplement would likely start to shrink after about 100 bps in cuts, but would likely continue to be paid at a smaller amount up to about 300 bps in rate cuts.

However, we should also note that BDC prices peaked when interest rates were 0%. While declining interest rates are a headwind for recurring cash flow, they are a positive for NAV and valuations as the high yields that BDCs pay become relatively more attractive in a low-interest rate environment. Additionally, like many BDCs, OBDC takes an equity position in many of its borrowers.

Common equity makes up about 9% of OBDC's portfolio. Equity in private companies is not liquid and is not traded on a public market. The value in equity for a private company is usually realized when the company is acquired, files for an IPO, or is recapitalized, and the BDC is bought out by other existing shareholders. When interest rates decline, the potential for these types of liquidity events increases. This can lead to large gains and "special" dividends.

This is why we are happy to continue buying more shares of OBDC while it is trading at a discount to NAV. The market is finally starting to see the quality of the company, and we don't think this discount is likely to stick around much longer.

Conclusion

With OBDC, We get a management team that knows what their target market wants. The manager has carefully raised the common dividend and supplemented with special dividends over the last 5 quarters. They know the regular dividend will remain strongly covered when interest rates decline again and those supplemented dividends will be forced to go away. This is something that I wish more companies would do when they are in a Goldilocks time frame: that they'd recognize that the regular dividend is something that people hold very sacred and that supplemental dividends be used rather than raising the regular dividend to an unsustainable level. Either that or I wish that they would just do a completely variable dividend, even though that would make it harder for most of us who like to budget our income around our dividends.

When it comes to retirement, the last thing that you want to do is have to wonder if the companies you hold in your portfolio are going to be able to sustain you over the long run. I want to have income that lasts for decades because I plan on lasting for decades, which is something that allows you to have true financial freedom and financial independence. Having income that vastly outweighs and overwhelms your expenses so that you have time to enjoy your hobbies and don't have to worry about your budget is a true result and blessing.

That's the beauty of my Income Method. That's the beauty of income investing.

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