2023-06-07 14:00:00 ET
Summary
- Ares Capital continues its robust recovery from its March selloff. Dip buyers who braved the impact have been rewarded.
- Economists are turning less gloomy about macroeconomic conditions. The US economy has proved to be incredibly robust.
- While ARCC has moved well past its peak pessimism, its valuation is still attractive, suggesting buyers have not returned in full force.
- The uncertainty over the Fed's pivot and high interest rates proffer an opportunity for investors to ride the current wave back up.
- Don't wait until the discount against its historical averages disappears before returning.
I urged investors in Ares Capital (ARCC) to capitalize on the panic that forced a steep March selloff but was stoutly defended by dip buyers. ARCC has not disappointed since then, with more buyers returning as it recovered more than 12% (in price-performance terms) since its March lows.
The doom and gloom over worsening credit and default risks have simmered down, justifying our thesis that the steep pullback was a fantastic buying opportunity.
Recent commentary about the economy has also improved, suggesting economic forecasters are increasingly less concerned. The US economy has remained robust despite the recent banking crisis crimping credit, and employment conditions remain favorable.
Apollo Global Management ( APO ) CEO Marc Rowan aptly calls it the " non-recession recession." He articulated the financial markets have "already adjusted to the changing conditions." In addition, he doesn't anticipate a "traditional unemployment level recession."
It also adds more color to the recent revisions in economic projections by some economists. In a recent commentary, Morgan Stanley ( MS ) highlighted that it believes the " US economy will dodge a recession in 2023." While it acknowledges risks from "tighter credit conditions," it's still convinced of a "soft landing" this year.
In addition, Goldman Sachs ( GS ) economists have lowered their predictions of a US recession over the next year. They pointed out that the risks from the Silicon Valley Bank debacle (SIVBQ) have abated, supported by the positive conclusion of a potentially " disruptive debt ceiling fight."
Hence, investors who didn't capitalize on the panic selloff in ARCC have likely missed out on some of the most favorable risk/reward opportunities I previously highlighted.
Keen investors in ARCC know that investing in high-yield business development companies or BDCs entails significant risks. With ARCC still printing a forward dividend yield of more than 10% (10Y average: 9.5%), a marked level of pessimism is still priced into its valuation. However, that discount is likely needed to justify the spread against the 2Y Treasury yields, which remains close to 4.5%.
Moreover, analysts expect that Ares Capital could see its forward earnings getting hit in 2024 as the market prices in a lower interest rate environment moving ahead. An analyst at its April earnings conference call also shared his concern about the impact of potentially lower interest rates on new loans to its portfolio companies.
The discussion focused on how successfully Ares Capital has used higher interest rate floors against a potentially lower rate environment moving forward. Management stressed that while rate floors were " effective, " the impact "across the overall portfolio is very small."
As such, I believe it's prudent for investors to reflect appropriate earnings growth normalization, depending on the curve of the Fed pivot. Notwithstanding, BlackRock ( BLK ) argued that it doesn't anticipate " major central banks coming to the rescue with interest rate cuts this year, and [it] sees rates staying higher for longer."
As such, it should proffer investors more time to assess the opportunities and risks of the current environment. With regional banks expected to turn more cautious on lending, leading middle-market BDCs like Ares Capital are well-primed to benefit.
However, a lower interest rate environment could also impact earnings growth, coupled with the need to reflect a reasonable valuation discount against the 2Y Treasury yields.
ARCC price chart (weekly) (TradingView)
ARCC's price action remains constructive. I'm of the opinion that ARCC's recovery from its March lows could bolster a more robust and sustainable recovery than the previous surge from its October 2022 bottom.
It indicates that buyers have not rushed back and have been accumulating "steadily," which is a possible sign of accumulation. However, ARCC has reached a critical juncture, likely requiring momentum buyers to return from the sidelines to help keep its price action above the 50-week moving average or MA (blue line).
If ARCC buyers can sustain their momentum above those levels, I am increasingly confident that ARCC's medium-term downtrend will be reversed.
While I don't anticipate dip buyers to add aggressively at the current levels, ARCC's relatively attractive valuation suggests that these levels are still reasonable.
Rating: Buy (Reiterated).
Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing, unless otherwise specified.
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Ares Capital: A High Yield Opportunity Priced At A Bargain