Co-produced with Treading Softly
When I was young, my parents - who were by no measure wealthy, but firmly middle class - loved to give presents at Christmas to my sibling and me.
We had a bay window facing our front yard, within that bay window set up, we would put our Christmas tree year after year. Underneath it, were carefully wrapped presents stacked diligently and with care.
The brightly colored wrapping would reflect the light from the Christmas lights adorning the tree.
Some years we had more presents and other years, fewer presents, I was none the wiser year-to-year as the best aspects of Christmas in my household growing up was the time with family and the exciting joyous atmosphere. It was infectious.
As new members join High Dividend Opportunities, or as investors try out income investing for the first time in earnest, I love the opportunity to interact with them as they start out on their journey.
The first dividends arriving into their account start off a lifelong joy of looking forward to and celebrating their arrival. In many ways it captures that excitement a small child has on Christmas morning, looking over the presents under the tree - waiting in anticipation to open them.
We don't buy or recommend any old company that's paying dividends. We vet and research thousands of ideas to distill the pool of choices into a smaller and smaller select group, which we have in our Model Portfolio.
Today, I want to discuss two picks we love to have wrapped under our tree, and love to see others open to get income for decades to come.
Let's dive in!
Pick #1: ARCC - Yield 10.1%
Ares Capital (ARCC) is one of the largest and most "blue chip" BDCs (business development corporations) in the market. We've been pounding the table about our strategy of being "agnostic" toward interest rate hikes. This means we own a variety of picks that benefit from rising rates and picks that benefit from flat/falling rates. We will not put our fates in the hands of a handful of people on the Federal Open Market Committee.
While the market is cheering the possibility that the Fed might "slow down," it's important to keep in mind that rates are still going up. The Fed is expected to "only" hike 50 bps in December and then slow down to hike 25 bps an unknown number of times.
On the other hand, the economy is showing definite signs of slowing, and inflation has been ticking down every month. The idea that the Fed might surprise the market with a pause or even a cut sometime in the next 3-6 months cannot be ruled out.
With such uncertainty, it's more crucial than ever to ensure we are positioned to be "agnostic" toward interest rates. Over the last couple of months, we've talked about a lot of fixed-income opportunities that will benefit from rates flattening or falling. It's important to keep balance, adding a few picks that will benefit if the Fed keeps hiking and maybe is more hawkish in 2023 than the market currently expects.
ARCC has a business model of borrowing fixed-rate debt and lending at floating rates. A business model that has obvious benefits in a rising rate environment. As rates have gone up, ARCC has seen the interest it pays remain fairly stable while the interest it collects has risen.
ARCC reported core earnings of $0.50/share in Q3, which would have been about $0.54 if market rates at the end of September had been experienced throughout the quarter. There's a lot more upside with rates up about 100 bps since the end of September, which would add approximately $0.0675/quarter to ARCCs earnings. Source
ARCC has raised its regular dividend twice this year, for a 20% increase year over year. That isn't counting the $0.03 supplemental dividend that ARCC has paid each quarter this year. Going into 2023, momentum is strong for even higher dividends.
What's the risk? When you're lending money, the risk is always whether or not the borrower pays you back. ARCC is one of the few publicly-traded BDCs with a track record from before the Great Financial Crisis – a difficult time for all lenders for obvious reasons. Despite that difficult period, ARCC has had very few credit losses, with realized gains far exceeding their credit losses.
If there's one BDC we are comfortable holding through a recession, it's ARCC. Today, ARCC is even lower risk than it was pre-2009. With its substantial size, ARCC has moved its focus to the "upper middle market." The weighted-average EBITDA of ARCC's portfolio companies is over $240 million. That's more than many publicly traded companies!
This makes ARCC a great option for investors who are looking to capitalize on rising rates but are also concerned about the risk of a recession that could be caused by the Fed's hikes.
Pick #2: BRSP - Yield 11.6%
BrightSpire Capital (BRSP) struck a cautious note in its Q3 earnings call. CEO Mike Mazzei stated:
BrightSpire expects the first half of 2023 to remain challenging. More presently, over the course of 2022, BrightSpire has been preparing for the impact of rising rates and the current risk-off investment environment. To this end, we have been throttling back our loan originations and maintaining higher cash balances.
Then wrapping up with the comment:
Finally, that will undoubtedly be great lending opportunities that will arise from this market dislocation. But to be clear, over these past few quarters and in the very immediate future, all things equal, our bias is that liquidity will generally take precedent over new loan originations and stock buybacks.
This is in extreme contrast to prior management from Colony Capital, which had a "pedal to the metal and forget the risk" attitude. Some might expect that the market would be happy that BRSP's new internalized management is being forward looking and cautious with shareholder capital, considering that the record of prior management is best described as an unmitigated disaster. Asking "What would Colony do?" and doing the opposite is a very good management strategy.
Instead, the market saw that BRSP was not growing and swiftly punished it. As a result, BRSP is trading at over a 40% discount to book value.
Let's get this straight: BRSP is being conservative and maintaining a modest leverage of 2.3x. It earned $0.25 in distributable earnings, covering its $0.20 dividend by 125%. It has ample liquidity at $387 million, including $222 million in unrestricted cash ($1.72/share). BRSP's loan portfolio is now 97% Senior Secured mortgages, emphasizing the strong multi-family sector. We would argue that BRSP's risk level is low compared to many peers. It's certainly very low compared to its own history when it was managed by Colony.
The best part is that earnings are still growing, even with a more conservative posture from management. BRSP directly benefits from rising rates and will see its income grow even without making new investments. Source
As a result, we can buy BRSP and receive a double-digit yield because some in the market believe that management is being "too conservative." Usually, companies with double-digit yields are accused of taking on too much risk!
There's no good reason for BRSP's massive discount to book value, and we're happy to keep buying before the market figures that out.
Conclusion
With ARCC and BRSP, we have two excellent income generators to look forward to having in our portfolio. ARCC is a blue-chip income generator with a long history of being a stable and reliable source of income. Its past encourages us to look forward to a great future. BRSP is laying the foundation for becoming a blue chip in the future. After its change of name, management, and overhaul of its portfolio, BRSP is becoming a new powerhouse throwing off outstanding income as its portfolio is developed further.
When building out an income portfolio, one should never look at yield alone, but do their due diligence and research every idea thoroughly. This is why resources like Seeking Alpha can be a massive benefit and tool in your research. Don't neglect understanding why you hold something - your reason to buy and sell will likely not be identical to others!
In retirement, many are looking for sources of income to supplement their Social Security and other income streams. ARCC and BRSP can be two additional sources of income to keep their income stream flowing at a strong, healthy rate.
As an added bonus, your inner child can sit in excited anticipation of your next dividend arriving into your account with the same joyous excitement as waiting to tear off the wrapping paper on presents and finding out what a loved one is giving you.
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