I’m buying the greek gods of income

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Co-produced with Treading Softly

It has been said that everyone loves something. Whether in a spiritual sense, some form of deity, or something tangible. Some like to worship at the feet of the “almighty dollar.”

In ancient Greece, they openly worshiped a pantheon of gods. All of them had abilities and powers different from each other and focused on specific aspects of daily life or the economy as a whole.

Apollo was the god of the sun, his work is self-explanatory.

Ares was the god of war, again it seems pretty straightforward.

Recently, we were able to see the earnings releases of two very popular companies for income investors: we buy for income and we ride price movements as they come and go. These companies are named after Greek gods and provide us with a great stream of income.

Therefore, I am buying the Greek gods of income to bring their unique abilities and skills to my portfolio. In the end, they will allow me to continue to earn excellent income month after month.

Let’s climb Mount Olympus together.

Choice #1: ARCC – 10% Yield

Ares Capital Corp. (ARCC) reported a very strong quarter and telegraphed that they expect these returns to continue with a strong dividend increase of 11.6% to $0.48/quarter. The market is surprised, but it really shouldn’t be. ARCC borrows at fixed rates and lends at floating rates. If there is a better business model in a rising rate environment, we can’t think of one.

You can see how ARCC’s return on investments has increased over the past year. From 7.7% to 9.6%. (Font: ARCC Q3 Presentation.)

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ARCC Q3 Presentation

Meanwhile, their debt is fixed rate and they don’t have many maturities for several years.

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ARCC Q3 Presentation

This provides a very long way in which rising interest rates directly contribute to the bottom line. We saw that in third quarter earnings, and we’ll see more in the fourth quarter as interest rates continue to rise.

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The risk for ARCC is “credit” risk. Lending money at high rates is great, but it doesn’t mean much if borrowers can’t pay. Many in the market have probably assumed that with the economy slowing down, the risk of default would increase.

ARCC rates their portfolio on a scale of 1 to 4, with 1 being the worst, meaning they do not expect to recover full principal, and 4, meaning the borrower is exceeding expectations and assumptions made in underwriting. All loans start with a “3,” which means the business is performing within expectations.

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ARCC Q3 Presentation

Note that ARCC’s credit quality improved during the quarter, with Grade 4 growing while Grades 1 and 2 remained about the same. This probably surprises a lot of people. However, we must keep in mind that inflation can decrease the purchasing power of earnings, but it makes it easier to pay off debt. GDP was negative in the second quarter after adjusting for inflation. Before adjusting for inflation, growth was high.

In general, companies are seeing higher revenues and higher EBITDA on a gross basis. This makes it easier for them to pay off their debt. We can see this happening in the ARCC portfolio. EBITDA is increasing.

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ARCC Q3 Presentation

Interest coverage has decreased to 2.0x. which seems low compared to last year, but is actually close to the average for ARCC history. Here’s a look at the same slide from Q3 2019.

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ARCC Q3 2019 Presentation

Our thesis with ARCC and other debt investments has been that companies are relatively well prepared for tough times. Balance sheets are stronger than average thanks to defensive moves during COVID, with many borrowers focused on refinancing fixed-rate debt at historically low interest rates. Thus, even as interest rates rise and the economy slows, default rates will remain low relative to historical experience.

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This thesis is being developed with ARCC and other credit sensitive investments. Their prices have been hit by market fears and they are an excellent opportunity to obtain high yields. Prices are down, but dividends are up!

Pick #2: ARI – Yield 12.4%

Apollo Commercial Real Estate Finance, Inc. (ARI) surprised the market. What did you do? Well, exactly what management said would happen. They said the rate hike would be good for their profits. They stated that they would not cover the dividend in the first semester but would cover it in the second semester.

Never be surprised by what surprises the market. ARI reported what is objectively a “good” earnings report. They had $0.37 in distributable earnings, covering their $0.35 dividend by 106%. It’s okay. not great. Certainly not a number that would make you think a dividend increase is imminent.

Book value increased during the quarter as ARI made a profit on a previously impaired investment that they received deed-in-lieu of foreclosure on and later sold. ARI also reversed a CECL (current expected credit loss) provision as a property that was in default and entered into a contract of sale. This is an example of why commercial mortgages are attractive. Even when a borrower defaults, there is real estate value that ARI can extract. With an average loan to value of 60%, the value of the property can go down a lot and ARI can still be fully recovered.

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ARI Q3 Investor Presentation

So why is ARI up almost 20% today? The price was ridiculously low to begin with. We’ve discussed this before, about how the market is irrational, and it’s like your crazy neighbors yelling random numbers at you to buy your house. In the short term, the market is a voting machine and the only requirement to vote is to have money in a brokerage account. In the long run, it is a weighing machine. Earnings matter.

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At HDO, we constantly preach about filtering out voter noise. Focus on the fundamentals. Is the business making more money? Is the dividend safe? Is it getting safer?

Well, ARI told us today that the business is making more money, the dividend is safe, and it’s getting safer. As a result, market voters have realized how wrong they are and the price is skyrocketing.

The lesson to be learned from ARI is that when the market is selling something, don’t assume it’s “right.” Don’t assume something is “wrong.” Focus on the fundamentals of the business. Take the time to understand the business and the dynamics that drive it. Rising interest rates are fantastic for commercial mREITs. They have variable rate loans! However, the market has sold them out of fear.

Just thank the market, buy when prices are low and earn dividends.

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conclusion

While you may not be worshiping at the feet of the sun god or the god of war, the associated religious beliefs have faded in the review mirror of history. We still see their names as parts of large companies or institutions.

For me, ARI and ARCC are great providers of regular and recurring income in my portfolio. Both posted solid earnings and based on my analysis, the outlook for both remains positive and strong.

What does this mean? Will I be decorating my garden walkways with the Greek art of Apollo and Ares? Probably not. Instead, I will cash the dividend checks I receive from the companies that bear their names.

You can too, by buying shares of the Greek gods of income! Then your retirement can enter a new phase of tranquility and relaxation. Less stress about when to sell stock, more enjoyment of receiving cash for doing nothing but being a passive owner of a large company.

Retirement should be a time when your active work ends and your passive income provides you with what you need to make ends meet and beyond.

That’s the beauty of income investing, even the Greeks would agree with that.

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