Here are 2 Capital Ideas to Buy With Unusual Options Activity

It's Father's Day weekend. That means two things: We all get to celebrate our dads, and they get to watch the U.S. Open. 

As I write this on Friday, a few minutes before the markets open, Christiaan Bezuidenhout has the best score in the second round, two under through seven holes. Patrick Cantlay has to tee off. He leads the tournament after the first round at five under par. Amazingly, Scottie Scheffler is way back in the 32nd spot. 

Enough about golf. I’m here to talk about unusual options activity. 

Two stocks caught my eye this morning. I’ve called them “capital ideas” because the word capital is part of their corporate names. 

Capital Southwest Corp. (CSWC)and Ares Capital Corp. (ARCC)are the two companies in question. 

Both had two unusually active call options in Thursday trading. Both are worth considering as long-term investments and potential income generators in the near term. 

Have an excellent weekend!

Why Own Capital Southwest?

Capital Southwest is an investment company that I came across years ago, but I’ll be damned if I could remember what attracted me to the Dallas-based company. 

Founded in 1961, it has provided capital to more than 250 middle-market companies over the years. It became an internally managed BDC in 1988. As of March 31, it had $1.6 billion in total balance sheet assets.  

In October 2015, it spun off its industrial businesses operating as CSW Industrials (CSWI)into a separate company to focus on lending to the middle market. Capital Southwest shareholders got CSWI stock on a 1:1 basis. CSWI stock is up 714% since the spinoff.

“With the completion of the spin-off, we are now solely focused on executing our investment strategy of lending to middle-market companies across a diverse set of industries, and we have made significant progress in divesting our legacy minority equity investments and redeploying the proceeds in debt investments,” CEO Bowen Diehl said at the time. 

The spinoff was necessary because Capital Southwest traded at a significant discount on its net asset value. Its industrial businesses had accumulated significant embedded capital gains and did not pay a meaningful dividend. 

In June 2014, 1% of the investment portfolio comprised income-earner assets. By March of this year, it was 89%. It focuses its investments on private equity-backed lower middle market businesses with annual EBITDA between $3 million and $25 million. It will lend up to $50 million, although the average tends to be between $5 million and $35 million. Generally, the loans are floating rate first lien debt securities. 

In 2023, it paid $2.42 in dividends, a yield of 9.7%. So far, in 2024, it’s paid two at $0.63 a share. It trades at a 49% premium to its net asset value per share. Its stock is up 31% over the past year.

While it makes sense to consider buying shares in the teens, it remains an excellent stock for investors who need income. I’ll get into why the options make sense in a little bit. 

Why Own Ares Capital?

Ares Capital is also a BDC. It is externally managed by an Ares Management (ARES) subsidiary, one of the world’s best alternative asset managers. ARCC is one of the largest direct lenders in the U.S. Its market cap is about 13 times larger than Capital Southwest's. 

Like Capital Southwest, it lends to the middle market. However, as of March 31, 2024, Ares Capital had $23.1 billion in investments. It finished the first quarter with 510 portfolio companies, up from 496 a year earlier. The investments it makes range between $30 million and $500 million, with the average company generating annual EBITDA between $10 million and $250 million.

Approximately 89% of its investments are in first-lien senior secured loans. The top three industries by weight are healthcare services (24%), pharmaceuticals, biotech and life sciences (21%), and software and services (15%). A tiny portion goes to consumer-focused businesses.

Over the past four quarters, it paid $1.92 in dividends, a yield of 9.3%. So far, in 2024, it’s paid two at $0.48 a share. It trades at a 6% premium to its net asset value per share. Its stock is up 12% over the past year.

Given its association with Ares Management, it is a slightly more conservative investment than CSWC, but I like both.

The Call Options From Thursday

As I said in the intro, each company had two unusually active call options in Thursday trading. They’re listed below. 

I’ll start with CSWC. 

Its calls expire next Friday with strike prices of $22.50 and $25.00. With the closing ask prices from Thursday of $3.90 and $1.35, respectively, the latter’s net price paid should you exercise your right to buy is five cents cheaper at $26.35. 

Based on yesterday’s closing price of $26.12, they both need less than 1% appreciation over the next seven days to be in the money. I’d go with the $25 strike. It’s a down payment of 5.4% compared to 17.3% for the $22.50.

ARCC has two different expiration dates: next Friday and Aug. 16, which is 63 days away. The strike prices are the same at $20. The ask prices were different by 10 cents—$1.50 for the June 21 call and $1.40 for the Aug. 16 call. Based on a closing price of $21.27, the former is $23 out of the money, while the latter is $13 out of the money. 

With ARCC’s price-to-book of 1.09 and trading at a slight premium to its NAV, the Aug. 16 expiration looks like the better of the two unusually active call options.