A high dividend yield, large-scale buying by company insiders, and recent buying by funds controlled by Joel Greenblatt and George Soros.
Sound interesting? Then I suggest you take a look at shares of Prospect Capital Corporation (NASDAQ:PSEC), a business development company (“BDC”) traded on the Nasdaq.
If you’re unfamiliar with BDCs, you can think of them as publically traded private equity firms. BDCs provide financing to small and middle-market companies that are too early in their development to get funding from more traditional sources, such as the bond and equity markets. It’s a high-risk but potentially very high-return financing niche.
Similar to REITs, BDCs pay no taxes at the company level on the condition that they distribute at least 90% of their income to their investors via dividends. This makes BDCs some of the highest-yielding investments on the market, but—as is the case with REITs and MLPs—their inability to retain earnings for future growth also means that they regularly have to issue new shares, which dilutes current shareholders. That’s not necessarily a bad thing if new investments are accretive to earnings. But it means that management has to be extremely disciplined.
Let’s dig into the details of Prospect Capital. PSEC invests primarily in first-lien and second-lien senior loans and mezzanine debt and provides financing for leveraged buyouts, acquisitions, recapitalizations, and capital expenditures for growth. PSEC also invests in the higher-risk but potentially much higher-return equity tranches of collateralized loan obligations. Most of PSEC’s individual investments would have to be considered risky given the early stages of the companies involved, but the portfolio is diversified across a wide variety of industries.
PSEC pays an absolutely massive dividend, sporting a current dividend yield of 13.7%. Now, normally, that would make me pause. An exceptionally high yield is often a major red flag for an income investment, as it is often a prelude to a dividend cut.
In PSEC’s case, our risk is mitigated by three major factors. First, the company managed to sail through the 2008 meltdown without slashing its dividend. The company survived Armageddon with its dividend intact; that says a lot about its staying power. Secondly, the company has continued to modestly raise its dividend throughout 2014. And finally, the company’s management team has been aggressively buying the stock on the open market. If a dividend cut were likely, I have a hard time believing the people running the company would be putting millions of their own dollars into the stock.
Speaking of the insiders, let’s take a deeper look at what exactly they have been up to:
Four company insiders—including the CEO, CFO and COO—have collectively poured $5.3 million into PSEC stock in 2014, and all at prices higher than those we see today. CEO John Barry made a mill-on-dollar purchase as recently as a month ago.
Oh, and as an added sweetener, funds controlled by hedge fund gurus Joel Greenblatt and George Soros have recently taken positions in the stock. Are there any risks we should be concerned about here?
Sure. PSEC’s dividend payout ratio is currently 125%, which means that PSEC is effectively issuing debt and new equity to fund its current dividend. That is sustainable in normal, healthy capital markets. If we were to see the markets seize up again as they did in 2008, PSEC’s dividend would be at risk. But I consider that risk small enough to safely ignore for the time being.
PSEC’s stock currently trades at a 10% discount to book value. This means that you could hypothetically sell the company for spare parts and come away with a decent profit. While PSEC is mostly an income play, the discounted stock price makes respectable capital gains over the next year likely as well.
Disclosures: Charles is currently long PSEC in his Dividend Growth portfolio.Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.