PSEC: Finding Yield Return In A Low-Rate Environment

In a recent blog post for the Brookings Institute, former Fed Chairman Ben Bernanke offered some theories about why interest rates are low and gave explanations for why this type of environment is likely to continue. Bernanke’s thesis ultimately rests on the argument that long-term trends in interest rates have shown declines since the 1980s and that inflationary pressures will probably remain subdued for an extended period of time.

If Bernanke is correct, there are some important implications here for investors, as opportunities for yield return could be limited for some time. By the end of the year, most market analysts expect that interest rates to be higher than they are now. Of course, individual estimates vary. But the early expectation that rates would be as high as 6.5% in 2016 looks completely unrealistic at this stage -- and investors will need to find ways of positioning themselves to avoid the potentially negative ramifications that could be seen with an extended period of historically low interest rate levels.

Star Dividend Players

One way of combating the current climate is to find high-yielding dividend stocks that have a strong performance history and have shown consistency in sustaining payout ratios. One of the standouts in this category is Prospect Capital Corporation (NASDAQ:PSEC), which meets the criteria in both of these respects. PSEC stock has been met with selling pressure in recent months but when we combine these lower valuations with its elevated dividend yield (11.8%), the stock quickly starts to look like one of the best selections in equities given the current market environment.



Chart Source: CornerTrader

It should be remembered that stock markets as a whole at still trading near record levels, so there is something to be said for buying beaten-down stocks that come with solid dividend return. Most of the recent pessimism is PSEC has come as a result of the slight disappointment in the company’s second quarter earnings release, where Prospect Capital reported earning-per-share of 24 cents. The consensus estimate on Wall St. called for an earnings-per-share of 28 cents, so the initial disappointment brought a wave of selling that sent the stock back toward its lows for the year. But it should be remembered that most of the market becomes overly focused on the headline figure when any closely-watched earnings release is made public, and there are often many positives that go unnoticed when we dig deeper into the details.

For Prospect, the hidden positive can be found in the fact that even with the lower earnings number, there were no changes in the company’s book value. When we look at the company in terms of its net asset value (NAV), Prospect is still showing valuations of $10.35 per share. This is a decline of 38 cents relative to what was seen the previous year but the vast majority of this difference can be attributed to Prospect’s massive dividend (which exceeded earnings for most of last year). Prospect has managed to avoid major write-downs, despite the difficult climate in areas like energy, so the argument can be made that the worst is already behind us and that the stock is now poised for long-term gains.

To forecast potential gains in PSEC, we must combine its massive dividend yield with its discount to book value. PSEC is now trading at $8.41 per share, and this translates to a NAV discount of nearly 19%. If this seems excessive, it should. This is especially true in the current environment where new record highs in the S&P 500 seem to be posted on a daily basis. Potential negatives in an investment like this would be seen in Prospect is later forced to cut its dividend, reducing the yield attraction that has been associated with the stock. But last year, Prospect’s managerial team made an important decision to cut risky assets from its balance sheet in a somewhat controversial but highly appropriate move to makes its dividend payout more sustainable.

All of this points to the potential for solid yield returns at excellent valuations in a company with a long history of stable performance. It would not be surprising at all to see Prospect post double-digit gains for the year, despite the recent turmoil in stock prices. Market prices in PSEC are currently trading at important historical lows, so the balance of the evidence overwhelmingly favors sustainable upside in the stock.