Prospect Capital Corporation (PSEC) may very well be the most hated stock on Wall Street.
And I say this as an investor with skin in the game. I am long Prospect Capital both personally and in client accounts, and I also have reputational capital at risk: I chose Prospect Capital as my entry in InvestorPlace’s Best Stocks for 2015 contest.
As of this writing, I am suffering the humiliation of being in eighth place.
So, just how hated is Prospect Capital these days?
The stock is down more than 30% from its 52-week high and trades at a 30% discount to book value. To put that in perspective, the median business development company trades at a 6% discount to book value.
When a stock trades for just 70 cents on the dollar, it tells you that investors are questioning the reported book value. And there have been some well-publicized incidents in which Prospect Capital did indeed list identical assets at higher values than their peers, which partially explains investor hostility toward the company.
I spoke with Chief Operating Officer Grier Eliasek this week to get management’s take on Prospect’s recent share-price slide. Eliasek was very open with me and shared a set of slides that, until now, have not been released to the general public (see Prospect Capital Corporation Investor Presentation). Don’t worry, it’s OK to read them. They are based on public, reported numbers and are being reproduced with permission.
The usual caveats apply here. The data was prepared by Prospect Capital, and while I believe it to be factually accurate, I have not independently verified all of the data. And you should always assume that management has its own motives for sharing any data with the public.
So with that said, let’s jump into the presentation.
Prospect Capital Operating Return
These first two slides will be somewhat controversial to anyone sitting on large capital losses, but it is instructive nonetheless. It also happens to be very close to how Warren Buffett has traditionally measured his success at Berkshire Hathaway (BRK.A).
Figure 1: Operating Returns
Figure 2: Operating Returns
Figures 1 and 2 measure Prospect Capital’s “Operating Return,” defined here as change in book value plus dividends. The thinking here, as with Buffett, is that management has no direct control over the share price. That is the prerogative of Mr. Market. But management does have control over the underlying investments, which show up in the company’s book value.
Are PSEC’s Book Value Reports Reliable?
In recent years, most of Prospect’s returns have come from its dividend, though its total operating return has outperformed its peers in the BDC sector.
I agree that these returns are distinctly not what investors have realized in the stock. But just as Warren Buffett has asked to be judged by his growth of Berkshire’s book value, I think the same logic applies here.
That logic hinges on book value being reliable, of course. And I raised that question with Eliasek:
Q: A lot of investors seem to be questioning Prospect Capital’s accounting these days. How would you respond to those who say that your book value estimates are overly aggressive?
A: “We actually consider our book value accounting to be a major source of strength. We don’t value the portfolio ourselves. Our third-party valuation firms start with a blank piece of paper every quarter and value our portfolio from scratch. And our auditors approve.”
Q: How does this compare to your peers?
A: “We consider ourselves to be among the most conservative. Some BDCs ‘self value’ or ask a third-party valuation firm to simply confirm in-house company estimates. We were one of the first BDCs to insist on truly arms-length, third-party valuation.”
Can a valuation firm be “encouraged” by management to inflate asset values? Of course. There are natural conflicts of interest when the company whose portfolio is being reviewed is the one doing the paying. We saw the same conflicts of interest with bond ratings agencies in the aftermath of the 2008 mortgage meltdown.
But I would still consider the third-party valuation firms to be more reliable than an in-house valuation, and I have no reason to believe that Prospect Capital’s asset values are systematically more inflated than their peers.
Prospect Capital Insiders Show Confidence
Figure 3: Insider Buying
Prospect Capital’s directors and officers also eat their own cooking. The insiders are very aggressive buyers of the stock on the open market. And to clarify, these are real, open-market purchases that the executives are making with their own money. These are not executive stock option grants or other forms of stock-based compensation.
Since 2010, six company officers have been responsible for buying a cumulative $43.6 million in Prospect Capital stock. Additionally, CEO John Barry, CFO Brian Oswald and COO Grier Eliasek all made major new purchases in the past six months.
Given the amount of money they have personally invested in the stock, the picture in the financial press of a greedy management team looting the company for its own gain doesn’t quite hold water.
Bottom Line for PSEC Stock
So, with all of this said, is Prospect Capital a buy?
As a value investor, I would answer that question with an emphatic yes. We have a wide margin of safety in the large discount to book value, and a management team that, while taking criticism from investors these days, has a lot of skin in the game.
We’re also being paid generously to wait for the market’s mood to shift, as Prospect sports a current dividend yield of 13%.
Additional dividend cuts may be in the cards if the company continues to de-risk or if there is an uptick in non-performing loans. But I consider the current dividend safe for at least the next nine or 12 months.
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. As of this writing, he was long PSEC. 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.
