Editor’s note: This column is part of our Best Stocks for 2015 contest. Charles Sizemore’s pick for the contest is Prospect Capital (PSEC).
It might sound somewhat defeatist, but in a year like 2015, I’m just happy that my entry in the Best Stocks contest is in the black.
It’s not that I don’t expect Prospect Capital (PSEC) to deliver solid returns. In fact, I expect it to deliver returns of 50% or more over the next 12 months. It’s just that 2015 has been one of those years when cheap, high-quality stocks have a way of getting cheaper.
With one quarter to go, let’s revisit Prospect Capital and why I still believe that winning the contest this year is a very real possibility.
I’ll start with valuation. With the single exception of the 2008 meltdown, Prospect Capital is the cheapest it’s ever been based on the price-to-book-value ratio.
Prospect trades for just 77% of book value. Under normal conditions, you would expect Prospect to trade at a slight premium to book value. After all, management expertise and access to cheap capital are worth something.
At current prices, the market is implicitly saying that book value is either overstated by 23% or that it expects management to destroy a lot of value in the months to come.
Now, I routinely criticize the price/book ratio as a value metric for most common stocks. Given the distorting effects of depreciation and general price inflation, book value is a meaningless metric for most mainstream common stocks.
But in the case of business development companies like Prospect Capital, the book value is assessed every quarter by professional valuation experts.
Could their estimates be overstated? Sure. There is always room for interpretation, and Prospect has routinely been criticized for being a little too aggressive on their portfolio valuations relative to their peers. Let’s assume the worse and say that the portfolio is overstated by a couple percentage points. Given that the stock trades for just 77 cents on the dollar, I’d say we have a nice margin of safety.
I expect Prospect to be trading back above book value soon. But simply returning to book value would mean a move of 30%.
And then there’s the dividend. At current prices, Prospect Capital yields about 13% in dividends. Adding in four quarters’ worth of dividends would get us to a total return of about 45% in a year. And if maybe — just maybe — Prospect actually returns to its normal state of trading at a slight premium to book, we could see total returns of 50%.
Insiders Snapping Up PSEC Stock
But that’s not where the story ends. While I like to say that a cheap stock is its own catalyst, a cheap stock can stay cheap for a long time absent some change in the status quo.
Well, we finally have that change. Bowing to shareholder pressure, Prospect is repurchasing its shares on the open market. In a press release last month, management wrote: “On July 28, 2015, we began repurchasing our shares of common stock as they were trading at a significant discount to NAV. Since that time, we have repurchased 4,158,750 shares of common stock at an average price of $7.22 per share. Repurchases total more than $30 million to date.”
And the company hasn’t stopped there. In a recent filing, management wrote: “During the period from September 4, 2015 through September 21, 2015 … we repurchased 150,000 shares of our common stock at an average price of $7.89 per share.” All I can say is, it’s about time.
As big of news as the share buyback is, Prospect is not alone in scooping up its shares. The management team itself has been aggressively buying. So far in 2015, four company insiders have bought more than 500,000 shares worth nearly $4 million.
I should emphasize that these are not executive stock options. The management team is whipping out their checkbooks and using their personal funds to snap up shares.
Bottom Line on PSEC
As I write this, the front runner in the Best Stocks contest, Rave Restaurant Group (RAVE) is leading the pack with a 31% year-to-date return while Prospect Capital is down 1%.
It might seem like a bit of a stretch for Prospect to come back from that kind of deficit. But if 2015 has taught us anything, it is to expect the unexpected. And we still have a quarter to go.
Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. 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.
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