Best Stocks for 2015 Recap: Prospects for Prospect Capital (PSEC) Stock

As we wrap up the year, it’s time to see how my selection in the Best Stocks for 2015 contest has performed. But first, congratulations are in order to Paul R. La Monica for his selection of Alphabet (GOOG,GOOGL), formerly Google. La Monica ran away with it this year buying one of the few stocks showing any real momentum in the entire S&P 500. This was was the “Year of the FANGs,” in which Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google spent most of the year rallying while the rest of the market languished.

high yield dividend stock prospect capitalThis time last year, I looked at shares of Prospect Capital (PSEC) and saw a real gem of a value stock. Well, Mr. Market seemed to have other ideas in 2015.

The combination of crashing energy prices and the looming threat of Fed tightening had a chilling effect on “alternative” stocks like business development companies (BDCs), master limited partnerships and real estate investment trusts. Essentially, anything that doesn’t look like a “mainstream” stock got clobbered this year. The entire BDC industry got hammered this year, and PSEC got hammered a little harder than average.

That said, the best defense against a fickle market is to buy at a reasonable price, and that is precisely what I did when I recommended Prospect Capital.  And even though PSEC lost money this year, my conservatism in a rough market put me in the top half of the contest.

As I wrote a year ago,

“I don’t expect much from U.S. equities in 2015. It’s not that I’m a bear — I’m not — but valuations look stretched, and U.S. stocks are priced to deliver flattish returns over the next 5 to 7 years.

Rather than buy, hold, and pray that this bull market has another good year left in it, I’d prefer to get my returns up front in cold, hard cash.”

It was the right call to be wary of the stock market. However, my preference for dividends and value wasn’t such a good call. Value sectors stocks have massively underperformed growth this year.

Let’s take a look at where PSEC was this time last year… and where it is today.

PSECLast December, PSEC traded at just 80% of its book value… a valuation it has only seen a handful of times in its entire history as a publicly-traded BDC. And remember, PSEC’s book value is updated quarterly by a third-party valuation firm and is based on the real value of its current investment portfolio. It’s not an obsolete accounting convention, as it might be with a lot of stocks. Well, after a rough year, the discount has actually risen. At today’s prices, PSEC trades for about 65% of book value.

Is it possible that book value is overstated a bit? Sure. In fact, it has been long argued by PSEC bears that the company holds assets on its books at higher values than some of its peers. But it’s hard to argue that the entire portfolio is overstated at anything close to a level that would justify the current discount we see in PSEC’s stock price.

It’s also a common criticism that PSEC is externally managed rather than internally managed, which creates conflicts of interest and essentially encourages management to loot their company for their own benefit.

Well, I understand the argument, and I agree that internal management would be better. I would go so far as to say that an externally-managed BDC should trade at a permanent (though mild) discount to an internally-managed BDC, all else equal.

But there is a big problem with this argument. PSEC’s management team have collectively been major buyers of the stock on the open market… meaning they are effectively looting themselves. On December 9, three PSEC insders collectively bought $1.4 million in PSEC stock. While that by itself may not sound like much, CEO John Barry has dropped over $5 million of his own money into the stock over the past 12 months alone.

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PSEC’s insiders have been aggressive buyers for years, but they’ve really stepped up their buying over the past 18 months. And in addition to their own buying, they initiated a modest share repurchase program.

So, what does all of this mean for PSEC’s share price going forward? If you bought PSEC based on my recommendation in the Best Stocks contest, I’d suggest holding the shares a little longer. Once the Fed’s rate hike is properly digested — and the investing public sees that the world really didn’t end — I expect shares to grind their way back to book value, which would mean rising about 54% from current prices. Add in the dividend — which is a ridiculous 15% at current prices — and you’re potentially looking at returns around 70%.

When you see yields this high, it’s only natural to wonder if they are safe, particularly when PSEC’s dividend payout ratio based on net income is a high 137%. And frankly, after the Kinder Morgan (KMI) debacle, even “safe” dividends look questionable these days. I suppose that were PSEC to get locked out of the capital markets, cutting its dividend might be required. But based on distributable income, a non-GAAP metric used by BDCs that strips out non-cash expenses, PSEC has a coverage ratio of 104%. So while we might not get much in the way of dividend growth any time soon, the dividend at current levels should be safe for now.

Bottom line: 2015 wasn’t PSEC’s year. But it remains an attractive value opportunity going into 2016.

Charles Lewis Sizemore, CFA, is long PSEC. Sizemore is the chief investment officer of 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.

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