Prospect Capital: Market's Best Dividend Play?

Over the last few weeks, activity in stock markets has been relatively lackluster. Holiday-thinned trading conditions have reduced volatility and limited opportunities for those looking to buy cheap stocks.

However, this is not the case in all market sectors. Asset buys that come with a high dividend yield are still quite appealing. One such company is Prospect Capital Corporation PSEC.

The stock had a turbulent 2014, with share prices falling roughly 27 percent. Most of the pessimism was driven by Prospect Capital’s announcement to reduce its dividend payout to $0.08333 cents per share (from the $0.111 cents per share paid previously). This may have prompted the market’s knee-jerk reaction that sent Prospect Capital to its lowest levels since late 2011.

What seems to be missed here is that even with the dividend reduction, those invested in Prospect Capital stock still benefit from a dividend yield that comes in at almost 12 percent.

Another Look At Business Development Companies

Prospect Capital is a business development company that provides first-lien and second-lien senior loans to private businesses. This is an important and often under-appreciated role that allows smaller businesses to secure the financing needed for recapitalizations, acquisitions and leveraged buyouts. Prospect Capital’s debt and equity investment approach is designed to achieve long-term capital appreciation and generate current income levels that far surpass most of what is seen in the dividend space.

Prospect Capital's decision to reduce payouts shows that the company is focused on strengthening its risk/return profile in producing higher quality earnings for its shareholders. Furthermore, stable investments are associated with lower yield. While Prospect Capital's move did spook the market for most of December, it was a decision that should help minimize volatility and ensure that the elevated dividend is sustainable going forward.

At this stage, the real question for investors is whether or not the market’s reaction to the dividend cut is justified. The 11 percent decline that was seen in December sent market valuations below $8.50 per share. This created a NAV discount of more than 20 percent, looking at the company’s last-reported figures. So, the stock is trading at a significant discount relative to its historical averages – perhaps lessening the likelihood of further declines.

Improved Outlook

Most encouraging is the fact that the market’s bearish reaction was not based on any worrisome changes in the underlying investment strategies that are used in running the fund. If anything, the more conservative approach could be viewed as a long-term opportunity given the higher probability Prospect Capital will be able to sustain its dividend at current levels.