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Berko: If you’re OK with risk, buy more PSEC

By Malcolm Berko

Published: April 9, 2016, 6:00am

Dear Mr. Berko: I bought 1,000 shares of Prospect Capital at $10 per share in the summer of 2014. The dividend was $1.33, and I got a 13 percent return. Then, not long after I bought it, the dividend was cut to $1, and the stock fell to the $5 level, because the Securities and Exchange Commission started an investigation. It’s now $7.10 per share. Is it safe? Should I buy more shares?

— G.S., Eden Prairie, Minn.

Dear G.S.: The SEC was looking into whether Prospect Capital (PSEC-$7.10) conspired to set improper values for the collateralized loan obligations in its portfolio. So far, that claim is much ado about nothing.

PSEC is a business development firm that provides capital to middle-market companies for refinancing, leveraged buyouts, recapitalizations, acquisitions and later-stage growth investments. PSEC’s management invests between $10 million and $250 million per transaction in sectors such as pharmaceutical, specialty mineral, textile, aerospace and defense, oil and gas, health care, food, consumer discretionary and transportation. PSEC also invests in subordinated debt tranches and collateralized loan obligations. PSEC aims to produce a high degree of current income with modest, long-term capital gains.

Investors who bought PSEC at the $10 range in the last quarter of 2014 and still own it lost 30 percent of their principal when the dividend was chopped to $1. It wasn’t pretty to watch as PSEC shares mirrored the volatility of the market. But many feel there’s a quiet turnaround story here.

CEO John Barry purchased more than 5 million shares of PSEC at between $5.75 and $6.96 a share for his personal account in February, raising his position to 20 million shares. Barry owns 5.6 percent of PSEC, which pays him $20 million in annual dividend income. And Chief Operating Officer Grier Eliasek doubled down on his position in February. He owns nearly 700,000 shares, worth more than $5 million.

These purchases were made after PSEC’s fourth-quarter announcement of better-than-expected results. Those results, 28 cents per share versus 25 cents per share, were impressive and the result of five new investment platforms totaling $692 million, plus a successful ongoing effort to roll over lower-yielding loans to higher-yielding loans. This portends the possibility of a dividend increase.

Many observers say that insider buying is a bullish sign. It suggests that management is anticipating improved operational performance, and the size of those purchases seems to confirm that assumption. The shares now trade at a huge 31 percent discount to net asset value, and the 14 percent dividend yield appears well-covered. The sell-off of high-yield securities in the early months of this year seems to have abated. PSEC has a Zacks No. 2 Rank (buy); that’s impressive. Analysts at Deutsche Bank, Barclays and Market Edge have a buy rating on PSEC. However, Wells Fargo, Raymond James and Ned Davis Research still rate PSEC as underperform.

If insider buying in February is accurate, if the current yield of 14 percent is attractive, if that dividend is considered stable, if there’s a possibility that management will increase the dividend this year, if earnings do improve this year, if the company is adding new investments to its portfolio and if management is reducing the costs of its capital, then PSEC shouldn’t be trading at a 31 percent discount.

If you are comfortable with risk, purchase of 1,000 more shares. It’s nice to earn a 14 percent dividend while waiting for a stock to move higher. The consensus suggests that PSEC could trade between $9 and $9.50. If PSEC were to move up to $9 in the next 12 months, you’d have a $1,900 capital gain, plus $1,000 in dividends. And that would be a nearly 41 percent total return on your investment of $7,100.

Malcolm Berko addresses questions about stocks. Reach him at P.O. Box 8303, Largo, FL 33775 or mjberko@yahoo.com

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