TAKING STOCK: The prospect of Prospect

Dear Mr. Berko:

I bought 1,000 shares of Prospect Capital at $10 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 all the way to the $5 level because there was an announcement of a Securities and Exchange Commission investigation. It's now $7.10, and I want to know whether it's safe and whether I should buy more shares.

-GS, Eden Prairie, Minn.

Dear GS:

The often risible SEC believed that 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 company providing capital to middle-market companies for refinancing, leveraged buyouts, recapitalizations, acquisitions and later-stage growth investments. PSEC's management typically invests between $10 million and $250 million per transaction in a wide range of 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. Management's objective is 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 from $1.33 to $1. It wasn't pretty to watch as PSEC shares mirrored the volatility of the stock market. However, many feel there's a quiet turnaround story here.

I noticed that CEO John Barry purchased over 5 million shares of PSEC (at between $5.75 and $6.96 a share) for his personal account last February, upping his personal position to 20 million shares. With his recent purchase, Barry now owns 5.6 percent of PSEC, which pays him $20 million in annual dividend income. And COO Grier Eliasek doubled down on his position last February. He now owns nearly 700,000 shares, worth over $5 million. These purchases were made after PSEC's fourth-quarter announcement of better-than-expected results. In fact, those results, 28 cents per share versus 25 cents per share, were impressive. They were 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 believe 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. Today the shares trade at a huge 31 percent discount to net asset value, and the 14 percent dividend yield appears well-covered. Also, the sell-off of high-yield securities during the early months of this year seems to have abated. Now PSEC has a Zacks No. 2 Rank (buy), and that's particularly impressive. Furthermore, 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."

Here are some ifs to contemplate. 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 the risk, then a purchase of an additional 1,000 shares would be a darn good, high-class speculation. It's always nice to earn a 14 percent dividend while waiting for a stock you own to move higher. This year, 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, for a total gain of $2,900. And that would be a 41 percent total return on your investment of $7,100. Certainly an acceptable return!

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Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at mjberko@yahoo.com. To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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Published: Thu, Apr 14, 2016