Prospect Capital Corporation: A Gold Nugget or Value Trap?

Key Points

• Prospect Capital started showing up on Marketbeat's Trending Stocks list. 
• The high-yield closed-end fund pays more than 11% and trades at a deep discount. 
• The business outlook is improving and may provide lift for share prices. 

Whether or not Prospect Capital Corporation NASDAQ: PSEC is a gold nugget or value trap depends on your objective. If you are looking for capital appreciation and a possible price-multiple expansion, there are better choices than Prospect Capital, even with the 11% dividend. If you are looking for steady, stable income in a high-yield dividend payer, Prospect Capital is a potentially good choice, but caveat emptor. Prospect Capital is not a run-of-the-mill financial stock, and it comes with a unique set of risks. 

Prospect Capital Exposed to Debt Market and Higher Rates 

Prospect Capital is a closed-end fund electing to be treated as a BDC or business development company. BDCs are tax-advantaged businesses that invest in privately held small and medium-sized businesses. As a BDC, it provides capital to businesses via debt instruments and is required by law to provide business assistance and oversight. 

One advantage of investing in BDCs is income; as a tax-advantaged business, they must distribute 90% of their income, making them potentially high-yielding instruments. The biggest risk of BDCs such as PSEC is that most of their investments are in illiquid debt markets susceptible to market swings and interest rates. 

A downtrend in net asset value is among the downsides to investing in Prospect Capital. The net asset value is a standard method of determining a BDC’s underlying value, and, in this case, the NAV is in decline. NAV is down significantly compared to last year and last quarter due mainly to the rise of interest rates. However, the market has front-run the fall and opened up a significant discount. 

Most BDCs trade at a discount to NAV, and that discount can be used as a trigger to buy. Prospect Capital’s discount to NAV widened to above 30% during the pandemic years and has yet to recover. The risk is that the discount will not recover soon or significantly, given the declining NAV. 

Prospect Capital: Dividend Coverage Good, Outlook Improving

Prospect Capital’s dividend is enticingly high at 11%. The 11% yield is a potential red flag, but the coverage is good, and the business outlook is improving. Regarding coverage, net investment income grew sequentially and YOY to $0.23, providing annualized coverage above 125%. This is sufficient to sustain the $0.06 monthly payout, but distribution growth should not be expected. PSEC has sustained the $0.06 monthly payout since 2017 but has a history of cuts tied to business downturns. 

Regarding the outlook, the company’s originations more than doubled in the last quarter, which suggests a substantial uptick in new business is at hand. The company’s cash hoard was close to $1 billion and provided ample liquidity for deployment; no debt is due for repayment this year. 

Insider buying confirms the upswing in outlook. CEO John Barry, who owns about 17% of the stock, made 2 purchases in September, and a director also bought shares. This is the 1st activity since September 2022, when another director and the CFO purchased shares. The fact the CEO has so much skin in the game should be reassuring to the market, but there is some concern about too much influence. Insiders hold 27% of the company. 

The Technical Outlook: PSEC In Value Territory

The chart action in PSEC shares isn’t bullish, but the value proposition should be noted. While the top end of the stock range is trending lower, the market is approaching a floor that has produced substantial rebounds. Based on the outlook for dividends, the discount to NAV, and the outlook for business improvement, the stage is set for another rebound to form in 2023 or early 2024. The risk is that price action will not bounce from the $5.75 level but continue lower to retest the 2020 lows.