I interviewed Grier Eliasek, the President and COO of Prospect Capital (NASDAQ:PSEC), a few days ago. Besides being a great experience, the research that led up to it and the interview itself put a solid yield-heavy investment on my radar. I entered into a small position that equates to about 5% allocation on Friday @$11.00 per share and plan on adding to that on substantial dips. I'd be comfortable weighting PSEC as much as 20% of my portfolio. This article will outline my reasoning for buying shares. It will be brief because the logic behind the purchase is pretty simple and straightforward.
The Retail Investors Have it Right
I've read several articles and comments on PSEC including the comments section of my interview, and I've found that the stock has a large DIY investor following. This isn't at all surprising. Retail investors are often looking for current income and gravitate towards yield. I am of the opinion that there is a rather large valuation discrepancy in the market right now between dividend-paying and non-dividend-paying equities. One of my favorite authors on SA, Chris DeMuth Jr., first brought this to my attention in his article, "Our Best Investment Idea For 2013: Gramercy Capital":
Looking at conventional investor behavior, it is hard to find any type of yieldy security on sale at the moment. I'd be thrilled to have someone list counterexamples in a response. However, it appears as if there are any number of foundations, endowments, advisors, and even families who are currently demanding yield at any price who are, in the process driving those yieldy securities to any price.
His argument makes sense to me and is supported by:
- Anemic interest rates, which theoretically lower risk-adjusted returns in all asset classes, but certainly seem to have a magnified impact on fixed-income and dividend-paying equities.
- Baby boomers beginning to retire, at which point their focus switches from saving and growth to current income and they begin demanding yield.
- The rise of "dividend" and "dividend growth" investing where in some cases stockpicking is oversimplified to listing stocks in order of dividend yield and average dividend growth and a basket of equities is selected, sometimes without regard to the sustainability of the dividend or the health of the underlying business.
- A growing misconception that equities that pay a dividend are inherently safer than non-dividend-payers.
So it makes sense that DIY investors love PSEC. In general, I am critical of this crowd's approach and skeptical about yield, but I believe the DIY community is correct to love Prospect Capital, and I believe the fact that yield is expensive right now highlights the value in PSEC's secure 12% yield and will lead to a higher valuation inside of 12 months that you can get paid an annualized 12% to wait for.
In the first half of fiscal 2014, Prospect generated $174.552M in net investment income and paid out dividends of $183.315M. So that dividend has been 95.2% covered. However, S&P, which assigns a credit rating to Prospect and communicates with the company regularly, giving the firm guidance as to what amount of maximum leverage it could take on and still maintain its current investment grade credit rating, recently upped their informal limit from .6x to .8x. Right now, the company's debt/equity is at 60.75%. The company could and does plan on increasing that to 70%, which would add about $300M to the asset base and cost very little because it would be done primarily through drawing on its revolver, which only costs about 2.9% right now. In the first 6 months of 2014, it has earned annualized NII equal to 6.74% of total assets. Assuming it earned that on the additional $300M, that would add $11.52M in NII or 3.82 cents per share, enough to cover much of the NII/dividend discrepancy alone. If it increased leverage to .8x, which I don't believe it would, but it could while still being considered investment grade, it would add $24M, or 7.95 cents per share.
Positive Interest Rate Exposure
The company also has a lever in the form of positive interest rate exposure. 91% of the company's assets are floating while 100% of liabilities - everything except the undrawn revolver, is fixed. If and when interest rates increase to a more normalized level, the company will benefit greatly. The following comes directly from the February Investor Overview:
While these other catalysts work themselves out to secure the dividend long term, the dividend is secured in the interim by a significant amount of excess NII. The following comes from the Q2 conference call:
Our net investment income has exceeded dividends demonstrating substantial dividend coverage for the cumulative history of the company. For the June 2013 fiscal year our NII exceeded dividends by $53.4 million and $0.26 per share. We utilized three pennies of that excess in the past six months.
That 23 cents that remains represents 17.3% of the current dividend and could cover the current shortage for 2 years, giving plenty of time for interest rates and the company's leverage ratio to rise. Based on all that, I believe the dividend is secure.
In late December, I bought AmTrust Financial Services' (NASDAQ:AFSI) A Series 6.75% preferred (ticker: AFSI.A or AFSI PRA depending on your broker) at $18.15 per share. The shares paid an annual dividend of $1.6875, so my effective yield was 9.3%. My reasoning was that the dividend was very secure and the yield unjustly high, so I expected to see 15-25% appreciation inside of 12 months to bring the stock to a more reasonable yield of 7-8%, and get paid 9.3% to wait. AmTrust was the target of short-sellers then and still is, but the company paid a significant common dividend on top of the preferred and has been reporting really great numbers, so I felt the dividend was secure. It also helped that insiders were significantly invested (over $20M in both the common and preferred) and buying a ton of stock at the time to silence the short-sellers. Less than a month later, the preferred was up nearly 20% and I sold at $21.55 for an 18.7% return. Now shares have increased all the way to $22.68, so it looks like my thesis was more correct than I thought. The point is that there is a lot of money to be made buying into secure, high-yielding instruments that are expected to appreciate soon.
While PSEC stock is a common stock, not a preferred, I believe it is another play similar to AFSI.A. The company is investment grade and as I pointed out in the previous section, the dividend is secure. A secure 12% dividend yield is unjustly high in this bubbly yield environment and that's why I expect to see significant appreciation, to the tune of at least 10-15%, inside of 12 months while getting paid 12% to wait. Even if shares stayed flat, in valuing financial firms I typically seek 9.5% annualized returns based on the 9.5% that equities have historically averaged. So even making a secure 12% is very appealing to me and I would assume to most other investors.
Management is significantly invested in the business.
I've had a lot of success investing around the same time that insiders buy shares and in companies where insider ownership is passive and high.
Why is The Stock on Sale?
In the case of AFSI.A, it was pretty clear why the security was cheap - the shorts scared investors in both the common and preferred into thinking the world was ending. Whether justified or not, there was a clear reason why the preferred was cheap. Here that's not really the case. I have a few theories, though.
One is that investors are wary of buying CEFs above NAV per share. Many of us feel that it is not attractive to purchase dollars for more than $1, especially in the realm of funds and investment management firms. The problem with that thought process is that a dollar in the hands of a skilled professional that can generate better returns than you is more valuable than a dollar in your hands. Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) has traded at an average premium of 27.5% to book value in the past 5 years because Warren Buffett and his team do better than many investors can selecting stocks for themselves. Regular companies trade at substantial premiums to book, sometimes over 500% of book, because they generate such high returns on capital that investors could not even come close to in allocating the capital for themselves. Assuming that equity is worth what the balance sheet says it is is a horrendous mistake. The value of a dollar is the higher of its liquidation value and a reasonable multiple of the annual returns generated by it. In the case of PSEC yielding 12.35% on NAV, it appears that the higher value is a multiple of the returns generated by it. The market hasn't awoken to that reality, but I believe it will.
My second theory is that the leverage is scaring investors away. 60.75% debt/equity is substantial, but in speaking to Grier Eliasek and researching the company, it became pretty clear to me that the company does a good job of managing risk. Only about 2% of investments survive the company's due diligence process. Non-accruals have been decreasing for 5 years and are now at an extremely low level as a % of assets.
The company made out much better than its peers during the financial crisis and was financially strong enough to acquire a competitor, Patriot Capital, in 2009. The company has investment grade credit ratings from 3 major rating agencies. The major risks for a BDC like PSEC are interest rate risk and credit risk. The company is well positioned for rising rates and prioritizes credit risk management in the due diligence process. So I think the idea that PSEC is a high risk investment is another misconception.
Prospect Capital is a well-managed company offering a secure, investment-grade, sustainable 12% dividend yield. DIY investors and insiders are right about this stock, and I think it's about time the rest of the market gets on board.