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Summary

  • The ETF selling of BDCs due to indices re-balancing has ended.
  • This is a positive catalyst for Prospect Capital.
  • Shares are up 10% over the past few weeks.
  • Prospect remains a solid choice, thanks to its high yield and parity to NAV.

I have been pleasantly surprised by the performance of Prospect Capital (NASDAQ:PSEC) over the past few weeks. The company had an extremely active quarter, adding increased volatility to the stock. However, many of these dips turned out to be buying opportunities, with Prospect's share price now largely recovered. That being said, I still think the stock has room to move higher and head towards a $11 per share handle relatively soon.

PSEC Chart

PSEC data by YCharts

Upside catalyst: The completion of the Russell rebalancing

As I hinted at in a recent article, Prospect stands to benefit greatly from the completion of the Russell's index reconstitution on June 27.

Basically, due to antiquated SEC rules, ETFs linked to the indices are required to add the cost structure of BDCs to their own, inflating their reported expense ratios.

In the extremely competitive world of ETFs, this was near unacceptable, as "low expenses" is one of the key selling points for investing via index funds.

As a result, back in March, the ETFs providers successfully lobbied both the Russell and the S&P to kick out the BDCs from their indices. This was a major event for the BDCs, as ETFs linked to these two indices held up to 8% (higher for some smaller BDCs) of the total shares outstanding for the sector.

Needless to say, the ETFs became sellers of BDC stock in anticipation of this change, largely depressing the share prices for the entire sector.

Thankfully, the Russell has now rebalanced and has kicked out the BDCs, at the cost of the index now technically being less representative of the broader market. This should take away some of the increased supply of BDC stock. Indeed, many names in the sector, including Prospect, have rallied in the past few days.

What to look forward to during fiscal Q4 2014 earnings

Over the past few quarters, Prospect has been seeing its NII per share head lower. Indeed, NII per share is now slightly below the dividend per share. However, I think NII should start to improve due to the following:

ATM program stopped

Due to the SEC problem (now resolved), Prospect has discontinued its at-the-market ("ATM") offerings. These equity issuances were a source of constant dilution, increasing the share count by 60% in 2013 alone.

Factors involved with this decision likely include the low share price over the past few months, sufficient "dry powder", and concerns of the company growing too big, too fast.

Increased use of leverage

I think the company will increase its use of leverage going forward in order to boost returns and increase NII. As noted above, Prospect seems to have enough "dry powder" at its disposal.

According to regulations regarding BDCs, the maximum debt-to-equity ratio is 100%. As of March 31, Prospect was still below this level, at 67.9%. The company has previously noted that it plans to increase this to 75%.

That being said, it appears as if the recent hassles have likely slowed down the pace originations. However, given the record level of originations last quarter, I still expected reported Q4 NII to come in strong.

Dividends are locked in through the end of the year

Finally, let us discuss the main draw for Prospect -- the dividend.

As I have mentioned previously, dividends are now "locked in", with the company having declared dividends through the end of the year.

Below is a summary of the declared dividends:

    • 11.0475 cents per share for July 2014 (record date of July 31, 2014 and payment date of August 21, 2014);

    • 11.0500 cents per share for August 2014 (record date of August 29, 2014 and payment date of September 18, 2014); and

    • 11.0525 cents per share for September 2014 (record date of September 30, 2014 and payment date of October 22, 2014).

    • 11.0550 cents per share for October 2014 (record date of October 31, 2014 and payment date of November 20, 2014);

    • 11.0575 cents per share for November 2014 (record date of November 28, 2014 and payment date of December 18, 2014); and

    • 11.0600 cents per share for December 2014 (record date of December 31, 2014 and payment date of January 22, 2015).

At current prices, Prospect's forward yield is north of 12%. Or in other words, Prospect yields above 1% per month. Given that the stock is trading in line with its NAV at $10.68, this level of income seems like a compelling reward for the level of risk.

Conclusion

With the ETF selling overhang removed, I suspect Prospect to slowly drift higher. Indeed, I expect the stock to head towards $11 per share, the level where it was at before the SEC news broke.

It should be noted that Prospect's management has never sold a single share. This implies a high level of conviction for the stock going forward. I took advantage of the recent dip, and more than doubled my position. I strongly suspect that Prospect's days of trading with a $9 handle are long gone.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Disclosure: The author is long PSEC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Prospect Capital: Can The Rally Continue?