Prospect Capital: Free Money

| About: Prospect Capital (PSEC)

Summary

Over the last few weeks, U.S. shares have been under pressure as a whole but BDCs have been crushed.

Remember the big picture and think long term.

Discussing the power of the distribution.

Over the last few weeks, U.S. shares have been under pressure as a whole. September has been a bit rough on markets, but have especially been difficult on high-yielding names. There has been a lot of profit taking, particularly in the BDC sector. Why? Well the sector has benefited from low rates, and there is a fear that a rate hike could be devastating for the sector. I think fears are overblown, as higher rates are generally a benefit for the sector. However, there certainly would be a quarter or two of transitional weakness. On top of rate fears, exposure to oil, which once sent the BDC sector lower about a year ago, is back as a risk. The return of weakness in oil has also led to weakness in the sector. Even one of my top high yielding holdings Prospect Capital (NASDAQ:PSEC) was not immune to the pain that stemmed from this action and the price of the BDC's shares has pulled back 10% since hitting new highs this summer. I contend, that despite what is happening globally, our yield plays are the ones we need to rely on during broader market turmoil.

Next week PSEC will once again hit its ex-distribution date. And so shareholders of record will be eligible to receive a cash distribution payment of $0.08333 per share. That distribution is scheduled to be paid on October 20th, 2016, for shareholders of record as of September 28th. Let's not forget that this week we will also be paid for August's ex-dividend on September 22. At the current stock price of $7.97, the distribution yield is 12.5%. But what is more remarkable is the cumulative total of distributions paid by the company. Long-term holders are in a fantastic position.

What do I mean by this? It is all about cost averaging and staying on top of the company. You have to buy on dips, and then ensure the company is covering its distribution. Over the long haul, you cannot lose. Why? Well previously I have shown previously the power of the distribution. If you look at the history of the distributions, you will see clearly the amazing reputation that the company has for paying its unitholders. Of course, the distribution can vary, and a large cut that came in late 2014 hurt. But it was out of necessity. The distribution can and will fluctuate. What I find most impressive, and this is really the point of this article, is that long-term, you will be a winner in the name.

If you have been holding this name for over a decade it is impossible for you to have lost money in this name. Let's say you bought units at $13.75 a share and never bought again. That would be foolish, as I encourage you to buy on dips, and sell some when the name trades at a premium to NAV. In other words, trade around the core position. In any event, as of the current share price of $7.97, you would be down $5.78 or 42%. That is an awful loss over a decade, but the key here is that is an unrealized loss of capital (that means it's not real, it hasn't happened, unless you push the sell button). However, this is where the power of the distribution comes into play. Look to the math. Distributions have been paid consistently over the last decade plus. In fact, after this week's ex-dividend for October payment, we will have been paid $15.12 in cumulative distributions. Thus, the investment is down $5.78 in unrealized capital losses but you have received $15.12 in distributions. That means you if you sold right after being paid the October distribution at the current $7.97 per share, you would have a total return of $9.34. That is a total of 68%.

Now look, 68% over a decade isn't the best return. No one is questioning that. But here is what I think is the most amazing part. Let's say you hold onto the name another 20 or 30 years. Well, once cumulative distributions hit $13.75, every single subsequent is "gravy" as the saying goes. What I mean here is that the entire investment has been earned in distributions. Every subsequent distribution is now "free money." I am not advocating that one simply buy and hold like this example, but I am advocating that the long-term investor, who buys on big dips and sells some on big rips, is going to do incredibly well. The distribution, so long as it doesn't go to zero, means that as long as you have patience, you will succeed in this name. I recommend PSEC as part of a diversified portfolio, and recommend keeping about 15% of your portfolio in moderate- to high-yielding names.

Note from the author: Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "follow." He also writes a lot of "breaking" articles, which are time sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."

Disclosure: I am/we are long PSEC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.