Prospect Capital: A Rate-Busting Dividend Diamond In The Rough

| About: Prospect Capital (PSEC)
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Most people who invest, either institutionally or individual retail investors, have a number. In fact, most people out there who are at all conscious of their savings have a similar number. Both of these numbers are relevant to (NASDAQ:PSEC), or Prospect Capital Corporation.

The first of which, is the number that a person would have to make on an investment in a given year to be content with themselves, you can almost consider it a personal internal rate of return. It's the number that would let most people with money in the bank sleep easy at night knowing they have invested in something worthwhile. The second of which is the number it would take, in dollars, that a person would need to drop everything and retire tomorrow. For some, it's the magic million, for others it's far higher. In both cases, what I am about to explain can help you reach either number.

Prospect Capital Corporation, from here out to be referred to as PSEC , is a "Business Development Company," or BDC. A BDC is a form of publicly traded private equity, these firms invest in small to medium sized private businesses through a combination of both unsecured and secured loans as well as equity. Companies use the needed capital for acquisitions, divestitures, growth, development and recapitalization.

BDCs are a terrific way for mom and pop investors and RIAs with smaller AUM to get a piece of action in the private equity market without considerable difficulty, and with high liquidity. The one major benefit of BDCs however, is that they enjoy a similar tax structure to REITs, in exchange for paying out 90% of their earnings in the form of dividends.

In fact, all of the BDC requirements are beneficial, in my honest opinion. Following are the BDC requirements to maintain BDC status:

  1. Vs. Banks and REITs, BDCs are exceptionally limited in regards to the amount of leverage they are allowed to use, and their total-debt to total-equity ratio must be under 1:1.

  2. BDCs must be adequately diversified amongst their investment portfolio. At least 70% of their portfolio must be derived from private debt or equity in companies with sub $250m market caps. Individual investments must make up no more than 5% of a BDC's overall portfolio, and a BDC cannot own any more than 25% of an individual company.

  3. 90% of a BDC's gross annual income must come from dividends, interest and other assorted capital gains from its portfolio.

  4. As previously stated, they must distribute at least 90% of gross annual income to shareholders.

  5. Lastly, perhaps the most important factor, is that BDCs must offer managerial assistance to the small and medium-sized businesses in which they invest, and in this sense you really are investing in real companies.

PSEC is a titan amongst BDCs, and I'd like to point out to you several benefits to ownership that you can enjoy in the coming years. PSEC stands out for several reasons, not limited to the following...

Monthly Dividends at 12% Annually: Monthly dividends are very nice because they offer a more frequent glimpse into the financial health of a company, as opposed to a dividend that comes on a quarterly basis. In addition, PSEC announces its monthly dividends for 4 straight months approximately one quarter in advance, offering investors an unmatched level of security in their short-term prospective future cash flows. In addition, the annual 12% approximate dividend offers investors the ability to enjoy current income in addition to long-term growth. While many other companies offer the prospect of future growth, a secure dividend as such offers the ability to enjoy your investment through ups and downs, so long as you are committed in the long run.

Management Team: PCM, the managing LLC of PSEC, has a 25-year history and track record investing in middle-market companies and managing private, high-yielding debt and equity investments. The team at PSEC has worked together for over a decade, and John F. Barry III has a history of excellence. This is a management team that has excelled in picking real equity investments, and their stock has reflected this. In the time that the BDC has been public, through the stock price ups and downs, the company has released very consistent, very handsome dividends.

Interest Rate Bulletproof: My favorite aspect of PSEC is their sustainability and ability to benefit from a rise in interest rates. In these trying times where a word or two from the wrong Fed branch leader can drop the market 100 points or more, PSEC stands well positioned as most of their investments are floating rate, whereas most of their financing is low, fixed rate and long term. Sometimes, PSEC moves in line with REITs and other high yielders on down days, due to the misalignment of the two investment types. Do not be fooled, take advantage of the future rise in rates with PSEC and buy on the dips.

Third Parties Agree: Recently PSEC was given a BBB+ bond rating by Kroll Bond Rating Agency, with a stable outlook. The rating, according to Kroll, was supported by their majority senior secured positioned within their portfolio, exceptional leverage metrics (well within limits for a comparable BDC), excellent asset performance and credit origination due diligence, and most importantly a strong management team with "proven expertise."

Going forward you should be thinking about many things, not the least of which is how you will prepare yourself for the eventual - not if, but when - rise in interest rates. How will this affect your portfolio? With PSEC you can take advantage of the rising rates. In addition, you need to consider your overall return on investment and the ability to pad losses with dividends. What is your retirement "number"? With a 12% dividend, using the rule of 72 we can see that an investment, based on the dividend alone, will double with compounding within 6 years. Over the course of 42 years, that doubling occurs seven times, and this kind of exponential growth is the perfect tool to help you reach your "number." And as for your personal internal rate of return... well 12% pre-tax really is pretty good, given that it is sustainable. And if you're worried, you'll be happy knowing that PSEC has already announced dividends through the end of the year, and they only continue to increase. Take advantage of a dip or two and grab a piece of this diamond in the rough, sit on the dividend and enjoy that monthly income on a rainy day, come what may.

Disclosure: I am 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.