Is Prospect Capital Corporation the Safest 14% Dividend in the Market?

After an excessive sell-off, Prospect looks more appealing than ever.

May 21, 2014 at 7:00AM

Last Tuesday, the shares of Prospect Capital Management (NASDAQ:PSEC)took a nasty 10% nosedive. The plunge took place after the company announced an increase in revolving credit facility commitments.

Although the price has recovered somewhat, shares of Prospect are still trading below $10 -- that's the first time shares have been that low since the fall of 2012.

With Prospect's recent announcement of dividend payments through the end of 2014, now may be a great chance to get in while the company's annual yield is above 13%.

The news and why it matters
Prospect recently announced it had increased the usage of its available credit facilities by about 5%, and shares dropped as low as $9.17 in early trading shortly after the announcement. Ultimately, the selling was overdone, and shares recovered most of the losses from the day of the news.

However, shares are still down by more than 10% since the company's 3Q results were announced, where Prospect disclosed its ongoing discussions with the SEC about possible consolidation of certain holding companies. In a nutshell, this is concerning to investors because it's impossible to know the outcome of the discussion or their overall impact on Prospect's accounting.

The company has ensured investors several times since then that it will have no impact on Prospect's dividend payment ability, and stated the proposed consolidation would not produce any significant change in their leverage ratio. So, the "crash" we saw in Prospect's share price was overdone, which is why the share price quickly recovered to its pre-news level.

Don't let the headlines make you ignore Prospect's solid business
Despite the recent price drop, Prospect is still a very solid company with plenty of compelling reasons to buy shares.

In the recently announced quarterly results, Prospect reported net income of $247.4 million, up 30% on a per share basis from the same quarter last year. In addition, the company reported a net asset value of $10.68, or more than 9% higher than the current share price. This discount to NAV serves to offset some of the risk related to the SEC negotiations. If the negotiations end badly for Prospect, it should help shareholders to cushion the blow to earnings.

If it turns out that Prospect's dividend-paying ability is indeed unaffected, then the discount could mean capital appreciation as well as great dividends.

The dividend is as stable as you can get
Unlike many other high-dividend stocks, Prospect's payments are not volatile or unpredictable whatsoever.

In fact, the company just announced its monthly dividend payments all the way through December (seven months in advance), and plans to declare its payments through March 2015 in its next quarterly report.

Prospect's dividends have increased slightly each month like clockwork, and the December payment will represent the 54th consecutive increase in the monthly distribution. There are a bunch of companies who increase their dividend every year, but a company like Prospect that raises the payment every month is extremely rare.

After the recent drop in share price, Prospect currently pays a 13.6% dividend yield, which is made even better by its monthly payment schedule. Because the income is allowed to compound more frequently, that 13.6% annual dividend rate becomes an effective 14.5% annualized yield when factoring in monthly compounding.

While this may not sound like much of a difference, consider two hypothetical $10,000 investments paying 13.6% dividends, one compounded monthly and one compounded quarterly. After 30 years, the quarterly paying investment would be worth over $552,000. Not bad at all, but we want to squeeze the most value out of our investments. The monthly paying investment would compound to nearly $578,000 in the same time period, giving an extra $26,000 in returns just by distributing its profits more frequently.

In other words, because Prospect chooses to distribute its income monthly, you could make almost 5% more over a 30-year period, as opposed to a quarterly dividend stock with a similar dividend.

Excellent yield and upside potential make Prospect a no-brainer
The current situation with Prospect is an excellent example of an overreaction to news.

Investors are generally fearful of the SEC meddling in a company's affairs, and their irrational selling pressure on Prospect's shares have created an excellent opportunity to buy a great income stream at a discount.

The discount to net asset value produces the added potential for upside, as shares would have to rise by about 9% just to get back to their intrinsic value. Provided the company's statements about the non-impact of the SEC's proposed consolidation, you could see returns of more than 23% in a year, combining capital appreciation and dividend income.

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Matthew Frankel owns shares of Prospect Capital. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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