3 Convincing Reasons to Add Prospect Capital Corporation to an Income Portfolio

Prospect Capital is an interesting bet on high recurring income as well as continued earnings growth while offering investors a reasonable valuation.

Aug 28, 2014 at 2:03PM
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Source: Prospect Capital.

Prospect Capital (NASDAQ:PSEC) is a well-run finance company with a convincing earnings and asset growth record. The company is funneling back substantial amounts of cash to shareholders in the form of dividends, and it could be an interesting addition to income-oriented investment portfolios.

Background
Prospect Capital operates in sort of a niche market, providing financing for North American middle-market companies with annual EBITDAs between $5 million and $150 million. Prospect Capital provides both flexible private debt and equity capital and competes on one hand with traditional banks as well as with private equity businesses on the other.

The company is structured as a business development company (BDC), which requires the business to pay out most of its earnings to shareholders.

Similar to real estate investment trusts or master limited partnerships, BDCs are preferred income vehicles for investors who want to accentuate dependable income. Since BDCs distribute large amounts of cash to shareholders, the value of investing in a BDC practically lies in receiving high, recurring income while capital appreciation potential is somewhat limited compared to companies that retain profits and deploy capital toward high-ROE reinvestment opportunities.

Three reasons in particular stand out as to why investors should consider an investment in Prospect Capital.

1. High dividend yield
Prospect Capital offers investors a diversified investment portfolio with which it generates high levels of net investment income. This income is distributed to shareholders in the form of juicy dividends.

Prospect Capital has the highest dividend yield in the BDC space and has successfully defended its top position as a dividend champion over the last 12 months compared to its closest peers, Ares Capital Corporation (NASDAQ:ARCC) and Apollo Investment Corporation (NASDAQ:AINV).

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The dividend yield comparison above is based on a trailing-12-month period. Prospect Capital's forward dividend yield -- the yield that buyers will get today on an annualized basis if they purchased the company and Prospect Capital upheld its latest dividend payment -- stands at a massive 12%.

2. Growth record
Business development companies generally had a good run over the last couple of years, and they were the primary beneficiaries of a cutback in lending activity of large-cap banks amid the financial crisis.

Prospect Capital benefited from explosive growth in assets and earnings over the last five years and should be able to continue to capitalize strongly on its increased market presence and visibility in the BDC space.

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Source: Prospect Capital investor presentation August 2014.

3. Moderate net asset value
I generally like to invest in industry leaders. With a market capitalization of $3.7 billion, Prospect Capital is not No. 1 in the market -- Ares Capital is with a market capitalization of $5.3 billion -- but the No. 2 spot is still pretty good.

Prospect Capital's valuation has seen both discounts and premiums to book value in the past, but it now trades about in line with book value.

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With just a 2% premium to its net asset value, Prospect Capital is not too expensive yet compared to its historical valuation: Investors can still invest in the second-largest industry player at a reasonable valuation.

The Foolish bottom line
Prospect Capital is an interesting high-yield income vehicle for investors who want to benefit from a 12% dividend yield and want to bet on continued growth of the BDC in its financing niche.

As laid out above, investors should expect the majority of total returns to come from Prospect Capital's regular cash distributions instead of capital appreciation.

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Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool recommends Apollo Investment. 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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