Sometimes falling stock prices can be a good thing for investors. If the stock market corrects and stock prices fall, most investors quickly give in to panic and sell shares, scared of further losses.
However, market disruptions and declining company valuations also have a positive side via rising dividend yields, which unfortunately don't get their due recognition. Some companies are structured in such a way that requires them to pay out most of their earnings -- such as real estate investment trusts, master limited partnerships, and business development companies -- so they can become more attractive as their share or unit prices fall.
Take Prospect Capital (PSEC -0.18%), for instance. Prospect Capital is a high-yield BDC that offers middle market companies with annual EBITDA of $5 million-$150 million access to private debt and equity capital. Business development companies fill a vital role in the financing sector: They adopt a private equity approach to their investments and often finance companies that would have difficulty obtaining funding through banks or other traditional avenues.
Background
Similar to REITs, Prospect Capital must pay out 90% of its earnings to avoid taxation on the corporate level, which suggest the business generally has low capital growth potential. The majority of Prospect Capital's return is likely to come from dividends, which makes the BDC interesting for income investors who want to access a constant stream of such payouts.
Business development companiess were among the primary beneficiaries of the financial crisis as banks and other private equity companies cut down on lending activity and deal making in order to de-risk and get their businesses and books in order.
Prospect Capital, one of the largest BDCs in the business, however, was busy managing its expansion. Both its net investment income, the basis for its distributions, and the number of portfolio investments increased greatly throughout the financial crisis. While Prospect Capital was invested in just eight portfolio companies at the end of 2005, the number skyrocketed to 143 by the close of the first half of 2014.
Source: Prospect Capital Investor Presentation.
Solid dividend value
The recent rise in Prospect Capital's dividend yield to almost 14% is mostly the result of the decline in company valuation as uncertainty about global growth reemerged in September and put pressure on equities.
Looking at Prospect Capital's dividend history, though, shows the company has not disappointed its investors. Since 2004, the BDC has returned almost $1.4 billion to shareholders in form of distributions. This record, of course, needs to be seen in the context of the banking crisis unfolding in 2008, which caused many financial companies to deliver vastly inferior performance results.
Source: Prospect Capital Investor Presentation.
While Prospect Capital's dividend record and dividend yield are appealing, something else also speaks for an investment in this $3.3 billion BDC: Prospect Capital pays its dividends to shareholders on a monthly (rather than quarterly or yearly) basis, which gives investors much more flexibility in using their cash as they see fit.
Attractive net asset value discount
As can be seen in the chart below, Prospect Capital's shares have historically traded at both premiums and discounts to their net asset value.
But weakness in the equity markets has now made Prospect Capital relatively cheap: the BDC trades at a fairly significant 9% discount to its net asset value of $10.56 per share.
Prospect Capital is an attractive addition to income portfolios now that Mr. Market has pushed shares of the BDC below $10. Investors who buy Prospect Capital not only get access to a 14.5% dividend yield (per S&P Capital IQ), but also benefit from monthly cash distributions, which have huge value in an environment of fluctuating stock prices.
