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Prospect Capital's Huge Dividend Opportunity, but You Have to Act Now

By Matthew Frankel, CFP® – Mar 8, 2014 at 7:00AM

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One of the high dividend sectors is temporarily on need to take advantage.

We all love high-paying dividend stocks. What's even sweeter is to be able to buy one of these stocks on sale. If you can buy one of the high-yielders, which we'll define as a 10% annual dividend or greater, at a significant discount, not only will you make money from the monthly distribution, but the shares themselves can rise in value making your total return even better.

The opportunity
The S&P decided to remove business development companies (BDCs) from their U.S. indices a little over a week ago, and the prices of these companies promptly took a dive. Across the sector, most BDCs lost around 2% of their value, with the sector's most popular name, Prospect Capital (PSEC -2.85%) down by about 4% since the removal.

PSEC Chart

More recently, the Russell Indexes also decided to remove the BDCs; however this is having a smaller impact on the stock prices in the sector. Once the S&P made its move, the market began to anticipate that the Russell removal wasn't too far behind.

This is an excellent opportunity because the decline really has nothing to do with the fundamentals of the companies themselves. Rather, it should represent a temporary dip as the companies adjust to the selling of shares from index funds which held the BDCs. 

Think of this like when a company is added to the S&P 500. Generally shares rise in the days following the announcement due to the anticipated increase in buying by index funds, but correct back toward their previous prices soon after.

Business development companies
These companies provide capital to businesses in exchange for either debt (the interest of which provides the BDC's profit) or equity. In a nutshell, these companies make their money through loans with high interest rates.

These high rates allow companies to pay some pretty nice dividends. Prospect Capital, which I consider to be the best-in-breed among BDCs, pays just over 12% per year and makes it distributions on a monthly basis.

These sales don't last forever!
One recent example of this was the tremendous discounts in mortgage REITs caused by the uncertainty in the Federal Reserve's monetary policy. Of course, the long-awaited taper began, rates began to stabilize, and the sector has since recovered a good amount of their losses.

Those who had the foresight to buy some of the major mortgage REITs before their recent rally not only are reaping yields of 12% or more, but in some cases saw their shares rise by 10% or more, creating total returns of well over 20%.

How to play it
Any investment that pays a high yield like BDCs do does carry considerable risk, so maybe owning the individual companies is not the way to go. There are a few really good index funds that are temporarily on sale due to the index removal, and they are all pretty similar in terms of fees and portfolio.

As far as the individual companies go, Prospect is the best value for the money, in my opinion. The company has an extremely diverse portfolio of holdings, and it pays one of the highest dividends in the market, outside of the mortgage REITs.

Whichever way you decide to go, the important thing is to act fast! Bargains that result from shifting companies around indices don't last too long.

Matthew Frankel owns shares of Prospect Capital. The Motley Fool has no position in any of the stocks mentioned. 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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