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Downgrades: 3 Reasons Wall Street Hates Prospect Capital Corp and Apollo Investment

By Rich Smith - Feb 11, 2016 at 11:15AM

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Two business-development companies. Two downgrades. Zero coincidence?

Thursday is turning into a bad day for investors in Apollo Investment (AINV 2.51%) -- and in Prospect Capital Corp (PSEC 2.58%), as well. In the space of just a couple hours, JMP Securities downgraded Apollo shares to market perform, and then Raymond James chimed in with a downgrade of Prospect Capital -- to underperform.

But why?

The news
It may surprise you to hear this, but while Thursday's downgrades concern two completely different companies, and come from two entirely different analysts, the reasons for worry about both these downgrades are strikingly similar.

Here are just a few of the commonalities investors need to consider:

1. Both of these companies are in the same line of business
Both Apollo Investment and Prospect Capital are business-development companies (BDCs). This is a pretty arcane area of the stock market, and one not all investors may be familiar with.

My Foolish colleague John Maxfield prepared a primer on the industry a few years ago, however (you can read it here). The upshot is that a BDC is a sort of publicly traded private equity firm. It's a business that invests in other, smaller businesses through such avenues as direct equity investments, mezzanine and senior secured loans, and subordinated debt and loans, with the aim of profiting as its clients grow.

From an individual investor's perspective, perhaps the two most important things to know about a given BDC are how much it pays out as a dividend (which can vary with the income it generates), and how its share price relates to the net asset value (NAV) of its stakes in the companies it's invested in.

2. Dividends
The dividend issue is the easiest to tackle. Currently, both Apollo Investment and Prospect Capital pay huge dividends to their shareholders. According to data from S&P Global Market Intelligence, Apollo Investment's dividend yield stands at a whopping 16.9%. Prospect Capital's divvy is even richer -- 17.2%! (Try getting your bank to pay that on your savings account.)

But here's the problem: Those dividends come with the risk that they might fall over time if business is bad. And because investors routinely compare stock dividends to the potential to earn interest on "safer" investments like bonds (or bank accounts), the higher interest rates rise, the less attractive it is to own stock in a BDC, relatively speaking.

For this reason, the Fed's intention to raise interest rates throughout 2016 poses some risk to investors in both Apollo Investment and Prospect Capital.

3. NAV
In issuing its downgrade on Apollo Investment, JMP Securities cited a fear that net investment income at the company will fall "over the longer term." At the same time, as fellow Fool Jordan Wathen recently pointed out, net asset value per share at Apollo has fallen steadily for six quarters straight. Falling to $7.56 per share at last report, it was down 14% from its height of $8.74 in mid-2014.

Similar concerns dog Prospect Capital, with Raymond James cutting its fiscal 2017 estimate of net investment income, and warning of continued NAV declines in the future. While not wholly negative on the stock, Raymond James was sufficiently worried to rate Prospect an"underperform, and said the "actual earnings impact" on the company is "still up in the air."

Bonus point 4: One of these analysts is probably right
And so you see, we've got very similar concerns weighing on pretty similar stocks today. What really distinguishes the two downgrades, though -- and what suggests to me that you might want to worry more about the risks at Prospect Capital and perhaps less about the risks at Apollo Investment -- is this:

Historically, the analyst downgrading Prospect has an amazing record of being right about its recommendations, while the analyst downgrading Apollo Investment...doesn't.

According to our data here at Motley Fool CAPS, more than half the recommendations that Raymond James has made in the capital markets sphere over the past four years have successfully beat the market. That strong record of 62% accuracy on its picks suggests that when Raymond James tells you Prospect Capital is a stock to avoid, you might want to pay attention.

On the other hand, JMP's record with capital markets stocks has been anything but good. Nine years of data surrounding JMP's picks of financial companies -- including Apollo Investment -- reveal that on average, JMP is right about these kinds of stocks less than 8% of the time. What's more, the one time we have JMP on record recommending Apollo Investment, that recommendation lost investors money. (Here, see for yourself).

Now, does all of this mean that Raymond James is definitely right about Prospect Capital, or that JMP is definitely wrong about Apollo Investment? Of course not. But investing is all a matter of weighing the odds. And right now, the odds are not in either of these companies' favor -- and they look stacked most heavily against Prospect Capital.

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Stocks Mentioned

Apollo Investment Corporation Stock Quote
Apollo Investment Corporation
AINV
$11.04 (2.51%) $0.27
Prospect Capital Corporation Stock Quote
Prospect Capital Corporation
PSEC
$7.17 (2.58%) $0.18

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