Insiders Prospecting in Prospect Capital

• ByJonathan Moreland, InsiderInsights Research Director
• On 3:59 pm EDT, Monday June 1, 2009

Risk still abounds in U.S. equities and in few industries more so than financials -- despite what the surging stock prices of the group suggest.

Not all sub-industries in the very broad financial sector are equally risky, however. I'm still concerned about the health of U.S. consumers and creditors and the financial institutions that rely directly on them. But the slew of publicly traded business development companies (BDCs) that act much like private-equity firms don't deserve such blanket condemnation. Each firm has its individual risks and rewards, and I'm finally willing to pull the trigger on Prospect Capital.

Prospect Capital is a private-equity and mezzanine-debt firm that trades like a closed-end fund. Prospect has historically leaned toward investments in the fields of energy and industrial sectors, including materials.

Shares of Prospect have rebounded sharply with the market from their March lows of $5.92. But on a risk/reward basis, I like this stock better now at its higher price. That's because the firm has used its recent share strength to sell 12.9 million new shares, bringing its total shares outstanding up to over 42 million and bolstering its balance sheet.

These recent equity raises were done far below the firm's stated net asset value (NAV) of $14.19 per share at the end of its third quarter, ended March 31. So the offerings were annoyingly dilutive to existing shareholders and understandably put pressure on the shares.

That's bad for investors who got in a month ago, but the double-digit percentage decline in Prospect's shares that the most recent offering recently caused is the reason why I've decided to jump in now.

Insiders Stocking Up

Insiders at Prospect have been jumping in for years -- and staying in. Insiders haven't sold one share in the open market since 2004. Last year, six executives purchased a total of $6.2 million of Prospect's shares as the stock wilted along with the economy. Their average purchase price was $12.23. Undeterred by the continued weakness of their stock, five insiders have bought $1.6 million more of PSEC so far this year at an average price of $8.56.

To its credit, Prospect has been able to increase its quarterly payout every quarter since 2004 -- if only by a fraction of a penny lately. The most recent distribution was 40.5 cents, which gives the firm's shares an indicated yield just above 19%. That metric obviously indicates that investors still see a fair amount of risk in this stock. But the enormity of the yield seems to offer a cushion, even if the payout suddenly becomes unsustainable.

So while past performance does not predict future payout trends, this firm's track record suggests that Prospect's securities can be expected to be a valuable income generator, even if the firm is forced to cut its payout for the first time.

Still, I admit to expecting the payout to at least be maintained. At this point, Prospect has survived the worst of the credit crisis, and management is now going on the offensive by shoring up its balance sheet to start taking advantage of the buyer's market for distressed assets. These are not the actions of a firm that's about to announce its first payout reduction.

To the contrary, the BDCs that can raise capital in this tough time seem more likely to accelerate payouts once the economy and their portfolio values recover in earnest. And though it's likely too much to ask for shares of Prospect (or any other BDC) to trade up to the stated NAV of its portfolio, a reduction of Prospect's presently large discount to NAV also seems likely when the economy -- and investors' sentiment -- improves.

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Know What You Own: Other business development companies and closed-end funds include Broadpoint Securities Group, NGP Capital Resources, Ladenburg Thalmann Financial Services, Oppenheimer Holdings and Stifel Financial.

Buzz up!