Should You Buy Prospect Capital Corporation Before Earnings?

Prospect Capital has been pretty active during the first few months of 2014, and in fact, its loan orientation volume is the highest it's ever been.

With the company's next earnings release a few weeks away, now is a great time to take a step back to see how things are going with Prospect and what we should expect over the next few months. Is their big dividend secure? How much potential downside is there?

A safe 12% dividend? How?
There is no such thing as a completely safe double-digit dividend, but Prospect comes close, and they do it through diversification. The company finances small- and mid-sized companies through either debt or equity, and in all fairness a lot of these companies are not the most solid in the world. However, if one of these companies were to default on their debt, it wouldn't be too devastating, as Prospect's investments are spread out over more than 125 companies.

In fact, the diversity is getting even better, and 2014 is turning out to be a record year for Prospect in terms of loan originations, which also generates fee income. The company originated $1.3 billion during the quarter ending March 31, and has already made significant new investments in April.

It is also worth noting that Prospect is funding its growth by issuing stock and debt, as opposed to using its credit facility.  If the company was having a tough time covering its dividend, there is the option of using more of its credit facility to make new investments, as my fellow contributor Jordan Wathen explained in detail in a recent article.

BDCs were removed from indices. How will this affect Prospect going forward?
The S&P announced in February its decision to remove business development companies like Prospect from its index funds, and the Russell Indexes followed in March. Prospect had been a part of the S&P Small Cap 600 index and the Russell 2000 index, which caused investors to panic.

Basically, funds tracking these indices allocate a portion of their holdings to each company in the index. When a company is removed, the funds are forced to sell the shares they hold, which can create tremendous downward pressure on the stock. It is estimated about 8% of BDC's shares were held by ETFs before they were dropped, so even though the process isn't completed, Prospect's share price is about 5% lower than it was before the announcement.

PSEC Chart

The price seems to have stabilized in recent weeks, and the Russell index funds will complete their transition away from BDCs sometime in June. I would look for the company to address this issue in their upcoming earnings report. Once the process is complete, the downward pressure should stop and we could easily see Prospect's share price gravitate back to where it was before the ETF selling began.

Net asset value...keep an eye on this number!
One of the main things to keep an eye on with Prospect is its price relative to its net asset value (NAV), which currently sits at $10.73. It seems like this has created a pretty solid "price floor" since the ETF selling began, and it should continue to do so.

However, if the share price drops below this level for whatever reason (a generally bad day for the markets or sector, high selling volume, etc.), any opportunity to buy below the NAV should be a no-brainer.

Prospect has one of the highest and most predictable dividends in the market. The company currently yields about 12.2% per year, and pays its dividends monthly. It has also declared its dividends through September, and once the company reports earnings we should know the dividends all the way through December. The payment has been steady, and actually has risen a little bit each month since the company began monthly distributions in 2010.

Once the downward selling pressure is done and the market once again realizes Prospect is a very solid high-paying company, the days of buying at such a discount will be over.

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