A Premier 'Banker' Goes on Sale

03/21/2013 7:45 am EST

Focus: STOCKS

Ian Wyatt

Publisher & Chief Investment Strategist, Wyatt Investment Research

This company knows how to do banking right, making money and rewarding their investors with a huge dividend, says Ian Wyatt of High-Yield Wealth.

There are companies that still excel at the basic banking function of borrowing at one rate and lending at a higher rate. They are called business development companies (BDCs) and frequently pay dividends three to four times those paid by the large Wall Street banks.

Prospect Capital (PSEC) is one of the higher-yielding BDCs, paying a dividend that yields close to 12%.

Prospect's business is straightforward: It lends to middle-market privately held companies. These companies generate revenue between $20 and $200 million, and operate in basic nuts-and-bolts sectors: adhesives, chemicals, insurance, food distribution, health care, energy, transportation, machinery parts, etc.

Prospect's portfolio is spread among 106 long-term investments with a market value of $3.04 billion. Prospect has been a lending machine, as the market value of its portfolio increased 50% over the second half of 2012.

Just as importantly, quality hasn't been sacrificed for growth. Fifty% of Prospect's loan portfolio is in a first-lien position. That means Prospect owns a high claim on its debtors' assets should the borrower go south (though that rarely occurs). That said, none of Prospect's loans originated in the past five years has gone to non-accrual status, meaning that its borrowers are paying their loans.

At the same time, Prospect continues to maintain low debt levels. Unlike traditional banks, Prospect is able to generate high yield with relatively little leverage. Its debt-to-equity ratio is only 47%. Most large banks have a debt-to-equity ratio between 150% and 200%.

The spread between cost of funds and the interest earned on those funds is even more telling. At the end of 2012, Prospect's weighted average interest rate cost was 6.8%, and the weighted average interest rate earned was 18.3%.

That’s an 11.5% spread, impressive when compared to the spread earned by many traditional banks. When I sold two quality regional banks last year—Community Trust Bancorp (CTBI) and Cullen/Frost Bankers (CFB)—their spreads were around 4%.

So if Prospect is such a worthy high-yield investment, why are its shares trading 5% lower than when I first recommended them in July 2012?

Many investors are put off because Prospect has been issuing additional shares. During 2012, shares outstanding increased by 86 million, with 35 million shares being issued in the fourth quarter alone. In other words, shares outstanding have increased by 78%. Dilution has deterred many investors.

But when investors speak of dilution in relationship to BDCs, I know they are unfamiliar with BDC capital formation. You see, Prospect has a “fluid” capital structure because it is a pass-through entity, meaning it must pass at least 90% of its taxable income to investors. Therefore, Prospect (and all BDCs) has to tap outside equity and debt sources to grow.

This isn't a concern from my analysis; Prospect has continually issued shares above their net asset value. Last year, the market value of Prospect’s investment portfolio continued to grow. That tells me that Prospect is able to raise funds and put these funds to profitable use.

Prospect's dividend history should also assuage any concerns about dilution. Prospect continues to raise its dividend, even though there are many more shares outstanding. The fact that Prospect can continue to raise its payout confirms—more than anything—that it's raising capital and putting it to profitable use.

Prospect's lower price and higher distribution and yield are an open invitation for investors to pick up additional income in a company that excels where so many banks today fail. Buy Prospect Capital shares.

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