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I consider myself a deep-value contrarian investor. Therefore, my world is somewhat topsy-turvy: What most investors consider bad news I consider good, and vice versa.
When I’m on the prowl for new opportunities, I’m naturally drawn to bad news: a poor earnings report, lawsuits, loss of a significant client, an imbroglio with government, incompetent management – anything that sends investors to the exit and weighs on the share price to create value.
Prospect Capital Corp: An Undiscovered Income Stock 
The key to exploiting seemingly bad news is differentiating the terminal from the ephemeral. I see nothing but the ephemeral in the bad news plaguing Prospect Capital Corp. (NASDAQ: NASDAQ), a large business development company (BDC).
Investors have been selling Prospect shares in droves over the past eight weeks. Exceptional selling, in turn, has compressed Prospect’s share price down to a three-year low, while lifting the yield up to a three-year high – 13.7%.
Of course, investors aren’t selling because they’ve tired of this income stock’s monthly dividends and double-digit yield. They’ve selling because of a multitude of issues; all of which are easily surmounted.
The deviltry begins in late March, when the Security & Exchange Commission (SEC) mandated that index sponsors, namely Standard & Poor’s and Russell, report BDC expenses as fees in the ETFs that track the indexes. The Index sponsors balked at the mandate, so they sold BDCs (Prospect and others) from their respective indexes.
But the SEC wasn’t through, at least with Prospect.
In early May, Prospect disclosed it was disputing the SEC’s requirements for it to consolidate controlled companies on its financial statements. Prospect believes it doesn’t need to, based on generally accepted accounting principals (GAAP).
Nevertheless, the perception among investors is Prospect could have overstated past earnings and understated its leverage ratio. (BDCs’ debt-to-equity can’t exceed 1, or they risk losing their pass-through status.) In a subsequent press release, Prospect assuaged concerns by stating there would be no adverse impact to income or the leverage ratio should the SEC prevail.
The fear of Prospect’s leverage ratio exceeding 1 was amplified after Prospect tapped its revolving credit line for another $65 million in the past month. Of course, this money isn’t sitting idle; Prospect borrows at a lower rate to lend at a higher rate to mid-market companies. This is the very nature of the business.
These issues alone would have produced no more than yo-yo movement in Prospect’s share price: up, down, and up again.
Unfortunately, the hounds have been released. In the past two weeks, Prospect has been hit with a barrage of class action lawsuits. All are gamed on the usual themes: fraud, mismanagement, and misrepresentation. Uncertainty to their outcome is yet another weight depressing the share price of this income stock.
Unless, management is lying about the SEC having no impact on the economics of the business, consolidating controlled-interests is a non-issue. As for the lawsuits, I expect they might cause some discomfort, but this isn’t asbestos, so they won’t be fatal.
Prospect is obviously viewed as risky, hence the 13.7% yield. But once the haze of risk dissipates, so will the yield. Prospect’s share price will rise.
But don’t misunderstand; the road to recovery will be peppered with potholes: More down days loom. If it were easy and painless, everyone would be a contrarian, and the expected return for contrarian value investments would be on par with a five-year Treasury note.
That said, I’m confident that the issues Prospect faces today will be little more than a fading memory 12-to-18 months in the future.
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