Charles Lewis Sizemore, CFA

About the Author Charles Lewis Sizemore, CFA

Charles Lewis Sizemore, CFA is the founder and principal of Sizemore Capital Management LLC, a registered investment advisor. Charles has been a repeat guest on CNBC, Bloomberg TV and Fox Business News, and has been quoted in Barron’s Magazine, The Wall Street Journal and The Washington Post. He is a contributor to Forbes Moneybuilder, and has been featured in numerous publications and well-reputed financial websites, including MarketWatch, SmarterAnalyst, TheStreet.com, InvestorPlace, GuruFocus, MSN Money, and Seeking Alpha. He is also the co-author, along with Douglas C. Robinson, of Boom or Bust: Understanding and Profiting from a Changing Consumer Economy (iUniverse, 2008). Charles holds a master’s degree in Finance and Accounting from the London School of Economics in the United Kingdom and a Bachelor of Business Administration in Finance with an International Emphasis from Texas Christian University in Fort Worth, Texas, where he graduated Magna Cum Laude and as a Phi Beta Kappa scholar. He also maintains the Chartered Financial Analyst (CFA) designation in good standing.

Prospect Capital Corporation (PSEC): A Deeper Look at the Most Hated Stock on Wall Street

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Prospect Capital Corporation (NASDAQ:PSEC) may very well be the most hated stock on Wall Street.

And I say this as an investor with skin in the game. Not only am I long Prospect Capital both personally and in client accounts, I also have reputational capital at risk: I chose Prospect Capital as my entry in InvestorPlace’s Best Stocks for 2015 contest. As of this writing, I am suffering the humiliation of being in seventh place.

So, just how hated is Prospect Capital these days?

The stock is down 34% from its 52-week high and trades at a 30% discount to book value. To put that in perspective, the median business development company trades at a 6% discount to book value.

When a stock trades for just 70 cents on the dollar, it tells you that investors are questioning the reported book value. And there have been some well-publicized incidents in which Prospect Capital did indeed list identical assets at higher values than their peers, which partially explains investor hostility toward the company. Investors have also never forgiven Prospect Capital for slashing its dividend last year, even though the reduction was necessary given the de-risking of the company’s portfolio and the lower investment income that came with that de-risking.

My view has consistently been that, at the wide discounts to book value we’ve seen over the past six months, we have a wide margin of safety. According to Prospect Capital’s latest investor presentation, 75% of its portfolio is invested in secured first and second lien debt. The portion of the portfolio under the most scrutiny — the CLO equity tranches — makes up only 16% of the portfolio. If you were to write the entirety of the CLO equity to zero — which not even the most bearish of bears would do — Prospect Capital would still be trading at a deep discount to book value.

I spoke with Chief Operating Officer Grier Eliasek this week to get management’s take on Prospect’s recent share-price slide. Mr. Eliasek was very open with me and shared a set of slides that, until now, have not been released to the general public (see Prospect Capital Corporation Investor Presentation). Don’t worry, it’s ok to read them. They are based on public, reported numbers and are being reproduced with permission.

The usual caveats apply here. The data was prepared by Prospect Capital, and while I believe it to be factually accurate, I have not independently verified all of the data. And you should always assume that management has its own motives for sharing any data with the public.

So with that said, let’s jump into the presentation.

PSEC1

 

Figure 1 comes pretty close to stock touting, but it is instructive nonetheless. This chart shows the subsequent total returns (capital gains + dividends) that investors experienced the last time Prospect Capital traded at deep discounts to book value. On March 17, 2009, Prospect Capital traded at a 30% discount to book value, just as it does today. And over the 12 months that followed, the stock returned 94%.

Can we expect those kinds of returns over the next 12 months? Probably not. March 2009 marked the beginning of one of the greatest bull markets in history, and a rising tide lifts all boats. That’s not our situation today, although I do believe total returns of 40%-50% are possible and very likely.

The next two slides will be somewhat controversial to anyone sitting on large capital losses, but it is instructive nonetheless. It also happens to be very close to how Warren Buffett has traditionally measured his success at Berkshire Hathaway.

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Figures 2 and 3 measure Prospect Capital’s “Operating Return,” defined here as change in book value plus dividends. The thinking here, as with Mr. Buffett, is that management has no direct control over the share price. That is the prerogative of Mr. Market. But management does have control over the underlying investments, which show up in the company’s book value.

In recent years, most of Prospect’s returns have come from its dividend, though its total operating return has outperformed its peers in the BDC sector.

I agree that these returns are distinctly not what investors have realized in the stock. But just as Warren Buffett has asked to be judged by his growth of Berkshire’s book value, I think the same logic applies here. This hinges on book value being reliable, of course. And I raised that question with Mr. Eliasek:

Sizemore: “A lot of investors seem to be questioning Prospect Capital’s accounting these days. How would you respond to those who say that your book value estimates are overly aggressive?”

Eliasek: “We actually consider our book value accounting to be a major source of strength. We don’t value the portfolio ourselves. Our third-party valuation firms start with a blank piece of paper every quarter and value our portfolio from scratch. And our auditors approve.”

Sizemore: “How does this compare to your peers?”

Eliasek: “We consider ourselves to be among the most conservative. Some BDCs ‘self value’ or ask a third-party valuation firm to simply confirm in-house company estimates. We were one of the first BDCs to insist on truly arms-length, third-party valuation.”

Can a valuation firm be “encouraged” by management to inflate asset values? Of course. There are natural conflicts of interest when the company whose portfolio is being reviewed is the one doing the paying. We saw the same conflicts of interest with bond ratings agencies in the aftermath of the 2008 mortgage meltdown. But I would still consider the third-party valuation firms to be more reliable than an in-house valuation, and I have no reason to believe that Prospect Capital’s asset values are systematically more inflated than their peers.

When a stock is doing well, investors tend to ignore executive compensation. But when a stock is lagging, investors look at it with a much more critical eye. A consistent criticism I read about Prospect Capital is that its management team is overcompensated.

Is this true? Well, let’s look at the numbers.

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According to Figure 4, Prospect Capital’s expenses — the largest of which are the management and incentive fees used to compensate management — are almost exactly in line with their peers. Yes, I realize that depending on numbers provided by Prospect Capital itself is a little like allowing the fox to guard the hen house. And as an externally-managed BDC, Prospect does not disclose the compensation of its individual officers. But I see nothing here that would indicate that Prospect’s management team is uniquely overpaid by industry standards.

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And finally, it is only fair to note that Prospect Capital’s directors and officers eat their own cooking. The insiders are very aggressive buyers of the stock on the open market. And to clarify, these are real, open-market purchases that the executives are making with their own money. These are not executive stock option grants or other forms of stock-based compensation. Six 2010, six company officers have been responsible for buying a cumulative $43.6 million in Prospect Capital stock.

Let’s take a look at some of the more recent purchases, courtesy of GuruFocus:

Insider Position Date Buy/Sell Shares Trade Price Cost Shares Owned Following This
John F Barry CEO 6/5/2015 Buy 131,060 $7.58 $993,434 5,300,786
M Grier Eliasek COO 5/8/2015 Buy 30,000 $8.00 $240,000 302,196
Eugene S Stark Director 5/8/2015 Buy 2,000 $8.00 $16,000 28,000
Eugene S Stark Director 2/11/2015 Buy 1,000 $8.50 $8,500 26,000
Eugene S Stark Director 12/12/2014 Buy 4,000 $8.20 $32,800 250,00
M Grier Eliasek COO 12/9/2014 Buy 25,000 $8.31 $207,750 272,196
Brian H Oswald CFO 12/9/2014 Buy 63,500 $8.35 $530,225 375,000
John F Barry CEO 12/8/2014 Buy 132,200 $8.46 $1,118,412 4,833,410
M Grier Eliasek COO 12/2/2014 Buy 50,000 $9.10 $455,000 247,196
Brian H Oswald CFO 12/2/2014 Buy 162,500 $9.12 $1,482,000 311,500
John F Barry CEO 12/1/2014 Buy 115,000 $9.08 $1,044,200 4,701,210
John F Barry CEO 11/10/2014 Buy 110,000 $9.57 $1,052,700 4,535,544
Eugene S Stark Director 11/10/2014 Buy 1,512 $9.40 $14,212 21,000
M Grier Eliasek COO 11/10/2014 Buy 5,000 $9.56 $47,800 197,196
John F Barry CEO 9/16/2014 Buy 100,000 $10.17 $1,017,000 4,329,941
M Grier Eliasek COO 9/16/2014 Buy 5,000 $10.10 $50,500 192,196
M Grier Eliasek COO 8/29/2014 Buy 20,000 $10.26 $205,200 187,196
Eugene S Stark Director 8/28/2014 Buy 4,000 $10.32 $41,280 19,488
Brian H Oswald CFO 8/27/2014 Buy 27,300 $10.40 $283,920 149,000
John F Barry CEO 6/13/2014 Buy 100,000 $10.37 $1,037,000 4,110,959
Brian H Oswald CFO 6/12/2014 Buy 30,000 $10.25 $307,500 121,700
Eugene S Stark Director 6/12/2014 Buy 1,000 $10.27 $10,270 15,488
John F Barry CEO 6/12/2014 Buy 100,000 $10.33 $1,033,000 4,010,959
M Grier Eliasek COO 6/12/2014 Buy 24,000 $10.28 $246,720 167,196
John F Barry CEO 3/20/2014 Buy 100,000 $10.86 $1,086,000 3,793,385
Eugene S Stark Director 2/6/2014 Buy 1,000 $11.10 $11,100 14,488

Through June 9, CEO John Barry owned 5.3 million shares worth over $38 million. And most of these shares were purchased at prices far higher than today’s. CFO Brian Oswald owned 375,000 shares, and COO Grier Eliasek owned 272,196. All three men have made major new purchases in the past six months.

Given the amount of money they have personally invested in the stock, the picture in the financial press of a greedy management team looting the company for its own gain doesn’t quite hold water.

So, with all of this said, is Prospect Capital a buy?

As a value investor, I would answer that question with an emphatic yes. We have a wide margin of safety in the large discount to book value, and a management team that, while taking criticism from investors these days, has a lot of skin in the game. We’re also being paid generously to wait for the market’s mood to shift, as Prospect sports a current dividend yield of almost 14%.

Additional dividend cuts may be in the cards if the company continues to de-risk or if there is an uptick in non-performing loans. But I consider the current dividend safe for at least the next 9-12 months.

  • Benjamin Graham – also known as The Dean of Wall Street and The Father of Value Investing – was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

    Warren Buffett once gave a speech at Columbia Business School explaining how Graham’s record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham’s principles are everlasting. The speech is now known as “The Superinvestors of Graham-and-Doddsville”.

    Graham’s first recommended strategy – for casual investors – was to invest in Index stocks.
    For more serious investors, Graham recommended three different categories of stocks – Defensive, Enterprising and NCAV – and 17 qualitative and quantitative rules for identifying them.
    For advanced investors, Graham described various special situations or “workouts”.

    The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund.
    The last requires more than the average level of ability and experience. Such stocks are also not amenable to impartial algorithmic analysis, and require a case-specific approach.

    But Defensive, Enterprising and NCAV stocks can be reliably detected by today’s data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.

    For example, given below are the actual Graham ratings for Prospect Capital Corporation (PSEC), with no adjustments other than those for inflation.

    Defensive Graham investment requires that all ratings be 100% or more.
    Enterprising Graham investment requires minimum ratings of – N/A, 75%, 90%, 50%, 5%, N/A and 137%.

    Prospect Capital Corporation – Graham Ratings
    Sales | Size (100% ⇒ $500 Million): 154.81%
    Current Assets ÷ [2 x Current Liabilities]: 46.36%
    Net Current Assets ÷ Long Term Debt: 0.00%
    Earnings Stability (100% ⇒ 10 Years): 100.00%
    Dividend Record (100% ⇒ 20 Years): 60.00%
    Earnings Growth (100% ⇒ 30% Growth): 70.95%
    Graham Number ÷ Previous Close: 228.87%

    Note: Stocks failing Graham’s rules are not necessarily bad investments. They may fall under Graham’s “special situations” category. Graham’s rules are also extremely selective.