Unintended Regulatory Risks:
The newly-elected president of the United States is strongly in favor of less regulation, however this may have significant unintended negative consequences on BDCs, such as Prospect. As you may have noticed, financial stocks (as measured by the financial sector ETF (XLF)), shot up following November election as investors anticipated less regulation.
Specifically, big banks have spent the last seven years shedding risky loans and investments from their balance sheets because of heightened regulations under the Obama administration, and this created somewhat of a boon for BDCs like Prospect (i.e. BDCs, like Prospect, picked up a lot of the business the banks were dumping or unwilling to take due to regulations). However, if regulations are dramatically reduced now, then Prospect could be facing a lot of daunting competition from the big, powerful, deep-pocketed, banks.
Perhaps compounding the risks, Prospect may have gotten “lumped in” with other financials and small caps (Prospect’s market cap is $3.1 billion) following the November election, two categories that soared as shown in the following chart.
However, given the unique risks that Prospect faces (e.g. it may actually get hurt by other financial companies like the big banks, and its high correlation with other small cap stocks, as measured by Small Cap ETF (IWM), as we saw in the earlier correlation table, may be unwarranted), its recent gains may be setting it up for a fall.
Valuation:
From a valuation standpoint, Prospect Capital Corporation (NASDAQ:PSEC) is significantly less attractive than it was just one-year ago. For example, the following chart shows Prospect’s current and historical price-to-NAV (Net Asset Value) and price-to-NII (Net Investment Income).
The first thing worth considering is that Prospect’s relative price is significantly higher than it was just one-year ago. And while these valuation metrics may make Prospect look cheap relative to 2010-2014, let’s not forget the market cycle. During 2010-2014 the markets, and subsequently Prospect’s investments, were distressed and thereby offering higher yields and ROEs. That is not the case today, and therefore Prospect should be trading at lower valuation multiples. And at the very least, Prospect is a lot more expensive than it was a year ago, and its prospects do not seem to have dramatically improved, especially considering it may soon be facing heightened competition.
This next chart shows Prospect’s Net Investment Income on absolute basis (in millions of dollars) and on a per share basis.
One thing worth considering in the chart is that absolute NII increased dramatically from 2010 to 2012 as the market wide recovery dictated (it created attractive opportunities) and as Prospect benefitted from big banks de-risking. Next, total NII leveled off from 2012-2015 as PSEC enjoyed the high returns on earlier vintage year investments. And now, at the end of 2016, total NII may be starting to fall off as some of those juicy vintage year investments roll off the books and are replaced with less-juicy investments (a trend that seems likely to continue).
Also, important to note, NII/share is declining in recent quarters which is not a good sign for investors. Further, as we saw in an earlier chart, price-to-NII is rising while NII per share is falling, a discouraging trend.
Also worth considering, this next chart shows Prospect’s historical dividend yield.
And as the chart shows, the yield is still large, but it has come down, perhaps a sign that the valuation may be getting ahead of itself, or simply a sign of lower yielding investment opportunities ahead (i.e. the middle market debt and equity opportunities in which Prospect invests may likely offer lower yields and lower returns going forward considering the market cycle and potential increased competition).
