The article excerpted below was originally published here on August 6 as a Friday File for the Stock Gumshoe Irregulars. It has not been updated, though the stock is up roughly 10% from that time. (For disclosure, I continue to be interested in the stock, but I haven’t bought the shares and continue to have no financial interest in any of the companies mentioned below).
The teaser came from the same ad as the SVB Holdings hint parade by Braden Copeland for Stansberry’s Investment Advisory (remember, this was teased as “pre-IPO shares” a couple weeks back, and the same ad is now circulating with the headline “Take a Flyer on the Silicon Valley ‘Tech Stock Jackpot’”).
And I know some folks are intrigued by Silicon Valley Bank — I don’t have anything against the stock, but I did think that the second investment that Copeland teased in the ad sounded a bit more intriguing. So let’s dig into it, shall we?
Copeland’s ad teases this as “A $6 Stock… for 7 Cents” and tells us that we can buy a company that essentially does venture capital funding for the energy industry … and that also comes with a 12% yield. Sounds interesting, right? Let’s look at the clues and find out if the reality is as intriguing as the tease.
“…like the Silicon Valley operation, it collects warrants on different companies.
“But instead of tech firms, this company is focused on energy.
“Over 33% of the companies in their portfolio are tiny oil and gas firms — everything from explorers to producers to service and pipeline companies.
“As you know, worldwide oil demand is going nowhere but up. New technologies have re-opened wells long thought abandoned…
“Oil shale, oil sands, a booming China…
“All of it has created a whirlwind in the energy markets as oil firms big and small have exploded.”
So there’s an assumption in there that wouldn’t have been accepted as blindly 18 months ago — the premise that oil demand is going “nowhere but up.” In the long term, I happen to agree that this is true, at least for the next decade or so, but it’s worth remembering that if and when the global economy collapses, it necessarily crushes oil demand. At least, that’s what folks feared during the financial collapse, when oil fell so dramatically (going down roughly 75% from the Summer 2008 all-time high price in just about six months). Still, oil prices recovered quickly, energy demand seems still to be growing, and all those Chinese drivers need something to put in their cars.
So what else are we told about this teased investment? Copeland gives one example of a company they’re invested in:
“Take Miller Petroleum (MILL), a tiny oil and gas producer you’ve likely never heard of.
“Despite its small size and anonymity, Miller is actually one of the most prolific energy producers in the Appalachian Basin, drilling or servicing over 65% of all the oil and gas wells in Tennessee.
“Over the last four quarters, their revenue has more than quadrupled.
“Even more impressive, since the end of 2007, Miller’s stock has soared from just 3 cents a share to $6.10 — a gain of 20,233%.
“It sure would have been nice to know about Miller three years ago, right?
“What if I told you could control shares, right now, for just 7 cents?
“As an investor in this energy operation, you could.
“These guys hold warrants to buy over 2 million shares of Miller any time between now and 2015 for just 7 cents — even though it trades for over $6 today.”
OK, so we can probably assume that, as with the SVB Financial teaser, a huge profit of 8,000% like that wouldn’t make the investing company move so much — but still, it’s impressive, and apparently this company pays a big dividend to boot.
Which is another clue:
“They are legally obligated to pay shareholders 90% of this income.
“I won’t bore you with the details, but basically, in exchange for special tax breaks, these guys are required by law to pay out 90% of their investment income to shareholders.
“Today, the stock yields an astounding 12%.”
And it probably shouldn’t be a surprise, since Copeland has also covered insider buying patterns for another newsletter, but one reason he likes this pick is that there is some insider ownership …
“No wonder the CEO of this company has bought millions of dollars worth of his own stock — and has never sold a single share.”
So that ought to be enough, right? Well, feed it all into the mighty, mighty Thinkolator and we find out that this must be …
Prospect Capital Corp (PSEC)
Prospect Capital is a Business Development Company (BDC), which is essentially a kind of low-leverage bank — they use equity capital and debt to fund investments in (usually small) businesses, usually in the form of loans but also equity investments with varying levels of control, not unlike other venture capital investments.
But unlike other banks, BDCs are largely a creation of the tax code and intended to help create a positive environment for lending to small businesses. Similar to MLPs or REITs, BDCs avoid taxation for the company itself because they promise to pass along the lion’s share of their income to shareholders, so most of these are owned by yield-conscious investors who are looking for a substantial level of income.
Many of these companies do lending as partners with the Small Business Administration as another way to get access to low-cost capital, and almost all of these companies — as levered lenders to what are typically very economically sensitive smaller copmanies — took a big hit during the market crash and recession.
Probably the most well-known BDC is Allied Capital, the firm that arguably got too aggressive and famously became a target of David Einhorn before legal woes and portfolio collapse led them to be acquired by upstart Ares Capital earlier this year. Stephen Pearlstein did a nice piece on this in the Washington Post, if you’re curious about the history (the Washington area, former home to the Gumshoe, is home to several of the big BDCs, as well as some similar companies like CapitalSource). And of course, unlike traditional banks they don’t lever up their investments nearly as much — they don’t have deposits to rely on, just invested equity and their own debt, and they’re restricted in the amount of leverage they can use (and lately they’ve been wary of even using what leverage is legal and most of them seem to have substantially more equity financing than debt).
But Prospect has a bit of a niche — they do use the same model, mezzanine lending to small and middle-market companies (basically, that means companies too small to get decent terms from a Wall Street bank, but maybe too big to go to their neighborhood banker for their financing needs — mezzanine debt is, and I’m simplifying, debt that’s junior to bank debt, but senior to common shareholders), but they do specialize in what they call “underrepresented” sectors: industrial and energy companies. Which should make a little light saying “cyclical” flash above your head.
There are other similar companies that also focus on energy — including NGP Capital (NGPC), and Tortoise Capital (TTO) and Kayne Anderson Energy Development (KED), with the latter two more generally considered to be closed-end funds, though they elected to be taxed as BDCs for at least part of their existence. Like Prospect, which is managed by Prospect Capital Management, many of them are externally managed for some variety of a management fee or other consideration for overhead costs.
When you dig into the books of most of these companies (as with most banks or investment funds, to be fair) you’ll find at least some stuff that doesn’t smell very good — especially now, when most of them are still carrying some very weak investments on their books, unrealized losses that were in many cases spurred by the market meltdown and the recession. And if you look a the basic balance sheet, many of these stocks are so investors-focused (meaning, they know that their investors want growing dividends) that they’ve been issuing more equity and borrowing money in order to keep the dividends rising, with dividends in some cases exceeding the company’s earnings, or even their free cash flow.
What you’re really buying when you invest in a BDC is a portfolio of loans to and investments in companies, in this case mostly industrial and energy companies — and you’re buying the ability of the BDC’s managers to effectively assess the risks of these investments, judge collateral, choose new investments, control costs, and ensure repayment of the loans in the future. None of them are perfect, certainly, but you hope that a portfolio of these investments will enable the company to consistently make money, and to distribute that money to you as dividends.
And unfortunately, Prospect Capital has cut their formerly even-more-tasty dividend, ending a long series of dividend raises that pretty clearly got to be unsustainable at the end. I say “unfortunately” because companies that commit to being “dividend growers” hate to cut payouts, and investors usually punish them for it, though given the challenges of the business it may well be that the dividend cut was the only sensible way to go.
That’s not a cut from the current level, by the way, the cut was down to what is now roughly 12% on a share price just a hair under $10 — and they tried to both make it more palatable for investors and, I assume, obscure the depth of the cut by also changing from a quarterly to a monthly dividend. The current dividend is now roughly 10 cents per share, payable monthly, for an annual payout of roughly 12%, when it had been up to 41 cents per quarter, for an annual payment of $1.64 and a rate of more like 16% (the stock topped out around $12 before the dividend was cut).
This one will probably take some reading of sleep-inducing filings to build a level of comfort before buying (should you so choose — for my part, I haven’t decided yet) — that’s because so much of assessing the value relies on guessing at what their earnings will be for the months ahead, and the earnings are impacted significantly by unrealized changes in the value of their investment portfolio, assessments of the value of loans and equity that they have outstanding. Right now, you can look through and see some very profitable deals, like the Miller Petroleum example, with a loan that was paid back in very short order, and the big pile of warrants they still hold, as well as some really sad looking deals like Yatesville coal, a company that they created as a rollup of several debt and equity positions in small coal mining or exploring groups and that has been written down to essentially nothing now under what is euphemistically called “other than temporary” impairment.
Still, if they are writing down debts as they need to when companies falter, then perhaps we can have at least some faith in their accounting — which is good, since we obviously have to largely rely on the company to tell us whether or not their investments are doing well. And right now the company trades for right around what they say their book value/asset value is, so you’re not necessarily paying more than the portfolio would be worth. Given that, there’s certainly a temptation to say that since they’re in very cyclical industrial and energy sectors, a better economy or higher demand for energy could significantly improve things for many of those companies, and lead to repayment or “write-ups” on loans and equity investments.
And yes, John Barry, the CEO of Prospect Capital, has been a very active acquirer of the shares for a couple years now — and there have been no insider sales recently. He currently owns about 1.8 million shares and has added more than 200,000 shares to his holdings just this year, at prices either right around where it now stands or a dollar or two higher (and these appear to be “real” buys, at market prices, not stock grants or other less interesting insider acquisitions). To add to the insider case, there have been a couple other officers and directors buying over the past year as well, which tends to be a positive for stocks — though “tends to be positive” means that most companies that have a pattern of several insiders buying, particularly C-suite insiders, see their share price outperform the market several months later. To reiterate, that’s “most” — insiders can certainly be wrong, or have other motivations, or be patient buyers who intend to hold for decades without much care for the current price … and they also know, believe me, that investors are looking for insider buys as a signal. That’s not to say it’s not a good signal, just that it’s far from infallible.
So as I noted, I’m personally undecided on this one, though a bit tempted — if you’re beginning your research it’s obviously worthwhile to start with the company’s filings, and with a look at their portfolio companies to get an idea of the kind of deals they like. For outside information, I’ve found the analysis of the folks a the BDC Reporter to be interesting and useful, and they cover Prospect and most of the others with some regularity (they also have a shorthand “why invest in BDC’s” primer that some might find useful as an overview of this small sector). If you like the idea of BDCs in general, or similar types of income investments, I’d urge you to check out QuantumOnline as well, that’s the best place to find listings of these kinds of investments (they don’t provide analysis, just lists and links, and they’re free but you have to register).
As for what you think, well, that’s what matters, innit? It is, after all, your money … feel free to share any thoughts you have about BDCs or about Prospect Capital with a comment below.