Should Investors Sell This Popular High-Yield Investment?

Prospect Capital Corp. (NASDAQ: PSEC) cut its dividend nearly 25%. Should investors cut Prospect from their investment portfolio? 
Though a small-cap ($3.1 billion market cap or less) stock, Prospect Capital is one of the more popular high-yield investments in the High Yield Wealth portfolio. I’m not surprised: Prospect has historically provided a stable payout that has generated a consistent 12% yield. What’s more, the dividend that generated the 12% yield was delivered in monthly increments.
Note that I say “historically.” Prospect’s dividend today generates an 11.5% yield. This sounds good, until you realize the yield isn’t the result of price appreciation. It’s the result of a dividend cut and price depreciation.
A few days ago, Prospect cut its annual dividend to $1.00 a share from $1.32. Investors reacted by cutting Prospect’s share price.
So is Prospect worth holding, given the reduced dividend payout?
On the upside, the lower payout is sustainable when juxtaposed with net investment income (NII) – a  key dividend-coverage metric for business development companies (BDCs).  Over the past year, NII was less than the dividend. Based on the last reported quarter, NII posted at $0.275 per share. The lower dividend will cost $0.25 per share per quarter (though it will still be parceled out monthly).
In the press release announcing the dividend cut, Prospect Chairman and CEO John Barry said, “We believe there may be upside to our new reduced dividend level, a dividend level we believe we can sustain over the next year and longer even with no dividends or fees from portfolio companies.”
To take Barry at his word, the current payout should be sustained at least through March 2016.  What’s more, the regular dividend could be supplemented with special dividends.
To quote Barry again, “To the extent our taxable earnings continue to exceed NII as well as our regular dividends, we may need to declare additional special dividends to meet our requirement as a tax-efficient regulated investment company to distribute 90% of our taxable income to shareholders.”
I discussed Prospect in detail last month for High Yield Wealth readers. In my narrative, I mentioned that the dividend outlook had become more opaque after management announced it intended to spin off a portion of its operations. At the time, management said the goal was to create shareholder value.
I’m all for value creation, but as I wrote last month, “My concern is that management will attempt to cloak a dividend cut under the guise of value creation.”
To be honest, I didn’t think a dividend cut was imminent.
There were mitigating circumstances, namely massive insider buying. In November, insiders were heavy buyers, accumulating over 116,000 additional Prospect shares. This month, heavy buying not only continues; it’s been amplified. Since Dec. 1, insiders have bought an additional 552,200 shares.
Insiders sell for many reasons, but they buy for one – to make money. Surely the insiders knew a dividend cut was imminent. They knew Prospect shares would take a hit. To buy into a rout means they must have at least some faith in Prospect’s outlook.
Today, the lower price and the lower payout generate a yield in excess of 11%. The lower price also means that Prospect trades at an 18% discount to its net asset value (NAV) of $10.47. You have to go back to 2009 to find such a deep discount. Prospect has historically traded at a 10%-or-more premium.
Yes, a lot has gone wrong with Prospect in 2014. But given its discounted price, Prospect appears to be more of a buy than a sell at this point.

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