#$psec

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The threat of the pace of default rates accelerating among the weakest credits continues to be a very real risk for business development companies. 

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By The Valuentum Team

Big name business development companies (BDCs) such as Prospect Capital (PSEC) and Main Street Capital (MAIN) continue to be vulnerable equities, in our view, particularly as credit conditions deteriorate. Ongoing pressure in the energy and metals and mining markets has increased the wariness of investors and their propensity to tolerate weak credits (and those tied to them), and several factors loom that may significantly increase the already-high level of business-model risk associated with BDCs. Investing in these relatively obscure publicly-traded “venture capital” entities is not for the faint of heart.

The market may bear witness to a surge in defaults within the high-yield arena in coming years, and a prolonged weakness in commodity prices may seal that fate. Mostly overleveraged upstream players have been the source of the investor anxiety, but the metals and mining industry is also home to a large number of equities that may not survive from coal miners to steel makers and beyond. The recent collapse in crude oil prices and other commodities is not making things easy, and the onset of a contractionary monetary cycle will only make matters worse, in our opinion. As a percentage of their entire portfolio, PennantPark (PNNT), Main Street and Apollo (AINV) have anywhere between 13%-17% tied to the energy markets.

The median high-yield default rate since 1996 has been ~3%, but according to Fitch Ratings, the trailing twelve month default rate is already higher than those levels, suggesting that the credit market cycle is already far past its prime. Looking ahead to 2016, Fitch is expecting the US high-yield default rate to climb to 4.5%, which may very well mark the threshold at which the pace of credit health and the incidence of defaults accelerate. Moody’s average expected default frequency metric has already risen over 5%, well above that 4.5% threshold. As we wrote earlier this year:

...what has us very concerned is that in the two prior instances since January 1996 when (Moody’s) average expected default frequency metric surpassed 4.5% (1998 and 2008), as it has, the actual high-yield default rate at the eventual depths of the credit cycle turned out to be far worse, ~11% in 2002 and ~15% in 2010. As in the two past instances, high-yield default rates may very well surge in the coming months, and a double-digit rate can’t possibly be ruled out, even as Moody’s says “doom does not necessarily impend.” Surging high-yield default trends tend to occur around recessions, at least in the US.

The expectation for rising default rates is primarily driven by significant pressure on the energy and metals and mining sectors; the two areas, for example, have accounted for ~70% of defaults in 2015. Fitch Ratings expects the 2016 default rate in the high-yield energy sector to be greater than 10%, but this is assuming that the average price of a barrel of crude oil will be $50 for the year, a number that can be viewed as optimistic when considering recent comments from OPEC and the current level of commercial supplies in the US. In the event the price of crude oil hovers in the mid-$30s (today’s levels) and below, we would expect default rates across high-yield energy participants in 2016/2017 to be significantly higher than a 10% incidence rate.

When excluding the energy and metals and mining industries, Fitch expects the remainder of the high-yield market default rate to be 1.5% in 2016, well below the credit rating firm’s non-recessionary average of 2.1%. The expected 4.5% high-yield default rate would be the fourth highest of any year since 2000, however. Though many BDCs aren’t completely levered to energy, it may not matter. Even a few missteps in the space could be enough to derail the resilience of their income profiles, and the contagion impact that may be felt from lost jobs in weakened local energy-dependent economies is difficult to overlook. Remember: subprime loans were only a small slice of total loans, but that small slice was enough to bring the global financial system to its knees during the Credit Crisis of late last decade.

Another cause for concern for investors in BDCs is the coming credit tightening cycle, if only that it will make yields on alternative less-risky assets increasingly more desirable. Though the timing remains uncertain, interest rate hikes are inevitable in our view, and once the Fed begins raising rates, we believe that it will continue to do so. We doubt Janet Yellen will pursue a “one and done” strategy, predoinantly because it may reflect poorly on her conviction in initiating a tightening policy at all (and the Fed may lose credibility as a result). More directly, a higher federal funds rate will also drive the cost of capital for BDCs higher, making it more and more difficult to generate sufficient returns. Higher rates will pressure the underlying valuations of BDCs, but not unlike that of most other equities (a higher discount rate would be applied to their future expected free cash flow streams).

As generally conservative, value-focused investors, perhaps the biggest reason we’re not fans of BDCs is that most hold a significant amount of leverage on the books and are required to distribute at least 90% of taxable income as dividends, leaving little room to handle cash shortfalls. Several BDC’s have cut their dividends, and with so many other companies in our coverage universe with substantial net cash positions and fantastic free cash flow profiles, why take on the added risk? 

We're staying on the sidelines.

Continue reading a primer on BDCs here >>

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A list of BDCs: American Capital (ACAS), Apollo Investment (AINV), Ares Capital (ARCC), Blackrock Kelso Capital (BKCC), CorEnergy (CORR), Equus (EQS), Fidus (FDUS), Fifth Street Finance (FSC), Full Circle (FULL), Gladstone Capital (GLAD), Golub (GBDC), Hercules Technology (HTGC), Horizon Technology (HRZN), KCAP Financial (KCAP), KKR Financial (KFN), Main Street (MAIN), MCG Capital (MCGC), Medley Capital (MCC), Monroe Capital (MRCC), MVC Capital (MVC), New Mountain (NMFC), NGP Capital Resources (NGPC), Oxford Lane (OXLC), Pennant Park (PNNT), Prospect Capital (PSEC), Solar Capital (SLRC), Stellus Capital (SCM), TCP Capital (TCPC), THL Credit (TCRD), TICC Capital (TICC), Triangle Capital (TCAP), Whitehorse Finance (WHF).

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We all have bills to pay. And whether it’s your mortgage, your utilities or just that pesky credit card bill, life’s little expenses tend to recur every month. There’s just one problem with this: If you’re living off of your investments, you normally get paid on a very different timeframe. Dividends are usually paid quarterly, and bond interest is usually paid semi-annually. 

I don’t know about you, but I don’t like trying to plan my expenses three to six months in advance. And for a retiree, I can’t think of too many things scarier than running out of money in between quarterly dividend payments. 

Well, fear not. I have a solution: Monthly dividend stocks. 

Many closed-end bond funds have traditionally paid their dividends monthly, which is nice. It shows that the managers understand their investors and try to accommodate them. But among everyday dividend stocks, it’s still surprisingly rare and usually limited to a REITs and business development companies. Today, we’re going to look at five solid monthly dividend stocks that can be used to round out an income portfolio.

STAG Industrial (STAG)

I’ll start with a young REIT that I’ve owned for years, STAG Industrial  (STAG). STAG is a small-cap REIT with a market cap of about $1.3 billion. That makes it large enough to be diversified but still small enough to fly under the radar of most investors. 

STAG switched from a quarterly dividend to a monthly dividend in late 2013. STAG’s business model is simple enough to understand. The REIT invests in single-tenant industrial real estate — things like warehouses and light manufacturing facilities — that tend to require little in the way of maintenance and ongoing expenses. As of the most recent investor presentation, STAG had a portfolio of 253 properties spread across 36 states and 231 tenants, most of which are investment-grade rated. 

More than 60% of STAG’s tenants have revenues of more than $1 billion per year, and the 10 largest tenants collectively only account for 15.5% of STAG’s annualized base rent. That’s a conservative profile, which is exactly what you want from one of your monthly dividend stocks. 

After the broad selloff in REITs this year, STAG’s monthly dividend yields a healthy 7.2%. And importantly, STAG has been a steady dividend raiser. STAG raised its dividend 4.5% this year after raising it 10% last year. That’s well ahead of the rate of inflation — something that every retiree should keep in mind.

EPR Properties (EPR)

Up next is a quirky REIT that I’ve highlighted in the past, EPR Properties (EPR). EPR operates in an interesting niche of the real estate market, focusing mostly on entertainment. (“EPR” is short for “Entertainment Properties.”) 

With its collection of non-traditional assets, including movie theaters, golf driving ranges and even charter schools, EPR is hard to classify. Most REITs get lumped into a broad sector, such as residential, commercial or office. There isn’t exactly a category for movie, golf and school REITs. 

That’s OK. I don’t need for EPR to fit into a neat category box. I just need it to keep paying its monthly dividends! In fact, EPR’s quirky asset mix works to our benefit, as it a lot of institutional investors frankly don’t know what to do with it. The lack of institutional buying helps to keep the price low and the yield high. 

Today, EPR yields a fat 6.8%, and the REIT has been a steady dividend raiser for years. Over the past five years, EPR has grown its dividend at a 6% clip. Not too shabby. As with STAG, EPR switched its dividend payment from quarterly to monthly in 2013.

Realty Income (O)

Of course, we can’t have a list of monthly dividend stocks and not mention the “Monthly Dividend Company” itself, Realty Income (O). 

In my view, Realty Income is about as close to a bond as you can get in the stock market in terms of reliability. It pays its dividend like clockwork every month, and its cash flows are supported by a rock-solid portfolio of high-traffic retail properties. 

This stock has made 542 consecutive dividend payments, and I see nothing short of nuclear war or the actual end of days breaking that chain. But while I consider Realty Income as safe as a bond, its returns are vastly superior. Since its 1994 listing, Realty Income has enjoyed compounded total returns of 16.4% per year. And it has also raised its dividend for 72 consecutive quarters. 

I have shares of Realty Income that I keep in my IRA that I have pledged never to sell. My dividends are set to automatically reinvest, and I never look at the account. (Well, I shouldn’t say “never.” Once a year I login just to make sure nothing is wrong.) I intend to leave these shares to my kids someday, and if they’re smart they’ll do the same for their own children. I expect Realty Income to still be around by then, and still kicking off a fantastic monthly dividend.

LTC Properties (LTC)

I’ll add one more REIT to our list of monthly dividend stocks: LTC Properties Inc  (LTC). To get an idea of what LTC does, just look at its ticker symbol: “LTC” stands for “long-term care,” making LTC an interesting way to play the aging of the Baby Boomers. More than 8,000 baby boomers turn 65 years old with every passing day, making this a durable trend with staying power. LTC is a stock you can buy and forget while enjoying a steady stream of monthly dividends. 

LTC Properties has a specialized portfolio of properties targeting skilled nursing, assisted living, independent living and memory care. About 20% of its portfolio is also invested in mortgages backed by these kinds of properties. 

LTC currently yields 4.9%. That’s lower than some of our other monthly payers, though still pretty competitive for a medical REIT. And like our other monthly-pay REITs, LTC has a long history of raising its dividend. LTC recently announced a 5.9% dividend hike, and the REIT has managed an 8.6% dividend growth rate over the past five years. 

Also worth noting: Unlike most of the REIT sector, LTC’s stock price is actually in positive territory for the year.

Prospect Capital (PSEC)

That’s enough about REITs. Let’s take this list of monthly dividend stocks a different direction, starting with business development company Prospect Capital (PSEC).

As with closed-end funds, business development companies (BDCs) tend to be held by individual investors rather than institutional investors. This goes a long way to explaining why many are monthly dividend stocks. They’re simply giving their investors what they want. 

Prospect Capital yields 13% at current prices and trades at a deep discount to book value, something that has only happened a handful of times in the company’s history. Use this as an opportunity. While you’re waiting for the stock to return to a more normal valuation, you get to collect a high monthly dividend.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

It’s not how much you make that ultimately matters in wealth accumulation but how much you keep, and the amount of your gains that get lost to taxes are a major factor in your realized returns. 

Thankfully, you don’t have to be a millionaire with an army of lawyers to effective game the tax code. Even the basic tools available to every American taxpayer, such as IRAs and Roth IRAs, can be wildly effective in lowering your tax burden and compounding your wealth at a much faster rate. 

But as wonderful as an IRA or Roth IRA can be as a tax-free accumulation vehicle, we’re limited to contributions of just $5,500 per person per year ($6,500 if you are aged 50 or older). And worse, your ability to contribute to a Roth IRA gets phased out at higher income levels. So, if you’re aggressively saving for retirement, you’re going to have a large portion of your savings invested outside of an IRA or Roth IRA and subject to ravages of taxation. 

This means we have to pick and choose which investments we put in our IRA or Roth IRA. And choosing poorly here can make a big difference to the lifestyle you can afford in retirement.

What Not to Buy in an IRA

Let’s start with what you shouldn’t put in an IRA or Roth IRA. Most obviously, this would include tax-free securities like municipal bonds. Any investor stupid enough to waste precious IRA funds on tax-free muni bonds should be taken out back and shot. Or at least sterilized. 

The same is true of MLPs and other “special” stocks that create tax complications. Because MLPs can generate unrelated business taxable income (“UBTI”), they can create bizarre tax situations in which your IRA has to file its own tax return and pay taxes. And looking at the bigger picture, given that most MLP distributions are indefinitely tax deferred, there is no benefit to placing them in an IRA or Roth IRA. You're effectively wasting precious IRA dollars. 

Casting the net a little wider, I would say the same about tax-efficient index mutual funds or ETFs you intend to hold for the long-term. There’s just no point in putting them in an IRA. Portfolio turnover is minimal in index funds, so they generate very little in taxable income other than the dividend yield, which these days amounts to all of 2%. Plus, once you sell the funds to pay for your retirement expenses, you’re going to be paying ordinary income tax rates on the full amount of the funds withdrawn from an IRA, whereas you’d be paying the long-term capital gains tax rate on just your capital gains on a taxable mutual fund or ETF investment. (You wouldn’t pay taxes on monies withdrawn from a Roth IRA, but my point stands.) 

Now that we’ve gotten that out of the way, we can talk about what makes a solid IRA investment. Ideally, you should prioritize for your IRA or Roth IRA any investment that gets a large chunk of its total return from current income. And specifically, it should be current income that does not benefit from special tax rates, such as qualified dividends taxed at the preferential 15% and 20% rates.

So with no more ado, let’s jump into the five best IRA investments.

Business Development Companies

Business development companies ("BDCs") are an interesting niche of the market. They essentially do what banks used to do back in the good ol’ days before the 2008 crisis: Lend money to up-and-coming businesses. 

The tax code gives a nice bonus to BDCs. In order to encourage them to provide funds to capital-starved young businesses, all profit is tax free at the corporate level…so long as they distribute at least 90% of it as dividends. 

As BDCs are unable to retain much of their earnings for future growth, a large chunk of the total returns to investors comes from the dividend. Many BDCs yield well in excess of 10%. 

That alone would make them an ideal IRA investment. But that’s not where the story ends. The taxability of BDC dividends will vary from company to company, but the dividend will generally be some combination of lower-taxed “qualified” dividends, higher-taxed unqualified dividends and tax-deferred return of capital. Typically, the biggest chunk of the dividend is considered non-qualified and taxed as ordinary income, making BDCs woefully tax inefficient. This makes them particularly well suited for an IRA or Roth Ira. 

I’m a fan of BDCs under the right conditions, and I made a BDC my pick in this year’s Best Stocks contest. Prospect Capital (PSEC) trades at a deep discount to book value and pays a fantastic 14% dividend yield.  Thus far, the stock has had a rough 2015, though I expect it to finish the year strongly. I also consider it an outstanding IRA investment…and happen to own it in my own IRA.

Equity Real Estate Investment Trusts

Along the same lines we have equity REITs. Equity REITs have one of the simplest business models out there. They buy or develop real estate, lease it out, and collect the rent. As with BDCs, REITs pay no taxes at the entity level…so long as they pay out 90% of their net income in the form of dividends. 

Though REITs are considered to be long-term growth vehicles, they also get a high percentage of their total return as income. But as far as tax treatment goes, REITs tend to get punished even harder than BDCs. In any given year, some portion of a REITs dividend may be classified as capital gains distribution or as a tax-free return of capital. But the lion’s share of the payout will generally be a non-qualified dividend taxed as ordinary income. 

One REIT I hold in my IRA that I am unlikely ever to sell is “the monthly dividend company” Realty Income (O). Realty Income has paid 540 consecutive monthly dividends and has increased its dividend for 71 consecutive quarters. At current prices, it yields about 5%.

Mortgage Real Estate Investment Trusts

Even less tax efficient than equity REITs would be their cousins, mortgage REITs. 

Like equity REITs mortgage REITs avoid taxation at the company level so long as they distribute 90% of their profits as dividends. But mortgage REITs are even more dependent on their dividends for their total returns than equity REITs, as there is virtually no long-term growth component. 

Equity REITs hold properties that are presumed to rise in value over time. Mortgage REITs hold mortgages…which are eventually paid off or refinanced. Many mortgage REITs, including blue chips like Annaly Capital (NLY), pay dividends well in excess of 10%. And virtually all of it is going to be taxed as regular income. This makes a mortgage REIT a very obvious choice as an IRA investment. 

Mortgage REITs have been slammed in 2015 by fears that a Fed rate hike would raise borrowing costs and crimp profitability, and today many mortgage REITs trade for just 80%-90% of book value. At these prices, they would seem to be a low-risk bargain.

Bonds

Personally, I think you would have to be crazy to own bonds at today’s yields. I am about as close to a “bond bull” as you are likely to find these days because I believe that long-term yields will stay low for a long time to come. But that is hardly a rousing endorsement. 

At current yields, you’re locking in returns of, at best, 2.2% in 10-year Treasuries, and high-quality corporate bonds don’t yield much better. In my view, you’re much better off trying your luck with high-quality dividend-paying stocks. 

Nevertheless, some investors crave the safety and predictability of bonds. And if you are going to invest in bonds, then by all means, you should protect your modest income stream by placing them in an IRA. Bond interest is taxed as ordinary income, and bonds get virtually all of their returns in the form of current income if held to maturity. This makes them an extraordinarily tax inefficient investment…and a perfect IRA investment.

Precious Metals 

And finally, we get to precious metals. I don't consider previous metals an "investment," per se. In my view, you keep a few gold coins around for the same reason you keep a gun: As "insurance" in the event that things really got bad. (Yes, my true Texas colors are starting to come out.) 

So, I personally would never keep a position in gold or any other precious metal in an IRA. In the event I actually needed gold, I would want it physically in hand. But I also realize that my views a little eccentric here. Plenty of investors consider precious metals a viable asset class and allocate a portion of their portfolio to it in the form of a metal-backed ETF such as the SPDR Gold Trust (GLD) or the iShares Silver Trust (SLV). 

If you are one of those investors, keep your precious metals investment in an IRA. Metals are considered “collectibles” for tax purposes, and gains are taxed at a 28% tax rate rather than the usual 20% capital gains rate.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. 

Prospect Capital Corporation (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 as would be the case with any company, 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. 

Figure 1: Historical Returns

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 (BRK-A).

Figure 2: Operating Returns

Figure 2 measures 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. 

Figure 3: PSEC Expenses

According to Figure 3, 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.

Figure 4: Insider Buying

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. Since 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: 

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.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. As of this writing, he was long PSEC.

The following is an update to the Best Stocks for 2015 contest. 

In December of last year, I wrote that I expected to see Prospect Capital Corporation (PSEC) generate returns of 40% or more over the course of 2015. 

Well, as we near the end of the first quarter, we have a little catching up to do. Prospect Capital is sitting on gains of about 4%. That’s beating the S&P 500 year to date, but it’s certainly nothing to write home about. Meanwhile, one of my competitors, Rave Restaurant Group (RAVE), is already up 116% and another, Ambarella Inc (AMBA), is up 43%. 

Up against competition like that, it is time to throw in the towel? 

Absolutely not. 

With more than nine months left in the year, Prospect Capital is still very much in the running. 

To start, Rave Restaurant Group is a microcap stock, and Ambarella is a volatile, high-beta stock. I consider it very likely that at least one of these stocks crashes and burns long before year end. 

I’m a little more concerned about Louis Navellier’s pick this year, Apple Inc (AAPL) I myself am long Apple and consider it a worthy competitor. But as much as I like Apple as a long-term holding, I consider Prospect Capital the better buy in 2015. 

Let’s take a look Prospect’s recent developments. Prospect had a lackluster earnings release last month,  with EPS coming in at 24 cents per share rather than the 28 cents Wall Street expected. 

But the far more important news in the earnings release was that book value remained stable. Net asset value per share was $10.35, a decline of 38 cents from the previous year. But substantially all of this decline was due to Prospect’s large dividend, which for much of 2014 was well in excess of current earnings. With the turbulence in the energy sector, there were concerns that Prospect might have some significant write-downs. Thus far, this has proven to not be the case. 

This is a big deal because I specifically mentioned Prospect’s large discount to book value as a major reason to own the stock. If Prospect’s book value had seen serious deterioration, it would have blown a hole in my bullish argument. At year end, Prospect was trading at 80 cents on the dollar. Today, that valuation has crept up to 83 cents on the dollar. 

That’s still ridiculously cheap. I don’t know about you, but I don’t come across too many 83-cent dollars, so I tend to pick them up when I find them. 

Now let’s talk dividends. Prospect Capital slashed its dividend last year, which is a major reason why investors are so sanguine towards the stock these days. To many investors, a dividend cut is a breach of trust, and that is not always easy to mend. But in Prospect Capital’s case, it was the right move. As management de-risked Prospect’s balance sheet last year, the lower-risk, lower-return Prospect was not able to sustain its dividend at the current level. Today’s 8.33-cent monthly dividend is far more sustainable. 

It also equates to a 12% yield at current prices. And 12% yields aren’t particularly easy to come by these days. 

So, what sort of returns should we expect from here? A return to book value—which I believe is warranted—would add about 20% in capital gains. Add to that about 1% per month in dividends, and we get another 9% for a total of 29%. Add to that the 4% we’re already returned thus far, and we’re looking at 33%. And we could see returns significantly better than that if we see a special dividend or if Prospect trades at a premium to its book value—as it has for much of its life. 

Is that a recipe for 100% gains in a single year? No, of course not. But it’s still a lot better than I expect the S&P 500 to produce over the next 2-3 years. And I expect that come December 31, it will be enough to make Prospect Capital the Best Stocks for 2015 winner.

This piece is part of InvestorPlace's Best Stocks for 2015 contest. Charles Sizemore’s pick for the contest is Prospect Capital Corporation.

I have a reputation to redeem. After winning InvestorPlace’s Best Stocks contest in 2011, coming within a hair of winning in 2012, and then winning it all in 2013, I finished 2014 at the bottom of the heap. My bet that 2014 would be the year that emerging markets assumed leadership proved to be premature.

This is my bet for 2015: Cash will be king.

I don’t expect much from U.S. equities in 2015. It’s not that I’m a bear — I’m not — but valuations look stretched, and U.S. stocks are priced to deliver flattish returns over the next 5 to 7 years.

Rather than buy, hold, and pray that this bull market has another good year left in it, I’d prefer to get my returns up front in cold, hard cash.

My pick for InvestorPlace’s Best Stocks of 2015 contest is business development company Prospect Capital Corporation (PSEC).

PSEC invests primarily in first-lien and second-lien senior loans and mezzanine debt and provides financing for leveraged buyouts, acquisitions, recapitalizations, and capital expenditures for growth. PSEC also invests in the higher-risk but potentially much higher-return equity tranches of collateralized loan obligations.

Most of PSEC’s individual investments would have to be considered risky given the early stages of the companies involved, but the portfolio is diversified across a wide variety of industries, and management recently announced it was lowering its risk profile by increasing its allocation to first-lien loans.

PSEC caused a ruckus in December by cutting its dividend to 8.333 cents per month from 11.1 cents to bring its dividend more in line with its reduced risk and return profile. But even after the reduction, PSEC sports a dividend yield of nearly 12%.

And the effective yield may end up being higher. In their recent press release, management indicated that additional special dividends are a real possibility over the next 12 months.

Investors hate dividend cuts, and PSEC’s share price has taken an absolute beating following the announcement.  PSEC now trades for just 80% of book value (see chart), matching its lows of 2011. At these prices, the market is valuing PSEC as being worth more dead than alive.  

What kind of returns do I expect in 2015? If PSEC share price were simply to rise to accounting book value, we’d be looking at 25% capital appreciation. Add in the 12% dividend, and you’re looking at returns north of 37%. And this is before the payment of any special dividends, which I consider very likely.

At current prices, we have a wide margin of safety. If PSEC’s accounting book value proves to be slightly overstated, that’s OK. Buying at a 20% discount, you have a little wiggle room.

Meanwhile, company insiders have been backing up the proverbial truck. In the month of December alone, PSEC insiders collectively bought 552,200 shares worth more than $4.8 million. Year-to-date, company insiders have plowed a combined $11.2 million dollars into Prospect Capital’s shares.

I should emphasize that these are open-market purchases made with the insiders’ own money, not executive stock options.

In 2015, I'm following the insiders and going with PSEC.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Photo credit: Ken Teegardin

With the market looking wobbly this December, the need to get paid in cold, hard cash has never been more apparent. If you are already in retirement, selling portfolio positions in a declining market to meet your living expenses is, for lack of better word, scary. Living off of dividend and interest income makes for a far less stressful retirement.

But while I am a major believer in dividend investing, there has always been one major disconnect with it: most of us pay our bills on a monthly cycle, yet our dividend checks arrive only once per quarter or, in the case of some international stocks, once or twice per year.  And with bonds, the story is much the same. Most bonds pay interest semiannually. This can make budgeting a headache and adds an extra level of planning.

Paying a dividend is an established sign of shareholder friendliness. But companies that pay their dividend monthly really take shareholder friendliness to the next level. There are actually quite a few companies trading today that pay their dividends monthly, and we’re going to take a look at some of my favorites today.

Before we get started, I want to make one important clarification. We should never buy a stock simply because it pays its dividend monthly. That would be phenomenally bad investing. When buying a dividend stock, dividend safety is your biggest priority followed by the possibility for dividend growth. A monthly payout—while convenient—is only a consideration once the first two conditions are met.

With that said, let’s jump into it.

Realty Income

I’ll start with a REIT that bills itself as the “Monthly Dividend Company,” Realty Income (O).

Realty Income paid its first dividend in 1970, before it was publically traded, and hasn’t slowed down since.  It’s paid 532 consecutive monthly dividends and raised its dividend 77 times—and in 68 consecutive quarters.

Since 1994, when Realty Income started trading on the NYSE, the REIT’s annualized dividend has risen from $0.90 per share to $2.197 per share.  At its current price, that amounts to a dividend yield of 4.8%.

Realty Income is one of those rare stocks that I believe you can truly buy, put in a drawer, and forget about for years at a time.  As a conservative, triple-net REIT, It’s what I would call an “Armageddon-proof” investment.  It owns a diversified portfolio of 4,200 properties spread across 49 states that are rented under long-term leases primarily to high-quality tenants.  The “typical” property for Realty Income would be your local Walgreens or CVS pharmacy—a high traffic, highly visible location that you pass on your daily commute.

Under a triple-net lease, it is the tenants responsibility to take care of the property and to pay the taxes and expenses.  The landlord’s only role is to collect the rent check.  Not bad work, if you can find it.

Last year, I listed Realty Income as a stock you can “buy and hold forever,” and I would reiterate that recommendation today.

LTC Properties

Next up is LTC Properties, Inc. (LTC), a real estate investment trust that invests primarily in the long-term care sector of the health care industry, including long-term care provider properties, skilled nursing properties, assisted living properties, independent living properties and memory care properties.  LTC also invests in first-lien mortgages secured by long-term care properties.

A little over 80% of LTC’s portfolio is invested in properties with the remainder in mortgages.  And among properties, skilled nursing is the biggest single segment, at 55%.  Assisted living comes in second at 37%.

LTC is backed by absolutely fantastic macro trends.  As the Baby Boomers age, there will be unprecedented demand for long-term services—and thus unprecedented demand for long-term care facilities.

The elephant in the room when discussion long-term care is, of course, Medicare.  It’s no secret that the U.S. government is short of funds these days, and Medicare cutbacks have been an unfortunate outcome. But that is what makes LTC such an attractive way to play the trend of Boomer aging.  LTC is a landlord, not a care provider, so Medicare cutbacks will have little impact on revenues.  And even better, as with Realty Income, most of LTC’s properties are leased under triple-net leases, meaning the tenant covers taxes, insurance and maintenance.

LTC’s monthly dividend works out to a current yield of 4.9%.

DoubleLine Income Solutions

Next we have DoubleLine Income Solutions (DSL), a closed-end bond fund run by one of the very best managers in the business, Jeff Gundlach, and his team.  Gundlach—dubbed the “King of Bonds” as a rival to “Bond King” Bill Gross—has done a fantastic job of navigating the treacherous bond markets of the past several years, and given the fund's flexible mandate, an investment in DSL is largely an investment in Gundlach.

DSL invests primarily in U.S. corporate bonds, though it also invests in Treasuries, mortgage securities and international bonds.

Closed-end bond funds are interesting investments in that, unlike ETFs and mutual funds, their market value can vary wildly from their net asset value (“NAV”). As a general rule, I do not recommend buying a closed-end fund at a premium to its NAV. If you’re patient and willing to wait, you can generally get them at a discount.

My guidance here is to buy DSL so long as it trades at a discount to NAV of at least 5%.  As of Morningstar’s latest estimates, we’re comfortably within that range at a 8.25% discount. If you believe, as I do, that rates will stay depressed for the foreseeable future, DSL should be a safe place to park cash.  You’re in good hands with Gundlach.

Prospect Capital

For my last two picks, I’m going to get a little more speculative. In both cases, I believe that the dividend is safe at current levels or that any cuts would be small and temporary. I listed diviend safety as a critical criteria at the beginning of this article, and I would repeat that here. 

I’ll start with a high-yielding business development company (“BDC”) with large-scale buying by company insiders: Prospect Capital Corporation (PSEC).

PSEC invests primarily in first-lien and second-lien senior loans and mezzanine debt and provides financing for leveraged buyouts, acquisitions, recapitalizations, and capital expenditures for growth. PSEC also invests in the higher-risk but potentially much higher-return equity tranches of collateralized loan obligations. Most of PSEC’s individual investments would have to be considered risky given the early stages of the companies involved, but the portfolio is diversified across a wide variety of industries.

PSEC recently cut its dividend to 8.333 cents per month from 11.1 cents. But even after the reduction, PSEC sports a dividend yield 12.1%. And the effective yield may end up being higher. In their recent press release, management indicated that additional special dividends are a real possibility over the next 12 months.

Speaking of the management team, company insiders has been aggressively buying the stock on the open market.  In just the current quarter, four company insiders have purchased 576,212 shares worth $4.7 million at current prices. Company insiders have been aggressively buying all year and there have been no sales. That kind of buying is a major endorsement by the people running the company.

American Realty Capital Properties

And finally, we get to the red-headed stepchild of the triple-net REIT world, American Realty Capital Properties (ARCP).

ARCP has taken a beating over the past two months after an accounting scandal that the now former CFO and chief accounting officer tried to cover up.

“Accounting scandals” brings to mind horrible memories of the Enron collapse, so investors promptly dumped ARCP, creating what I believe to be a fantastic bargain.

The accounting adjustments were minor, reducing funds from operations by about 46 cents over the span of two quarters. And after the selloff, ARCP now trades just below the liquidation value of its real estate holdings.

At current prices, ARCP yields about 10.9%. A yield that high generally indicates that the market is pricing in a dividend cut, and indeed, ARCP may decide to modestly trim its dividend in the next year. I don't take that risk lightly. But I also want to keep it in perspective. I would expect any cut to be in the range of 5%-10% at most, which would put ARCP's dividend more in line with its adjusted funds from operations.

ARCP is definitely a little riskier than the rest of the stocks covered in this article, but at current prices I consider it well worth the risk. It's hard to argue with buying a high-quality portfolio of real estate at liquidation value.

Disclosures: Long O, DSL, PSEC, ARCP

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.