What I'm Watching With Prospect Capital To See If They Beat The Market

Prospect Capital (NASDAQ: PSEC), a mid-tier business development company (BDC), pays a whopping forward dividend yield of 20.8%. But over the past five years, its stock price declined 66%. Even with reinvested dividends, it delivered a negative total return of 39%.

That dismal performance makes Prospect Capital seem like a high-yield trap instead of a worthwhile income investment, but could it bounce back and beat the market this year? Let's review its business model, major challenges, and valuations to decide.

Why did Prospect Capital's stock plummet?

As a BDC, Prospect Capital invests in debt and equity in "middle market" companies that struggle to secure bank loans because they're considered higher-risk clients. In exchange for taking on that risk, BDCs charge higher interest fees than traditional banks. BDCs also need to pay out at least 90% of their taxable income as dividends to maintain a lower tax rate.

Prospect Capital holds over 450 investments in its $6.5 billion portfolio, but it's much smaller than top-tier BDCs like Ares Capital (NASDAQ: ARCC), which manages $29.5 billion in assets. Prospect Capital also holds riskier, lower-quality investments (including structured credit, payment-in-kind loans, equity, and real estate) than Ares Capital, which allocates most of its portfolio to senior secured loans. That's why Prospect pays higher yields than Ares and other BDCs, but it's also riskier and more exposed to the macro headwinds.

To gauge a BDC's quality, we look at its net asset value (NAV) per share. But from fiscal 2020 to fiscal 2025 (which ended last June), its year-end NAV per share declined from $8.18 to $6.56. That figure dropped to $6.21 by the end of the second quarter of fiscal 2026.

Prospect's exposure to smaller, riskier companies backfired over the past five years, as inflation, high interest rates, geopolitical conflicts, and other macro headwinds rattled the global economy. As a result, it racked up losses, marked down its investments, and saw its NAV crumble. At the same time, Prospect constantly issues additional shares at a steep discount to its NAV, further diluting its existing investors, while charging high fees pegged to its total assets under management rather than its total shareholder returns. In other words, Prospect's management is incentivized to simply expand its portfolio rather than optimize it for long-term gains.

Could Prospect Capital beat the market this year?

I don't think Prospect Capital will come anywhere close to matching the market this year unless it stabilizes its NAV, stops issuing more shares at a discount, and rethinks its fee structure. Until then, bigger and more disciplined BDCs like Ares Capital will remain much better investments.

Leo Sun has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.