EC: (…) I don't know how to
value any of the FANG stocks, but it can be helpful to sit on the opposite
side of the capital structure table. As an example, I don't own Netflix bonds.
They trade very well. It's a BB-rated company and I've always been very
skeptical of any company that doesn't generate free cash flow. If I were to
truly challenge myself, I would try to take an equity perspective and think
about why the equity market has so much comfort in a company’s ability to march
towards free cash flow, asking myself “what is it I’m missing here?” Conversely,
if I were an equity analyst, I would probably take a fixed income approach to Netflix
and say "this company doesn't generate cash flow. In fact, its operating
cash deficit seems to be growing because it's investing so much in content. How
could that possibly translate into the valuation that it has in the equity
market?"
G&D: Do you see any
bubbles in the market right now? Are you cautious against any industries?
EC: I think the biggest
bubble right now is in the corporate debt market. There are a couple of
different aspects of it that are particularly troubling. The first one is the explosion
of BBB-rated bonds. A certain percentage of BBBs get downgraded to junk
within five years of issuance based on rating agencies’ seasoning models. Over
the next five years, there will be pressure on the High Yield market because
the capital structures of Investment Grade companies are much larger. Take GE
for example: there were concerns they would be downgraded to High Yield earlier
this year. If that had happened, GE would’ve represented about 10% of the High
Yield market value. It would be really difficult for the High Yield market to
absorb that tremendous "issuance". Investment grade portfolio managers
are overweight BBBs. They tend to overweight the highest risk part of the market
because the default statistics on BBBs are virtually nil, yet you get paid some
incremental spread over higher -rated corporate bonds. The fact that a lot
of money has been invested in that part of the market makes me nervous about
what will happen if there is either a recession or an exogenous shock. I’m
also worried about the Leveraged Loan market, which is exhibiting the same type
of underwriting behavior, exuberance, and frothiness that it did in 2007. I
think of High Yield bonds as a pretty stable asset class. There are ups and downs
in covenant quality and deals underwritten at this point in the cycle are typically
not great, but the High Yield market doesn't boom and bust the way the Leverage
Loan market does because it has a pretty stable investor base. High Yield investors
don’t change that much from cycle to cycle, whereas there is often new money
flowing into and out of the Leveraged Loan market. The collateralized loan obligations,
or CLOs, that we saw in 2005 to 2007 are back. Most of these investors are not
sophisticated analytical buyers; they are buying primarily because something has
a certain rating, although in some cases what they’re buying isn't worth as
much as what they think it is. Those buyers are also the ones who will probably
be forced sellers at the wrong point in the cycle.
G&D: Could fallen angels
be attractive, given their relative safety and liquidity?
EC: I think they could be in the
long-term. During the 2005 fallen angels’ cycle, the auto companies got downgraded
to High Yield. Ford, GM, and Chrysler combined became 15% of the High Yield
issuances. The market wasn’t ready to absorb all that volume. These issuers were
downgraded to High Yield because they were deteriorating, so it took them a
long time and, in the case of Chrysler and GM, a Chapter 11 process to get back
to Investment Grade. I don't anticipate a similar thing to happen in this
cycle, but rather that some companies will gently slip from Investment Grade to
High Yield. That will give us a chance to buy better issuers, which is positive.
However, even in the case of a perfectly good company that’s become risky in
terms of leverage and gets downgraded to High Yield, there are two factors that
will make an orderly transition difficult. First, the sheer
amount of supply will require some time to be absorbed. When there is massive
selling pressure, with Investment Grade holders forced to sell bonds from previously
BBB issuers which get downgraded to High Yield, it creates a vacuum until High Yield
buyers have had a chance to research the credit and get to know the individual
bonds in the capital structure. Secondly, the fallen
angels’ bonds are structurally inferior to other bonds in the High Yield
market, because High Yield bonds generally enjoy covenant protection and are issued
at the operating company level with subsidiary guarantees. To the contrary, Investment
Grade bonds are for the most part lacking these structural protections. Even
if you like AT&T better than Sprint as a company, you still might look at
Sprint's secured bonds and prefer the collateral protection as opposed to a general
unsecured obligation at the parent company level for AT&T bonds. These may
look like technical differences, but in the High Yield market they matter a lot.
(…)
G&D: Do you usually hold bonds
to maturity, or is your return coming more from spread compression?
EC: By and large I'm not looking
for capital appreciation as much as I’m looking for something to mature at par.
At my firm, the primary mandate on the High Yield side is a short duration one.
We have a five-year maturity limit. Once I buy, unless the credit deteriorates
meaningfully, I intend to hold it to maturity, particularly due to the high trading
costs in High Yield. Early in my years as a portfolio manager I made selling mistakes.
I would sell a company that was up four points because I knew it didn’t deserve
to trade at that valuation. Yet contrary to what happens in the Equity market, if
you sell something at a high price in the High Yield market, then good luck on
ever buying it back below or finding something reasonable to replace it with.
Once I get invested in a name it takes a pretty big change in my credit opinion
to sell it. Having said that, I’m not afraid to sell something if my credit opinion
has changed. I recently sold Pitney Bowes, which became a fallen angel a couple
of years ago. When it entered the High Yield market I liked the bonds for two
reasons. First, a number of bonds had coupon step-up protection, meaning that
every time the bond got downgraded by a notch, the coupon increased by 25 bps
to a maximum of 200 bps, meaning a holder of the bond was protected from spread
widening as the downgrades occurred (i.e. the increased coupon offset the spread
increase). Second, I liked the company's free cash flow generation. So even
though it had been downgraded and had several businesses under assault from different
internet business models, Pitney Bowes still had a tremendous amount of free cash
flow, and it was also investing in new business lines. I owned the bonds for
about 18 months and, every quarter, things didn't exactly go the way management
said. There was always some new story about why this business line wasn't as profitable
as they had hoped or, even if the revenue trend was good, management had overestimated
the margin potential. Finally, after five or six quarters, I decided to exit the
position because my initial thesis that the company would both continue to
generate good free cash flow as well as maintain its margins was gradually
disproven. When something goes against my thesis for more than a couple of
quarters, I sell.
(…)
G&D: In addition to
collateral, what other fundamental factors do you look at when assessing an
issue?
EC: I always focus on free
cash flow and that takes many different forms. I'm looking for companies that
generate free cash flow and are interested in deploying that free cash flow beyond
giving it back to their shareholders. That might be paying down debt,
reinvesting in the businesses, or maintaining capex to keep the businesses in
good shape. The focus on free cash flow allows me to think bottom-up as opposed
to taking an industry view. In top-down industries, such as the Commodities
sector, no matter what the management team does, the company's fortune will be
dictated by what's going on in the Commodities market. If you go back to the
Exploration & Production (E&P) cycle, Chesapeake had bad management
before they booted the former CEO. The new management was good and did
everything they could to position the company for a down market. But when the cycle
hit, it overwhelmed even the new management team's best intentions. The company
was too levered and hit a rough patch. In these industries, you want to have a view
on the industry and that’s why I tend to avoid the more commoditized sectors. I
like bottom-up industries because even during an economic slowdown, if management
executes well, the companies will do well. The retail sector is a great example
of that: if you have a great value proposition and sound execution, even if
there is a recession, customers will still come to you because you built a
better mouse trap.
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