What is risk and how is it defined? To us, risk is about losing money and managing risk is what portfolio management is all about. Let’s begin with credit risk, which is something we take on and expect to get paid for. First of all, credit investing is a negative art. What you don’t buy is more important than what you do buy. Investors will not appreciate this until the cycle turns, which will inevitably happen at some point.
What are we looking to avoid? The common answer is defaults. But this is not entirely accurate. We can make money if a company defaults assuming that the perceived recovery of the bond or loan is higher than what we paid for it. Let me be clear: we are not buying distressed assets in the hope of making money; this type of vulture investing is very specific. We are in fact looking to avoid defaults and losses.
But just how do we seek to avoid defaults, or more accurately seek to avoid losses? Let’s look at the negative first. Here is generally what we don’t like:
- Companies that use cash and don’t generate it.
- Businesses that have a lack of liquidity.
- Enterprises that are highly levered with lack of free cash flow growth.
- A product or service that is non-essential.
- Buying bonds/loans priced well above their call prices (negative convexity).
- Bonds/loans issued for “bad” purposes such as dividends to private equity sponsors.
- Bonds that do not pay cash interest, such as PIKs (pay-in-kind) or PIK toggles.
While this seems pretty straight forward and sensible, it is remarkable to watch these disciplines get thrown out the window in the chase for yield. These errors are glossed over when capital markets are wide open, but get magnified when they close up. On the positive side of the ledger, here is generally what we like:
- Companies that generate true free cash flow (cash flow from operations less normalized capital expenditures).
- Businesses that have excess liquidity in the form of cash and/or bank line availability.
- A company selling a product or service that is considered a consumer essential.
- Recurring/contracted revenue streams.
- Buying bonds at discounts to par or call prices.
All of this seems pretty straight forward and much of it is pitched by other value investors. Execution of this (holding one’s discipline when everyone else is waving it in) is much tougher to do than to say. More difficult yet is real “alpha” generation, which involves buying what is believed to be undervalued securities with the goal of generating excess yield and/or capital gains. Most of what we have said above is related to business fundamentals. That is only the first step in the process. We then have to look at the price of the securities (loans/bonds/equity) that represent the investment. Investing is a non-linear art form. Our job is to ferret out those securities we believe are “mis-priced.”
There are a number of reasons securities become mis-priced including, but not limited to, the following:
- General industry unpopularity
- Asset class unpopularity
- Quarterly earnings miss
- Poor forward guidance
- Product or cost pricing issues
Our analysis must determine that whatever factors caused the “mis-pricing” are not serious enough to cause impairment or default and they are temporary. Each business must be analyzed independently and an assessment has to be made of where the best value lies in the capital structure. The high yield and floating rate loan markets are large and growing markets, with what we see as attractive opportunities for active managers who are able to look for value and identify potential mis-priced securities within a company’s capital structure.
This article was written by Tim Gramatovich, CFA, CIO for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD).