Friends in Leveraged Places
<July 17, 2019>
Every market cycle is a learning experience. Throughout each cycle, we review our achievements and shortcomings to help us improve our absolute return process. Although we were very pleased with how we managed through the last two full market cycles, there were things we could have done differently.
One of the biggest mistakes in my career was made in the 2002-2009 market cycle. It was related to my decision to remain invested in companies with strong balance sheets during the beginning of the cycle. While sticking with strong balance sheets worked well for investors throughout 2001-2002, that strategy created opportunity cost in 2003, when credit spreads narrowed and many small-cap stocks with debt rebounded sharply.
Our experience in 2003 caused us to rethink our position as it relates to companies utilizing financial leverage. Prior to 2003, we considered ourselves balance sheet purists and focused exclusively on businesses with below-average debt. We were particularly fond of companies with zero debt and large cash balances. Although an investment strategy focusing on strong balance sheets can be very rewarding during recessions and credit crunches, it can also dampen performance during economic expansions and credit booms. After a decade of avoiding companies with debt, we decided it was time to expand our opportunity set and reconsider our avoidance of financial risk.
Shortly after 2003, we adjusted the strategy’s screening process to be more inclusive. Going forward, we would consider investing in businesses with debt, assuming they met two important conditions. First, debt levels must be manageable. We would only invest in businesses we believed were capable of paying off their debt with internally generated cash flow. To steer clear of distressed situations, we sought to avoid being at the mercy of a fickle banker or unreliable credit market. Second, the company’s cash flows must have above-average predictability. Constellation Brands (symbol: STZ) is a good example we’ve seen in the past. While the company had debt at the time we evaluated it, its wine and beer business had a history of generating consistent cash flow. In summary, when considering buying a company with debt, we wanted to avoid combining operating risk (uncertain cash flows) and financial risk (above-average levels of debt).
Having a more open mind towards owning companies with debt expanded our buy list in the 2008 and 2009 financial crisis. As credit spreads widened sharply, we believed there was value in many companies with financial leverage. Equity prices were extremely depressed as investors were fearful leveraged businesses would not survive the cycle. During the crisis, our higher tolerance for financial risk helped us increase our opportunity set and potential absolute returns.
Taking manageable levels of financial risk can be rewarding, but, as is the case with many things in investing, price is often everything. When it comes to the price of businesses with debt, we often look to the credit markets for guidance. Specifically, we’re typically attracted to companies with debt when credit spreads are wide and avoid financial leverage when credit spreads are tight. So where are we today?
Credit spreads are currently tight, or below their historical average. Furthermore, yields remain near record lows in absolute terms, with corporate bonds rated BB currently yielding 4.3% (ICE BofAML US High Yield BB Index as of 7/15/19). In our opinion, the securities of most companies with debt are not properly compensating investors for the financial risk assumed. As such, we are avoiding companies with above-average levels of financial risk and are focusing on businesses with very strong balance sheets.
Of the ten businesses (equities) the portfolio owned as of 6/30/2019, eight had zero net debt and five had cash balances greater than 10% of their market capitalization. In summary, at this stage of the credit cycle, we are embracing liquidity and refusing to incur meaningful financial risk.
Given the sharp rise in corporate debt this cycle, the number of businesses we classify as having higher financial risk has grown considerably versus last cycle. We created the chart below showing the number of companies that either generated negative EBITDA or have net debt to EBITDA over 3x. As the chart illustrates, the number of companies with increased risk of becoming financially distressed has grown noticeably this cycle (53% as 6/30/19) versus last cycle (32% as of 6/30/2007).
We believe this cycle’s elevated net leverage is especially alarming considering we’re in a period of high corporate profits, which in theory should depress debt to cash flow ratios. While concerning, we look forward to the end of the current credit cycle and the potential opportunities a tighter credit market will bring.
We’ve included this chart and others in our Q2 2019 quarterly letter. In the letter we also provide a brief summary of the Fund’s equity holdings and discuss our current positioning. Put simply, at this stage of the cycle, we are attempting to avoid overvaluation and financial leverage, and we are positioned for future opportunity. We are optimistic there will be a time in the future when it pays to assume risk, including financial risk. However, in our opinion, today is not that time.
Index performance is not indicative of a fund’s performance. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions
expressed are subject to change at any time, are not guaranteed, and should not be
considered investment advice.
Fund holdings are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. For a list of the Fund’s top 10 holdings, please click here.
Credit spreads: The difference between the yield of a Treasury and corporate bond of the same maturity.
EBITDA: Earnings before interest, taxes, depreciation, and amortization.
Net Debt: A company’s total debt minus cash and equivalents.
Russell 2000: The Russell 2000 Index is an American small-cap stock market index based on
the market capitalizations of the bottom 2,000 companies in the Russell 3000 Index.
It is not possible to invest directly in an index.
ICE BofAML US High Yield Master II Index: An index that tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market.
ICE BofAML US High Yield BB Index: A subset of the ICE BofAML US High Yield Master II Index tracking the performance of all securities with a given investment grade rating BB.
Option-Adjusted Spread (OAS): The measurement of the spread of a fixed income security and the risk-free rate, which is adjusted to take into account an embedded option. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.