Monthly Archives: December 2013

Who Spiked the Eggnog?

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Christmas arrived a little early in the credit markets. Spreads have been grinding in for most of the fourth quarter, but over the past week are tighter by a solid 7 or 8 basis points. That may not sound like a lot, but for the whole market to move that much tighter in such a short span of time is pretty extraordinary, and is the biggest weekly move tighter we’ve seen in the past couple of years. The market closed yesterday at a spread of 116, feels like it’s moving tighter again today, and all sectors are participating.

Long credit is having an especially good month. In fact, it’s had a great year. Excess returns in long corporate bonds are 128 basis points this month, and 377 for the year. It looks like the great rotation out of bonds into equities is not happening on the long end. If anything, it’s the other way around, driven by pension funds. They started the year underfunded, and given the move in rates and equities, we’re guessing many are now close to fully funded, which allows them to de-risk. That means selling equities, and buying long bonds, including investment grade credit.

There are also some good fundamentals underpinning the move in credit. Stronger economic growth, a rebound in housing, and a masterfully orchestrated taper announcement from the Fed all contributed to the positive sentiment.  We’ve had a modestly-more-benign-than-expected announcement regarding the Volcker rule, at least around dealer market-making. There was some concern that corporate bonds would face another decline in liquidity depending upon what restrictions were placed on dealers under Volcker, and so the market is breathing a sigh of relief on that front. Finally, with the new issue market shut down for the rest of the year, and virtually no supply this week, there has been little paper to buy if one did feel like going long credit all of a sudden.

All of these factors have contributed to a downright jolly party in credit. No one feels like playing Scrooge at this bash, everyone just wants to belly up to the eggnog punch bowl. So raise a glass to toast a great year in credit….and let’s hope we don’t all have a massive headache on January 2nd…

What is Art, Besides Keith’s Guitar Work?

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We are taking a break from our series on getting an edge in the market because of what we read in an article in the Wall Street Journal about Keith Richards, the Rolling Stones, the song “Street Fighting Man” and the creative process. Some people might look at us strangely but we have always considered equity analysis as at least partly a creative process, not unlike the creation of a song, or a piece of art. Therefore we occasionally refer to our job as being a “financial poet”. Sound unusual? It really isn’t. There are two parts to our job. The first is determining theoretical asset values using well-worn financial analytic tools.

In actuality, determining the intrinsic value of a company mathematically is what we need to know to become analysts in the first place.  We all know the tools and the language. We all know what questions to ask. We all know how to read financial statements. But there is so much more. What is that? Specifically it is the art of investing. That’s the second and equally crucial part of our job.

Yes, we feel financial analysis is an art and a creative process; not unlike Keith crafting music on his guitar. Most guitar players can bang out notes and play a song, but how many can do so with emotion, feeling and originality? The same is true with the financial analyst. Feeling and originality in our case is determining value. Value is different than valuation. Valuation is an empirical term that can be measured by standard formulas and measurements. Value is much more esoteric and often cannot be measured by mere accounting measures. Accounting measures are more backward looking. How do we look forward? This is where the art comes in.

Taking a forward look means determining future values, user tastes, and various other things that are unknown. It means we need to look at needs and how the need can potentially be fulfilled. This is also how we differ from entrepreneurs and business managers. Entrepreneurs and managers try to craft an idea and make a business out of it. Financial analysts look at many ideas from entrepreneurs and managers, especially in smaller companies, and attempt to determine which one is the most viable and will succeed as an investment.

The challenge is eliminating our biases. In that regard, we need to put ourselves into the mind of the person whose problem is being solved by that new product or service and then try to determine if it is an investable concept. For instance, how many people are there that will be motivated to act by that product or service? Would, say, a Chinese citizen react differently than an American to that product or service?  How about a younger person versus an older one? Analysts essentially have to leave our experiences, biases and beliefs at the door and look at the world from a different perspective in determining value.

Once we determine value, then can we open up our financial toolbox and determine valuation. Therefore we are not unlike Keith Richards (minus the chemicals). Keith had to learn the chords and notes before he could play the guitar. However, to make the guitar tell a story he needed to determine if a concept he had was worth pursuing. That takes art.

This will be the last Freezing Assets Shout Out until after the New Year. Happy Holidays everyone!!!

Living on the Edge, Part 1

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Snow and us have a mixed past. We loved it growing up, but our liking for it soured when we moved back here from grad school in the South—just in time for the 1991 Halloween blizzard. Lucky us. Overall we like winter, but the first storm irritates us because it is shock to our system. What else irritates us? Near the top of our list is when people ask us “do you have an edge on the stock?” when discussing a new idea.

We dislike that question since people in the investment community usually talk to the same analysts, read the same regulatory filings, go to the same conferences and often know each other in the financial community by name at least locally—how does one get an informational edge when there is that much intimacy with the companies we follow, especially with mid and large cap stocks? We think a better question is how does your investment thesis different than conventional wisdom and why?

Having said that, we think that the “edge” question is an occupational hazard we must live with daily. Therefore over the course of the next couple of weeks we’ll explore the topic if can one get an edge from both a large cap and small cap perspective and if is it relevant. What do you think? Can one get an edge on a particular stock/security?

Let It Snow

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Predictably, the weather outside has turned frightful. We’ve been hit by the first real storm of the season with snow, ice, temperatures below zero, higher interest rates….

Okay, if you’re looking at interest rates, this is arguably at least the second storm of the year. But unlike last summer, the Credit markets are taking this winter storm in stride. 10 year government rates are higher by 13 basis points, while excess returns for credit are modestly positive month-to-date. We’ve seen a little weakness in finance, but nothing significant, and a little bit of strength in the industrial sectors. The new issue calendar has remained solid, with over $26 billion in supply for the first week of December, and deals are performing reasonably well.

There were two “AAA” rated issuers in the market this week, which is unusual since there are so few “AAA” rated issuers left. Microsoft brought $3.25 billion across three tranches in the U.S., and about €4 billion in Europe, while Johnson & Johnson brought $3.5 billion across six tranches. Lower quality issuers such as Thermo Fisher ($3.2 billion) and CVS ($4 billion) tended to outperform the AAA deals, suggesting that risk appetite for credit remains in place. One thing we’ve noticed, though, is that risk appetite is different across the yield curve. 30 year deals have outperformed, and shorter deals have also done pretty well, but new issue 10 year bonds have lagged. So if there’s one place where risk appetite is waning in credit, perhaps it’s the belly of the curve.

But for now, owning credit seems like the investment equivalent of sitting next to the fireplace wrapped in a warm blanket. Let it snow, let it snow, let it snow…..

But These Go to Eleven (or Twenty Times), and Over What Time Frame?

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When we were in high school we were in a band called Felix Flux and the Flemtones. We had it all: the looks, the clothes and the attitude—however that talent thing got in the way getting our star on the wall of First Avenue. What we lacked in talent we compensated for in volume. The Flemtones were loud enough to drown out a fleet of garbage trucks, and we provided about the same audio enjoyment. Luckily our time horizon for the band was short-term fun, in the long-run we would have starved.

The stock market volume as measured by both a return and market multiple basis has been increasing as well this past year. Thankfully we are not writing about if the market is correctly valued at this point in time. Rather, we are wondering what is the investment time horizon the market is implying with current multiples. Theoretically speaking one can back into that number at a certain spot in time via various methodologies, e.g. Black/Scholes, but we do not think that tells the whole story. After all investing is putting a value on future cash flows—therefore adequately predicting the length of time of future cash flows will be discounted by the market is as important as accurately predicting such flows in our opinion. Our question therefore is what is the market’s implied time horizon in the future?

Of course, the correct answer is “it depends” as the market is nothing but an amalgamation of millions of individual investment decisions. But as we remind ourselves every day, we are not always trading with humans. With a good percentage of the market’s volume is done by computerized and algorithmic trading, one can make the argument that the market’s time horizon has been and may continue to shrink. Additionally many institutional investment firms are judged not on a multi-year or even yearly basis—oftentimes it is quarterly. Sometimes in our more cynical moments we think that the market time horizon is the amount of time between Fed announcements. Finally, anecdotally speaking, the past several earnings seasons we often observed certain stocks going up on “beaten” earnings estimates that had been lowered relentlessly throughout the preceding quarter, which also may point to a shortened investment time horizon.

Having said that, there are occasions when we hear market prognosticators say that a stock is “good for the long term investor” we often think that translates to “this is a catalyst-free stock, but it’s cheap.” While we jest, we do believe there is some positive truth to that statement. Time after time it seems that good old-fashioned Graham and Dodd investing wins out in the long run. Mean reversion is a powerful force and buying inexpensive assets at historically lower valuations usually is a great strategy.

What do you think? Is the market time horizon shortening or is the market still driven by long-term fundamentals and investment techniques?