Monthly Archives: January 2014

Wild Horses

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Emerging markets have taken center stage in the credit world over the past week, just in time to usher in the year of the Horse in China.  Here’s what we’ve learned about Horses: they are active and energetic and full of ambition. They are also hot-headed and impatient, and this sure felt like a week where the hot-headed prevailed. Fears about the potential impact of higher rates in Turkey, Brazil, South Africa, and other emerging economies had an obviously negative impact on equities, but also helped to push Treasury bonds higher and credit spreads wider. Total returns in corporate bonds this month are positive on an absolute basis, but excess returns are slightly negative. It has not been a very big move in credit, to be sure. While equities are down about 3%, broadly speaking, credit spreads are just 5 basis points wider. Some sectors, like banks and mining, have seen a little more volatility, but it’s been a modest move so far.

The spread volatility did keep a lid on new issue this week – the market saw just $13 billion in supply, heavily skewed towards the banks. Given the weak tone to the market, deals actually performed reasonably well, and look like they are generally trading a basis points or two tighter – though not without some noise. We expect that the calendar will pick up a little bit next week, as more companies get through earnings season. But if we see further volatility coming from emerging markets, all bets are off. Many high quality issuers were active in tapping the markets in 2013, so there is not a lot of pent-up supply, and you could see a sharp drop in new issue if volatility continues.

To say it has been a wild start to the New Year might be an overstatement. Let’s just hope they aren’t dragging us away before its over…

Highlights of the CFA Society of Minnesota Economic Dinner Keynote Address

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Howard Marks, Chairman of Oaktree Capital Management gave the keynote address to a sold-out audience at the annual CFA Society of Minnesota Economic Dinner on January 23. The title of the presentation was “The Human Side of Investing: the Difference Between Theory and Practice”.  Some of the highlights of the speech were as follows:

  • If riskier assets always equaled higher returns, they would not be riskier assets.
  • In theory the market is efficient, clinical and risk averse. In practice it is filled with emotions, insecurities, foibles, mistakes and risks—but the returns may never arise.
  • Why is there a discrepancy between market theory and market practice?

–The “happy medium” (i.e. what happens on average) is rarely seen, the market can    and does go to extremes.

–Errors of herd behavior among investors.

  • The three stages of a bull market

1) Few people realize things will get better.

2) Most recognize improvement.

3) Everyone thinks things will improve forever.

  • The secret of investing is not what you buy, but what you pay for it. One example he gave was how in the 1970s everyone was seemingly buying the “Nifty 50” but ignoring underpriced high yield bonds, which was where opportunity laid at the time.
  • The conclusion of this topic was “What the wise man does in the beginning, the fool does in the end.” Mr. Marks then brought up contrarian investing.
  • What will enable you to be a good contrarian investor? Be analytical and unemotional.
  • Memory and prudence always come out the loser when pitted against greed.
  • Overestimating what you know about the future encourages further risk taking. Mr. Marks does not take much stock in macro forecasts.
  • Risk means more things can happen than will happen. Don’t invest for the likely outcome (which is what everyone else is doing); instead we investors need to look at all potential outcomes.
  • Avoid the twin impostors of short term out- and under-performance. It is important for us to remember what really matters is the long-term.
  • Being too far ahead of your time is indistinguishable from being wrong.
  • Conclusion: don’t forget that buying assets well matters most, and to be successful investors need to be disciplined, objective and unemotional.

Living on the Edge Part III: Let’s Get Small

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Last week we discussed if investors can get an edge on large cap stocks. This week is focused on smaller cap stocks (e.g. $3 billion or less).  Most investors and academic studies usually concur that one can get an edge on small cap stocks because there can be an informational advantage as smaller companies get less coverage on both the buy and sell sides.  Investors can occasionally see their money double or more as Wall Street becomes aware of these underfollowed companies.

That’s the good news. However, for every success story there are dozens of small cap stocks that will continuously languish in obscurity. The investor’s challenge is often not if you can get an informational edge on an underfollowed small cap, the challenge may be determining if anyone besides you will ever care enough about the name to purchase it. This is a major concern, especially with illiquid stocks that can take days, if not weeks, to exit a position if the stock fails to work. Therefore it is crucial to not only know a small cap company and the catalysts that theoretically should propel it higher, but also the ownership structure.

Knowing the ownership structure not only entails knowing how much of the float is owned by management (and oftentimes the management’s family) but also other investors that are currently involved in the name and activities surrounding those investors that could “loosen up” some shares of a small cap company. These activities can include things as changes in Portfolio Managers, tax needs of the investor, estate property changes or modifications, or any number of things other than valuation reasons that can influence the sell decision for an investor.

It also helps to know, or get a sense from your analysis, if there is a secondary offering coming, which improves the number of shares not held by management. Those offerings usually are followed by growth initiatives such as M&A activity, increasing the distribution channels of the company, increasing capacity, international expansion or any number of investment opportunities.

Therefore the investor can likely get an informational edge with a small cap stock, but sometimes that might not be enough. You need to know other factors quite well, such as ownership structure, for that edge to matter and happen within the investor’s time horizon as well for the stock to work.

One Hundred Years of Solitude

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We have all heard complaints about how lonely it is being a portfolio manager. Good decisions are celebrated by the team, but bad decisions seem to be made alone. Not that it was a bad week in credit – everything was just fine. Spreads were perhaps a touch weaker, but excess returns are still positive for the month, interest rates are cooperating, and market tone feels pretty good.

This is probably what paved the way for about $45 billion in investment grade supply, and investment grade sovereign issuers added another $8 billion. One of the notable issuers last week was EDF (Electricité de France), which globally brought over $12 billion in supply, of which about $6 billion was in US Dollars. Among the bonds issued was a new 100 year bond – the 7% of 2114. Now that is credit risk worth thinking about.

In the late 1990s, there was a spate of 100 year issuance, and some of the credits have fared better than others. Fox America (formerly NewsCorp) has improved somewhat since issuance in 1996. JCPenney, on the other hand, has sunk from being a solid, single-A rated company to a CCC company. From a credit standpoint, this underscores the perils of underwriting a bond for such extended periods. How, exactly, do you evaluate 100 years of credit risk?

The answer may be – you don’t. Beyond a certain period of time, we think insight into business fundamentals grows a bit foggy. Even so, these bonds can still make a lot of sense from a portfolio standpoint, particularly if you are hedging long duration liabilities. The duration of a 100 year bond is not much longer than that of a 30 year bond, but you generally get a lot more convexity, so you should outperform as interest rate volatility increases.

All that convexity should really make you feel better when credit quality tanks. There’s no way around it, buying a 100 year bond introduces loneliness that could be handed down from generation to generation.

CFA MN Book Club (St. Paul) Notes: The Physics of Wall Street.

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Earlier in the month the CFA Book Club (St. Paul group) met to discuss The Physics of Wall Street, by James Owen Weatherall. The book featured biographies of some famous, and not so famous, physicists that used their knowledge of physics systems in nature, such as chaotic systems, and how they were able to translate those theories into actionable strategies in the financial arena. Additionally those biographies were interlinked so you could see how one person’s work influenced others.  Some of those names would be familiar to those in the financial industry, such as Scholes, Black, Merton and others.

Overall, the book received good-to-mixed reviews. About half of our group would have recommended the book to a friend, while the other half had reservations. Here were some of the observations from the group:

What people liked about this book:

  • This would be a good book for undergraduate Finance and Economics majors to read to see why it is important to understand quantitative analysis and calculus, because sometimes as a student it’s not easy to see how those disciplines are used in finance every day.
  • It was a good lesson on how we all need to talk to others in related disciplines to gather insights that we would not have gotten otherwise.
  • It was interesting how the people in the biographies intertwined and utilized each other’s ideas to build upon their own theories offered a nice insight on how quantitative analysis in finance and trading strategies came into existence and evolved over time.

What people did not like about the book:

  • Sometimes the biographies dwelled too much on the subjects’ academic background and how those people became physicists in the first place.
  • The book dwelled too much on historical information and background and less about the interpretations of the theories and how it influenced today’s financial world.

Our next book for the St. Paul group will be Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market, by Scott Patterson. Our next meeting is at Sweeney’s Dale Street Room on Wednesday, February 26 from 5:30 to 7:00.