Monthly Archives: May 2014

Nuthin But a “B” Thang

·

It was just last week that Apple came to market with a $12 billion bond deal, presumably to fund its share repurchase program. The market (as readers may recall) breathed a sigh of relief that the deal was significantly smaller than the $20+ billion that had been speculated.

And now, just a few days later, Apple is again in the news, this time on speculation that it will be paying $3.2 billion for Beats Electronics LLC, the maker of expensive, hip headphones and sponsor of a new streaming music station. We will leave it to the equity analysts to decipher whether this is a good deal for shareholders. We are trying to sort out whether it means anything for bondholders. The short is answer is: probably not. For a company with $150 billion in cash, a $3 billion deal is simply not large enough or transformative enough for it to have any impact whatsoever on credit quality. Credit spreads haven’t budged (one way or another) on the news. Even the 10 year from last week, which we noted was the weakest performer, is trading about 2 basis points tighter than new issue.

The potential transaction does underscore the danger of owning bonds of high quality issuers. There is an enormous range of potential outcomes, a whole host of nasty things that Companies can do with their cash. So which poison would we pick? Acquisitions are generally scarier – they can dramatically and suddenly alter a company’s risk profile. But share buybacks can result in death by a thousand cuts. As we move through the credit cycle, anemic growth and deteriorating margins tends to drive managers increasingly into the realm of financial engineering. Credit risk’s single tail becomes ever longer.

But for the past week, there was little sign of heightened risk. Or return, for that matter. Corporate bonds generated total returns for the weak of -0.06%, and excess returns were about the same. The new issue calendar was very average – about $22 billion of deals, and no big blockbusters this week. JP Morgan brought $2 billion of a new 10 year bond, which priced at +100, and did not really perform. Caterpillar Inc. came with $2 billion, with 10 year, 30 year, and a 50 year. The 50 year is not a typical maturity, and we think the pricing was very attractive – bonds traded 11 basis points tighter in the secondary. Next week looks like it will be more of the same – spreads continuing at tight levels, an average calendar of $20 billion….

….and the beat goes on…..

I Miss Earnings Season!!!

· · Leave a comment

If there is one thing I hate more than earnings season, it’s when it’s not earnings season. Why? Because then more often than not we investors, and especially the talking heads on the financial news networks, bloviate non-stop about macro data in between company quarterly reports. After this has gone on for several weeks, I actually find myself BEGGING for earnings season to start.

We feel this way because much of the discussions on these macro data points often end up as being so much noise. Take for instance the discussion on first quarter GDP. Most would agree it was lackluster, with a good percentage of analysts blaming the performance on the weather. Really? Earlier in the year we discussed that weather doesn’t really have much of an impact on retail sales. Additionally, if weather really does have a sizable impact on the economy, why was it not anticipated as estimates for the first quarter off by so much as the consensus was 1.5% with the actual tally being 0.9%? Conversely, when GDP is more than forecast, how come we never hear that absolutely great weather biased results upward? Our point is that when you have something as complex and organic as the US economy, it’s difficult to shrug off any result to just one factor.

Perhaps the bigger question is what comes first; unexpected GDP changes or unexpected corporate results changes? Usually in our observation GDP is fairly coincident as corporate earnings are an important part of the real economy. Sometimes we think of it as slightly lagging as we often hear from companies and their supply chains what they are seeing and expecting on Main Street before the official GDP data is released. For reference here’s one example, the S&P 500 revenues plotted against nominal GDP. We used this chart as we believe revenues are a better indicator of demand than earnings, which can be more influenced by accounting assumptions, cost controls, and changes in capital structure.

shoutout_earningsseason

However, we also think that one completely ignores these macro data points at their own peril. Macro data can help confirm or deny an investment thesis and there are plenty of quantitative and algorithmic strategies that can influence your positions, at least in the short-term. Our best use for them is to help confirm or deny existing theses we have on individual sectors or companies as some of our companies are influenced less by US macro data than others, e.g. large multi-national companies are less influenced by US data than, say, a small cap retail chain.

Sideways

·

The yield curve is flattening in a big way. The spread between the 5 and 30 year treasury bonds is 168 basis points, compared to 250 last November. We have been expecting a flatter yield curve –it is an important sign of normalization. But investors seem to have been caught off guard by the strength of long term bonds. Treasuries with maturities of 20+ years have been among the best performers in the market, generating over 11% returns year-to-date. Not too shabby, especially given that rates are supposed to be moving higher.

Of course, rates will be moving higher – the Federal Reserve has made that perfectly clear. But not quite yet, and they’re only talking about short term rates. So the curve that is taking shape is significantly flatter, and at least right now it looks like higher rates will mostly be felt inside of 5 years. The long end tells a very different story, and for Credit, the story unfolding suggests a pretty benign, if uninspiring outlook. Looking back to the last credit cycle, when the curve finally started to flatten, credit spreads largely moved sideways for several years, in a range of about 10 basis points.

Looking at the past week, spreads were a little tighter, and for the month of April, generated positive excess returns of 41 basis points. The long end outperformed strongly, with total return for the month of 2.24%, and 62 basis points of excess return. Supply for the week came in at $32 billion, driven by the Apple deal. The market had been anticipating this deal following Apple’s announcement on April 23rd that it would be issuing bonds to fund share buybacks, but the deal was much smaller than expected – just $12 billion instead of $20 or more. The deal was well received (with the exception of the 10 year – the only tranche that moved wider on the break) and spreads for existing Apple bonds tightened.

The market as a whole right now has a complacency that leaves us wondering what else is going on out there. It feels a lot like middle age – reviewing where we’ve been, wondering if we’ve done enough, and when it all falls apart. The signs of middle age for the market are definitely there – a flatter yield curve, modest movement in credit spreads, modest economic growth. Now I guess we’re just waiting for someone, somewhere in the market to push things a little too far. It always seems to happen in middle age. The risk is greatest when we are no longer content with moving sideways.

The Power of Observation

· · Leave a comment
Tom Brakke, CFA

How do you process the torrent of information that comes your way as an investment decision maker? On April 29, Gregg Groechel of Inferential Focus gave a presentation to CFA Society Minnesota that challenged the attendees to see their information gathering and decision processes in a new way.

The talk was titled, “Identifying Meaning Versus Noise: Getting Past Biases and Seeing What is Actually There.” We all can agree that is a lofty goal.

Groechel, a Twin Cities charterholder, led the group through a series of exercises to show how hard it can be to put things into context. He used photographs to illustrate how background and foreground information can be difficult to separate – and how meaning can be obscured.

A couple of key questions from him: “How do you set up an intentional way of operating? How do you open up the organization [to process information effectively]?”

The mission of Inferential Focus (website; Twitter feed) is to “make sense of a changing world” for its clients, which include investment firms of all types, corporations, and governmental organizations. Groechel walked through some of the firm’s principles and its process.

What does the firm do? The start of the process involves intensive, far-reaching, and unusual reading. Unusual in the sense that most of the reading is done from paper (because the processing of the information is better in that form) and the Inferential Focus team is designed to look for information in a very specific way.

The members of the team are all generalists, reading across disciplines and avoiding the specialization that characterizes research efforts in most organizations. In addition, they are looking to glean specific kinds of information from the materials that are read.

The firm believes that there is a hierarchy of information, with events most important and then facts. What aren’t very important are opinions and commentaries. Groechel deconstructed an Economist article to show that a very large part of was made up of that relative fluff, with very few events and facts referenced.

Think about the typical investment report or presentation. A high percentage of the content is made up of opinion and prognostication. The percentage is even higher in many of the stories in the financial media.

Inferential Focus ignores that and focuses on what is actually happening, piecing together developments from an array of sources to observe a context through which it can help its clients see economic, political, social, and technological changes. It then communicates the ideas in written materials and in-person meetings.

To provide an example, Groechel distributed to the attendees one of the firm’s “packets,” a collection of the source material that it uses to support its observations and its communications with clients. In this case, the readings concerned China, specifically a variety of hurdles being erected by China to impede the success of foreign consumer brands while simultaneously buttressing the competitive position of its domestic firms.

It was a good example, in that the information came from a variety of different publications, was focused on facts and events, and pertained to a variety of companies. In considering the prospects for firms in China, most observers are either focused on their own narrow specialty (and making predictions in that regard) or speculating on the level of Chinese GDP (and assessing the prospects for firms in relation to that). Each approach, according to Groechel, is missing the essential context: There is a general headwind to most foreign consumer brand companies doing business in China that wasn’t there before. On balance, that is likely to make results worse than will otherwise be expected.

As investment professionals, we are immersed in information and our greatest challenge is in deploying our powers of observation in a differentiated and advantageous way to the benefit of our clients. Inferential Focus’ approach stands apart from that of most organizations, in that it is slower, more selective, more structured, and focused on identifying the big, important changes before others do.

Could it work for you? As Gregg Groechel said, this “consulting think tank looks at change through a different lens.” If nothing else, its divergent approach should make you think about how your own organization processes information and makes decisions.

 

Disclosure: I have known the Inferential Focus organization for thirty years. I have been a client and have also worked with the organization on some projects. Therefore, I have seen “the sausage being made” and have relationships with the principals of the firm. I have previously written about IF in a posting about a 1983 book that stemmed from its work (“The Tao Jones Averages,” long out of print but now available as an ebook) and in a piece that was inspired by an April 2013 IF report on applications of virtual reality that included a look at Oculus Rift, which was recently purchased by Facebook. (My essay focused on applications of the technology in the investment world.)