Category Archives: Hot Topic Commentary

Love Me Tender

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Credit had a much better week, pushing month-to-date excess returns solidly into positive territory. Spreads held in even as Treasury bonds sold off following the release of Fed minutes on Wednesday. Supply has continued to be very heavy, with over $33 billion of new investment grade offerings. Deals also seem to be performing better this week than last. For example, Coca-cola Femsa (the largest Coke bottler globally) brought $2,150 million of a 3 part deal; the 10-year tranche priced at a spread of +135, and is trading 10 basis points tighter on the bid side.

The interesting question for us is why? After languishing for two weeks, in the midst of a week where taper fears were re-ignited, and when spreads are already trading at the tight end of their post-crisis range, what is pushing spreads tighter? While it is possible that regular readers of the weekly credit wrap noted that we called the end of the financial crisis a few weeks ago, and are responsible for driving spreads tighter, we think there is more at work here.First, volatility (as measured by VIX) has moved lower, and even with the move higher in rates, credit spreads generally respond favorably to a lower-vol environment.

Second, corporations have been active in tendering for outstanding debt, and this reduces net supply. There have been about $15 billion in tenders so far this quarter, and this provides a nice boost for the market. This week, Mondelez announced an offer to purchase up to $1.5 billion of outstanding high coupon debt, at spreads inside of where bonds were trading.  Companies will engage in tender activity in order to reduce high coupon debt, which will generate a loss in the current year, but reduces interest expense going forward. For total return investors, it is just a gift. You want to pay how much for my bonds? Ummm…okay. We love tenders. And we always will.

Credit had a much better week, pushing month-to-date excess returns solidly into positive territory. Spreads held in even as Treasury bonds sold off following the release of Fed minutes on Wednesday. Supply has continued to be very heavy, with over $33 billion of new investment grade offerings. Deals also seem to be performing better this week than last. For example, Coca-cola Femsa (the largest Coke bottler globally) brought $2,150 million of a 3 part deal; the 10-year tranche priced at a spread of +135, and is trading 10 basis points tighter on the bid side.

The interesting question for us is why? After languishing for two weeks, in the midst of a week where taper fears were re-ignited, and when spreads are already trading at the tight end of their post-crisis range, what is pushing spreads tighter? While it is possible that regular readers of the weekly credit wrap noted that we called the end of the financial crisis a few weeks ago, and are responsible for driving spreads tighter, we think there is more at work here.

First, volatility (as measured by VIX) has moved lower, and even with the move higher in rates, credit spreads generally respond favorably to a lower-vol environment.

Second, corporations have been active in tendering for outstanding debt, and this reduces net supply. There have been about $15 billion in tenders so far this quarter, and this provides a nice boost for the market. This week, Mondelez announced an offer to purchase up to $1.5 billion of outstanding high coupon debt, at spreads inside of where bonds were trading.  Companies will engage in tender activity in order to reduce high coupon debt, which will generate a loss in the current year, but reduces interest expense going forward. For total return investors, it is just a gift. You want to pay how much for my bonds? Ummm…okay. We love tenders. And we always will.

Lutefisk Buyback

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The holidays are rapidly approaching. Unfortunately for us in the Upper Midwest, holidays often equal lutefisk. Lutefisk in our view has to be the worst holiday food tradition in the region, even worse than receiving a fruit cake. At least fruit cake can be re-gifted, often for years at a time—kind of like a culinary chain letter.  When it comes to lutefisk, we would rather perform open heart surgery on ourselves than eat this alleged food. Some hearty souls claim to like lutefisk. In fact several years ago there were lutefisk microwave entrees. For most of us, the less lutefisk—the better.

On the opposite end of the scale, there are stock buybacks. The more we get, the happier most investors are. Usually for growth-oriented stocks we are not fans of stock buybacks. While we think it can be an effective way to return cash to shareholders in a tax-efficient manner, the timing and the amount of the buyback can dramatically impact the return on the company’s (and ultimately the  shareholders’) investment. For instance, most share buybacks undertook during the 2006-8 timeframe likely did not deliver a good, if any, return for shareholders. Additionally, while a share buyback can grab headlines, oftentimes stock options and grants can dilute or even undermine the earnings per share impact of a buyback.

Furthermore, U.S. based companies usually use cash domiciled in the U.S. for a buyback—all from the same pile of cash used to pay dividends, U.S. based pensions, U.S. employee health care costs and many other expenses. This can leave far less cash for growth-oriented activities especially here in America. These activities can include additional property, plant and equipment that can lower costs in the long run or increase productivity and/or capacity, additional investments in research in development, U.S. based acquisitions, new marketing channel development and sales force enhancements. The expected return of the buyback has to outstrip all of those other potential uses for cash in our view to be worth the risk and potential long-term growth opportunity costs.

Having said that, there are times when buybacks are worthwhile and we need to incorporate the potential for them into our investment analysis. For instance, for companies with a cyclical bent, there may not be any worthwhile investments for the company’s cash other than purchasing their own stock at that point in the cycle. Additionally we also know that if the buyback is timed properly, it can enhance shareholder returns. It is also nice to have the company conceivably buying stock on pullbacks, potentially supporting the stock. Finally at the end of the day, an investor should be concerned with generating an abnormally good return over the investor’s investment horizon. Buybacks certainly play a role in that regard. Therefore, when there is a buyback announcement one may have a percentage of float number in mind that would make us take notice of it being material to the stock’s shorter-term potential investment attractiveness.  Do you have such a number? What do you think?

To Hold Cash or Not to Hold Cash That is the Question

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Lissa Rurik, CFA, CAIA

One of the central tenets in money management is that cash is not the place for money that is not earmarked for transactional purposes.   Not only does a cash position lose its real purchasing power over time, but the opportunity cost of holding cash is quite apparent in times of good market returns.  We’re all familiar with the studies that illustrate the drag on returns to the extent an investment portfolio doesn’t participate in the market’s best performing days.

However, data as to the impact of avoiding the market’s worst days is less widely touted in the investment community (although it is easy enough to search out and offers a compelling argument at that).  Certainly there is value in avoiding exposure to a market decline.  Additionally, there has to be value in the opportunity of being able to put cash to work during times of lower market multiples.

A recent article in the Wall Street Journal’s Money Magazine reported that the well-known investment firm GMO LLC had built up cash levels in its mainstream investment portfolio to 50% of assets earlier this year.  According to James Montier, a member of the firm’s asset allocation team, they had concluded that most other investment opportunities – particularly in the western markets – were too expensive and investors were likely to lose money after inflation from current valuation levels  (http://online.wsj.com/news/articles/The Case for Cash 9202013 ).

Montier published a white paper on this topic in November, 2012, and it’s an interesting read (The 13th Labour of Hercules: Capital Preservation in the Age of Financial Repression  — James Montier).  Before diving in however, it’s important to appreciate a couple of key premises in GMO’s intellectual framework.  First, risk is understood to be less about volatility and more about the permanent impairment of capital.  Second, GMO’s models are developed within the context of mean reversion; i.e., the forecast period incorporates a return to “normal” conditions. Continue reading →

FUNDAMENTALLY FLAWED: Why We Vote Against All Stock Option Plans

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Disciplined Growth Investors

The theory behind stock options is quite sound. That is, options are a form of de facto stock ownership that should provide managers strong incentive to focus on operating the business in a way that would maximize shareholder value. Unfortunately, in practice stock options suffer from four fundamental flaws that subvert this basic premise:

 

1. option holders have limited financial risk,
2. options holders often profit from sub-par performance,
3. short vesting periods encourage a short-term business focus, and
4. options are blunt incentive/retention tools.

Close examination of the impact of these structural flaws combined with a dearth of corroborative evidence tying option use to long-term value creation have led us to the conclusion that stock options as they are structured today simply do not work. Therefore, we have reluctantly decided to vote against all stock option plans.  Over the balance of this paper, we discuss the aforementioned fundamental flaws and detail how each works to prevent stock options from fulfilling the promise of enhancing long-term value creation.

FUNDAMENTAL FLAW #1:

Option Holders Have Limited Financial Risk

Stock option proponents passionately argue that options place senior executives in the same financial camp as long-term shareholders. After all, both option holders and shareholders benefit from stock price appreciation and are penalized by declines in the price of the stock…right?  Well, not exactly. While it is true that both option holders and shareholders benefit from stock price appreciation, they are not equally at risk to declines in the price of the stock.

Remember that an option confers the right to purchase stock at a fixed price, a.k.a. the exercise price. However, corporate employees and directors do not pay for this valuable right. Additionally, if the stock declines in value, option holders are not required to exercise their options, i.e. purchase stock. They simply let them expire. Since option holders put no personal capital at risk upfront and there is no future obligation to invest, option holders have no financial downside.

In contrast, shareholders assume significant financial risk when they purchase a company’s stock. Because shareholders exchange cash for their ownership position, they can actually lose money if the stock declines. Ultimately, shareholders only benefit if the total return from holding the stock exceeds the rate of return required to compensate them for the potential loss of principal plus the opportunity cost of foregoing other investments.

The difference in financial risk assumed by option holders and shareholders is evidenced by the change in behavior that occurs after options are exercised. In our experience, the vast majority of option exercises are followed by the immediate sale of all the exercised stock. This behavior suggests that option holders recognize the difference in financial risk between options and direct stock ownership and typically act swiftly to eliminate that risk by converting their holdings to cash.

Some option proponents contend that the lack of financial risk for the option holder is irrelevant, because the issuing company incurs no cost. There is no cash outlay and therefore no cost to the business, so the argument goes. We beg to differ. The company (and by proxy the existing shareholders) incur a clear economic cost when an option is issued. Focusing on the lack of cash outlay from the option grant obfuscates the value transfer that occurs. The issuance of an option clearly confers a valuable right to purchase stock at a fixed cost. This right represents a real claim on the future cash flows of the business.

One final counter argument we often hear regarding the absence of financial risk to options holders relates to options as part of an overall compensation package.  These option proponents contend that option holders do indeed have financial risk, because they are accepting option grants in lieu of additional cash compensation. In other words, option holders have essentially put a portion of their cash compensation at risk by agreeing to substitute options. We give little credence to this argument given there is scant evidence of corporate executives in the United States being under-compensated on a cash basis (salary plus cash bonus). Continue reading →

Climate Change and Investment Analysis

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Tom Brakke, CFA

When readers of the print edition of Bloomberg Markets received the November issue, they were confronted by bold letters on a red background that proclaimed, “The Risks Heat Up.”  A light blue circle provided visual contrast and more context: “Special Report:  Climate Change.”

The four items in the issue included a feature story (the subhead for which began, “As the risks grow on a hotter planet . . .”); a sidebar on how rising seas have affected agriculture in Vietnam; a look at the “laboratory” that is Alaska; and a graphic of the threats and opportunities around the world as a result of climate change.

Bring up climate change and you are sure to get immediate reactions from those on one side of the debate or another, although this is an issue where the political lines aren’t always predictable.  For analysts, however, the question should not be a political one, but a research-based one, dependent upon the facts to date, the scientific possibilities, scenario analyses, and educated estimates of probabilities.

Like it is with other investment endeavors, time horizon is very important here.  As a society, we should be considering the potential long-term impact of climate change and making the appropriate policy changes on that basis.  As investors, that societal horizon might seem too long for our purposes, the impacts too far away to be relevant.  But at some point, our analytical methods may need to be adjusted based upon the range of possible climate outcomes.  (Disclosure:  I wrote a piece on warming up the models of investment analysis in 2008.) Continue reading →