An eye towards risk… and opportunity

By George Cipolloni

The Nedgroup Investments Global Cautious Fund’s positioning has lived up to its name.  It is underweight both stocks and high-yield bonds and overweight cash and short-term corporate bonds - which is about as cautious as a fund manager can get today.  As contrarian value investors, we continually seek to add value without assuming excessive levels of risk.  No matter what the markets may be doing, this is the lens through which we view the world.  How much risk do we have to assume to earn a good return?  As a result, we may not always be optimistic, but we are certainly always ready to be opportunistic. 

The current markets have presented us with quite a challenge from a risk perspective.  After a multi-decade decline in bond yields (and a corresponding rise in bond prices), there are few fixed income securities that present a favourable balance of low risk and high potential return.  After a seven-year rally in equities, there are also fewer opportunities coming from the stock markets.  Given this current context, while we have no interest in predicting future market levels, we do see the potential for more disruptions and volatility, which excites us, as we believe that volatility presents opportunity.

Opportunistic research process

A key part of our investment process is attempting to identify the risk inherent in each candidate we research.  What we have noticed over time is that even though we are strict bottom-up investors, certain trends emerge from our individual company research.  Groups of companies tend to move together both in terms of their stock or bond prices and in terms of the capital allocation decisions made by management teams within a specific industry.  Competition for market share tends to create similar decisions by managers – i.e. when one company makes an acquisition, their competitor may be more willing to make an acquisition.  We also recognise that this group-think remains a prevalent part of the investment markets. Wall Street (investment bankers) is always eager to give the market (investors) exactly what it wants, when they want it.  Investors wanted technology stocks in 1999, and a ton of new IPOs hit the market.  Yield-hungry investors were looking for a ‘less risky’ way to gain higher levels of income in 2007, so packages of mortgages were bundled to satisfy them.  When high yield investors wanted to participate in the fracking revolution in 2014, speculative energy companies sold tons of debt deals.  The market usually gets what it wants and then ultimately, what it deserves. 

Cycles

Nearly everything in life has an inherent cycle.  There are cycles in the weather, personal behaviour, etc.  This cyclical phenomenon is clearly evident in the financial markets.  There are business cycles and earnings cycles; there are growth cycles of industries; there are cycles as it relates to specific companies.  This cyclical nature also enters into many behavioural aspects of investors’ thinking. 

The willingness to take risk as it relates to both individual company management teams and investor sentiment is also very cyclical.  Over the past few decades, we have experienced several wild swings.   The irrational exuberance of the Tech Bubble in the late 90s was replaced by the economic slowdown of the early 2000s.  The euphoria of the Housing Bubble in the mid-2000s led to the Great Recession of the late 2000s.  These periods were presumed to be influential, generational events that should have had a lasting impact.  Yet, what did the past two decades teach? Did investors learn to stay away from companies that have little or no earnings?  The run-up in biotech stocks would suggest not. Have investment bankers become more discerning about which companies deserve debt deals?  The torrent of debt coming from commodity and energy companies would prove otherwise. Have management teams learned how to allocate capital more wisely?  The extensive use of debt to buy-back stock would indicate just the opposite.   Management teams continue to make bad capital allocation decisions (in aggregate) and investment bankers and investors continue to encourage this bad behavior.  So, the cycle rolls on.

Debt

Two important macro data points that have not been subjected to this cyclical movement are global interest rates (down steadily) and debt levels (up dramatically).

From a logical, economic standpoint there is a good argument that higher debt levels can be absorbed as interest rates decline.  The cost to service debt today is far cheaper than it has been in a long time.  However, no matter how cheap money is, once debt is incurred, the principal amount stays on a country’s, company’s or an individual’s balance sheet until it is paid off.  Simply put, the debtor must answer to a third party.  Specifically for companies, debt can restrict a management team’s financial flexibility during unfavorable industry conditions.  In a perfect world, a responsible management team who understands their operations and are sensitive to the cyclicality of their industry will manage their company’s balance sheet efficiently.  Any debt issued will enable them to generate higher levels of cash flow which will allow them to repay the debt. But as we have witnessed over time, this is not always how it works.  Capital does not always flow to the right companies at the right time. Too often, debt is incurred by many companies (and countries and individuals) for the wrong reasons.  Often the money generated from debt issuance goes to unproductive uses that have not increased their net income or cash flow. The chart below shows that most share repurchases over the past ten years occur when stock prices are high.

Companies can be just like an individual who crawls out on the credit limb for a fancy vacation or a flashy car. They have very little room to maneuver if they lose their job.  For an energy company, tough times occur when the price of oil falls from $100 per barrel to $40 per barrel.  Heightened debt levels during economic downturns or recessions can lead to very poor outcomes.  A company’s future itself can become a binary event - a pass or fail situation dictated to them by their debt holders. 

After a long period of increasing total debt levels, something needs to give.  Corporate profits must expand; a country’s GDP rate must increase; or an individual has to get a raise.  Broadly speaking, throughout much of 2015, none of this has happened.  As a result, the corporate bond market started to see some signs of concern.  The first chart displays credit spreads for BBB-rated U.S. corporate bonds.  Over the past year, credit spreads have been widening (from near all-time lows).  This spread widening is an indication that investors are more concerned about the credit-worthiness of corporate bonds.  The second chart is a 10-year chart of the TED spread (the difference between the interest rates on interbank loans and on short-term U.S. government debt), another indicator of perceived credit risk in the general economy. 

Over the past year, perceived credit risk has increased with both measures at their highest levels since 2012.  While this may not be a warning sign of disaster for the credit markets, they are signs that the complacency seen the past few years could be coming to an end.  If credit spreads remain at this level or increase, this can have an impact on companies that are over-levered and in need of access to the capital markets to refinance debt.  We started to see some debt deals get cancelled for the first time in many years during the third quarter of 2015.

Volatility

Global debt expansion can also be a major contributor to another factor affecting the market volatility.  In August of this year, the markets received a pretty good shock to the system.

The VIX Index is an index of expected future price volatility implied by S&P 500 Index options contract prices and is often called a ‘fear index’. Its value rises when investors are concerned about future volatility.  From 2011 through July of 2015, the VIX Index signaled widespread complacency.  The equity markets marched higher.  Many bond indexes also rose as interest rates declined, and credit spreads narrowed.  All was right in the financial world.  Or was it? 

Such long-lasting low interest rates and such high stock prices lulled some investors into thinking that nothing could upset the status quo. They were blindsided in August. China’s surprise devaluation of its currency stoked global fears that the world’s second largest economy was faltering badly and would drag the rest of world down with it.  Equities and high yield bonds plunged while interest rates fell as investors flocked to U.S. Treasury bonds to preserve their capital. The VIX Index climbed sharply and dramatically to over 50, a level not seen since the Great Recession of 2008 and 2009. (The VIX Index has since come back down under 20 in the past few months.)

Ultimately, the amount of risk each market participant assumes is only realised during a crisis.  While August 2015 did not yet determine that a new crisis is at hand, it showed that the risk inherent in many portfolios can be realised in a very short period.  In our experience volatility is not a bad thing, as it creates opportunity and allows disciplined, patient investors to take advantage of fearful market participants making poor, non-fundamental decisions.  The Nedgroup Investments Global Cautious Fund’s current conservative positioning clearly reflected the essence of this message throughout 2015.  We hope that our recent display of patience will be replaced by the decisive action that can benefit the fund for years to come.