Bonds: careful on how its role in many portfolios is changing

When I started investing, my vision for the role of bonds in a portfolio was to help produce a steady source of income greater than the cash rate, whilst providing only a small increase in risk relative to the cash position (i.e. we did not see the risk of the issuer we bought being greater than the average bank that is holding your deposits! In fact, we would only buy the bond if we felt the bankruptcy risk was quite remote). Hence a 40% allocation to bonds offering a 5 to 6% source of income (in those good old "normal" times) supported a 60% exposure to equities that were expected to generate around a 10% return per annum over the business cycle. This would allow a portfolio to credibly generate around 8% per annum over the business cycle with the bonds reducing the volatility in the portfolio, which many clients are so afriad of (at this moment I don´t chose my clients, but deal with clients from private banks, many who are lead to believe that volatility is risk in investing: a fact that would be ridiculous for them to consider if it was applied in there family/corporate businesses). However, today this role of bonds is quite limited. Rates are so low for the senior bonds of high quality corporates with duration less than 6 years that the small premium to cash rates today are substantially below the average cash rates for the currencies we deal with (for hard currencies you can assume the average cash rate over the last 100 years is around 4.5%). It is not silly to think that current cash rates will converge to the average over the next 6 years. So to generate that 5 to 6% in bonds today one must buy fixed income securities that are lower in the capital structure. This introduces the world of subordinated and perpetual bonds, as well as preferred shares, contingent convertible securities and the like. In a sentence: you are forced to increase risk to generate the same income. However, since in your portfolio statement all these securities fall under the BONDS section, many still assume it to be near risk free, or at least considerably less risky than equities. Again, as is often the case, the problem is how we define risk. The word risk without an adjective is meaningless. Are you afraid of the size of price risk (i.e. volatility), duration risk (the affect interest rates may have on the price of your investment security), bankruptcy risk, lack of income being generated in your portfolio etc. Depending on what your objective is, it will affect which risks you will be willing to take. For me, my view of bonds has changed, at least for the moment. When I look at great investors I see many don`t buy high quality bonds, but buy junk bonds. I guess if you focus on high quality companies to buy their equity, their is some logic to take advantage of the seniority of debt and focus on the average companies. When you buy a quality stock you often ask will the company prosper. But when you buy a bond, since you do not share in the profits, you only need to ask the question, will they survive. Indeed, I compare this strategy to buying net nets. These are companies that often have deteriorating operating results, but often have no debt on their balance sheet. Hence buying the equity is effectively equivalent to buying the bond. However, in this case you have the potential of a strong capital appreciation as well as any income that may be offered to shareholders. The question would be, is it more fruitful to invest in net nets of poor companies, or the senior debt of poor companies; which historically offers the more attractive return. Note should your analysis be wrong and the company goes through chaper 11 (in the US), as a bond holder you then become the shareholder of effectively a net net company (so you get a second chance!). With a net net unexpected costs may accrue leading to a lower return of capital than expected (book value is often much less in bankruptcy than it is stated on the balance sheet). However, junk bonds role in the portfolio will not be to reduce volatility! But will be there because the risk/reward is attractive and merits its position over cash. This is the only way I think it makes sense to build portfolios. Not to assume what correlations between asset classes may be, or make macro assumptions the pillar of your asset or security selection. You focus on the risk/reward of each investment. If the potential risk adjusted return is offering a satisfactory return greater than cash, it should be considered a worthy investment. Unfortunately client facing institutions rarely think like this. Instead their aim is to make money every year, every quarter, every day. Indeed, it is for this reason value investing continues to make above average returns. The vital ingrediant of patience is simply lacking from our important financial institutions. As a side note, if it was up to me I would focus on working with clients that (1) define risk as the potential of permenantly losing capital, (2) are keen on buying the securities of good companies at good prices, and (3) assess the performance of there investments over a three year period (over apprx. half the business cycle). A client who understands and agrees with the investment philosophy of their investment manager is more likely to have a fruitful relationship in terms of results, and to be more aware when the situation requires patience, or if their manager is sub par. If you cannot explain an idea to a client in a few minutes, it is not worth investing in their portfolio. Transparency and understanding leads to loyalty, and the best possibility of generating good results.

The role of inflation in valuation

Our simple approach to valuation was described in a recent blog. However, though simple, we find it to be effective in focusing on what really matters: long term corporate profitability - rather than terminal values, theoritical discount rates or the volatility of stock prices. We would like to show the power of this model by focusing on how high inflation can affect the pricing of the stock market. Many readers are aware that during the 70s inflation rates increased and the stock market reached a valuation close to x7 earnings, a large displacement from its historical average of x16 earnings. When the value of money is perceived to decrease over time, it is rational that investors want to pay less for future cash flows, hence the multiple of the market contracts. However, focusing on those companies that have more manageable costs (consider their cost structure, its operational efficiency to competitors and the margin of the business) and pricing power, inflation over the long term will cause little permenant damage. If anything, it can increase their market share as competitors have a more difficult time, allowing the strong to become stronger. Focusing on these companies means we do not need to alter our x15 multiple on free cash flow generated. We do not adjust our multiple on macro fears: because these class of companies have suffered a number of macro issues over their many decades of existence. Their flexible management team often handle the event better than competitors, and they have the resources, balance sheet and cash flow to overcome it. Hence when we see x7 multiples as market continue to go down, we have a lens to generate the strength to buy. Of course macro environments can change our margin of safety: rather than 35% in a high inflationary environment it will be 45%: but if our approach suggests a buy, we must be ready to fight our stomachs, the biggest problem of an investor.

How we can lose money

There are several situations we try to avoid where we think the probability of loss is too high for us to find the return interesting, irrespective of how large it may be potentially. (1) High leverage, non consistent free cash flow and/or non liquid high quality assets combined (2) No revenue growth and declining margins, yet high FCF yield (3) Small FCF yield (overpaying) (4) Capex heavy cost base creating problems in an inflationary environment from high spending and high borrowing costs to fund the maintenance capex (5) Decreasing demand (i.e. product substitution) (6) Increasing supply (including changing market structure) (7) Quality of business model declining

Current update

The year has been dynamic. Legacy positions in non cyclical, high quality companies such as Sanofi, Glaxo, Roche, Kraft etc have now been sold. The current fad is high quality, non cyclical, hence the good prices we got several years ago are now fairly valued. Perhaps we should have held on to enjoy the full momentum of the movement of capital to this strategy as bond yields get so low all the best known and highest quality dividend payers are being bought by these clients. Everyone now seems to say low beta stocks outperform, hence everyone buys them so no performance is left for the future. All great ideas are at best temporarily killed when it becomes the consensus strategy. The consensus cannot beat the average (i.e. the market). We find cyclical companies are now considerably cheaper than non cyclical on average. Macro fears means few want to bet longer than 2013 estimates of EPS. Should these estimates drop, we find stock prices fall heavily. Recent victoms include BG, Burberry, Hewlett Packard etc. We find European companies are cheaper than US equivalents. We find large caps are well priced relative to small caps. We find deep value large caps are most easily found in finacials and technology in the USA. We continue to stay away from direct stocks in emerging markets for the moment.

The Success of Hedge Funds

It seems to me that many average hedge funds have found much interest for their products because investors focus more on reducing volatility, rather than generating returns. No doubt a consequence of losing money in 2000/02 and 2007/08. However, I could go long Apple and short the S&P 500, and over the last year I would have had less volatility than the S&P 500. However, would I have beat the S&P 500? For us, our view on investing is different. We would rather make a manageable number of investments (30 - 40 securities) and deploy capital when we think we have found the right company at the right price, rather than lose any potential alpha and time from finding good ideas by offsetting our good ideas in case they become bad (i.e. volatile) in the short term. We are willing to accept above average volatility to attempt to make above average returns because we do not associate risk with volatility. For us risk is the probability of losing our money.

The Business Cycle

Since we often discuss the idea of stable earning power over the business cycle, some have mentioned that the business cycle is non relevant concept at the moment due to interest rates continuously being kept low in many developed economies. An interesting point. But one I disagree with. Firstly, interest rates on paper are being kept constant. In relaity, the cost of borrowing for the same company over the last few years has not been constant. Secondly, GDP has varied over the same time period, as has inflation. Interest rates are just one component which can be used to indicate the business cycle. Many factors including investment, total activity, credit creation etc can be used to show the evolution of the business cycle. The business cycle evolves whether or not interest rates are manipulated on paper at being constant and extremely low. I would add that considering the current macro sitation for many developed economies, the business cycle is likely to be shorter and more volatile relative to the historic average. This will translate into the average position in the portfolios we manage being held for a shorter period of time than we would historically (or in the future).

Our valuation approach

Much emphasis is made in academic circles and from nieve investors (both extremes of the spectrum) on valuation methods used to determine if an investment security is attractively priced, or not... We have little to add on this debate. Many of our clients know we use a simple, transparent process that places greater emphasis on understanding the business, rather than crunching the numbers. We have often mentioned our process requires the mathematical skills of an average 12 year old pupil, and tries to incorporate the most powerful tool humankind has developed: applying trial and error. A simple method that reduces the number of assumptions used helps achieve this more successfully, in our opinion. Not all companies can be valued using the below mentioned process due to the assumptions we must make. All models are a detachment from reality, the best we can do is determine when the model is more useful, than dangerous... 1. For certain companies it is easier to determine their stable, normalised earning power. Such companies have a sustainable, competitive advantage that can render this number relevant throughout the business cycle. We attack this number by understanding the companies market structure, demand and supply dynamics for their products/services, the source of competitive advantage, their cost structure, business model, and management behaviour, operational efficiency and capital allocation. 2. We apply a x15 multiple to this stable earning power 3. We ask ourselves if this company can increase their free cash flow generation in the next 3 - 6 years. Hence, if it deserves to trade at a premium to its current stable earning power 4. We consider to purchase the companies stock if it trades at a greater than 35% discount to our estimate of its fair business value For companies whose products are continuosly changing, as may be there market structure, this method can be useless. Stable earning power is non existent in many technological companies as the products they would be selling in 5 years time are likely to be different. There customers may be the same, but the distribution model may have changed, hence how they interact with clients will have changed. Such businesses are outside our scope of competence as we are not close enough to such companies to feel comfortable with how their businesses may look in 10 years time. Since we do not have the resources that compete with hedge funds, mutual funds etc that have an army of analysts doing continuous inventory checks, talking to well placed friends in these industries, may even hire detectives to get data etc, we are not foolish enough to compete with their network and capital resources to determine how a businesses results may evolve on a quarter to quarter basis. Our aim is to pitch for those investments that have a recognisable stable earning power, the potential to grow their fair business value through investing their free cash flow generating satisfactory returns on capital whilst, not being in a capital intensive business or having an over leveraged balance sheet, whilst competing in a market that has a favourable market structure, stable demand for their products over the business cycle (an essential item) with a product that is hard to substitute via technological change, and a competitive advantage(s) that generate high barriers to entry to keep supply in check. This may seem demanding. However, several events may create this opportunity: A market crash Recession & other macro fears A publically recognised operational error (when history suggests this is an exception rather than the norm) A recent bad investment (leading to writedowns and lossing faith in management) Litigation Poor management (leading to temporary poor usage of free cash flow generated) An over leveraged balance sheet Buying/selling an asset A corporate event (i.e. rights offering, spin off) Changing business model An underperforming business in the company that is publically discussed Technology change (whose impact is not fully understoof yet) This is not an exhaustive list. But indicates certain catalysts that allow the stock to trade at a greater than 35% discount to our estimate of the companies fair business value.