Making Stuff is Hard

The most valuable lessons in high yield investing are usually delivered using a mix of shock, pain and humiliation. A rare exception to this occurred to me a few years ago; however I suspect more recently, similar lessons are visiting Tesla investors, albeit more painfully.

German company Heidelberger Druckmaschinen (HD) is a precision manufacturer of high quality printing presses. In late 2011 it hit a rocky patch where revenues were down, and the high yield market began to seriously worry about its imminent collapse. The timing was lousy. A European high yield market recovering from the Eurozone crisis was in no mood to tolerate any missteps by a CCC rated issuer, and its bonds were duly hammered.

However, taking a closer look, a few things stood out. For one, its lag was entirely predictable as historically orders ALWAYS dipped before the major industry showcase (‘drupa’) which was held every four years, and 2012 was the next one. In addition, there was a view that HD was at the wrong end of the terminal decline of newspapers (what with the internet n’ all), and to make matters worse, Chinese competition was about to take what was left. This nuanced assessment played well to the ‘gut-feel’ view of the world favoured by a certain type of investor. Except it was wrong. HD had actually disposed of its newsprint business many years prior, instead focussing on the growing need for high quality consumer packaging. Chinese threat? Sure, the lower end of the market had been subject to it, however they seemed to struggle to replicate the most advanced presses. Thematic investing is great, but it’s even better when accompanied by some due diligence.

So how does this relate to Tesla? Making ‘stuff’ is hard. The beta version and constant update model of the software industry works well, as their products can be costlessly tweaked after sale. Not unreasonably, software companies are given high valuations based on this high operating leverage. Applying this to the auto industry is more problematic. Tesla is running into problems scaling up production due to the presence of bottlenecks, labour issues, and even difficulty in welding. If this sounds all terribly 19th century, I apologise but it still matters – it is very difficult to sell a car you can’t make. All of this would be manageable except Tesla’s valuation allows for nothing but a non-stop journey to global domination; not a decades-long on-the-job training programme.

Upon visiting HD’s factory I was struck by the huge amount of accumulated skill, knowledge and expertise amongst its many thousands of employees. Not only ‘had’ it accumulated, it was ‘still’ accumulating. I saw first-hand the factory floor work groups that measure absolutely everything and are constantly refining their process to save 12-mins here, reduce 400g of scrap there. To scale up any advanced manufacturing takes this kind of process which simply cannot be replicated – nor should it be dismissed – overnight. Following the visit I invested in HD, confident that it had a significant embedded competitive advantage and that its ability to earn economic profits – and pay our coupon – was intact. I won’t bore you with the details, but it ended very well for the company and the investors who backed it at the time.

Electric cars are certainly the future, but Tesla’s valuation reminds me that the market can sometimes underappreciate the challenges of operating in the physical world, at scale. This can be a great opportunity, as in the case of HD, or it can lead to risks being under-priced by financial markets, as with Tesla’s recent swoon. It’s our job to recognise these factors and it remains a core focus of the way we do things at Kames.

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Paying the price for excitement

A common investment mantra is that high risk equals high returns. Yet, if we look back at history, we see so often this is not the case, for the simple reason that excitement is fundamentally overvalued.

We can of course in hindsight look back on bubbles throughout history and wonder why on earth anyone was willing to get involved. Take for example the Dutch Tulip Bulb Market Bubble in the early 1600s, when speculation and social status drove the value of tulips to extreme levels – the rarest tulips up to 6 times average salaries at the height of the market!

Or indeed the Great Baseball Card Bubble of the 1980s, where collecting went from a niche hobby to big business, as irrational exuberance drove prices to absurd levels.

Rising values created demand in both of these examples but before long, prices reversed as exuberance was swapped for panic selling as the bubble popped.

Yet we see market experts also overpaying for excitement. Whether it was mortgage-backed securities in ’07 or technology stocks in ‘99, it seems that the market easily forgets irrational exuberance from years gone by. Today we have the crypto-currency boom which is drawing investors in, on the hope you are smart enough to ride the boom and get out before the bust, or indeed that ‘this time it’s different.’

As high yield investors, we do not believe that investing is as simple as high risk equals high return – we are firm in our belief that excitement is so often overvalued. Rather, we believe that while quality is boring, boring is fundamentally undervalued. For that simple reason, we enjoy the not-so-secret pleasure of buying undervalued, ‘boring’ bonds.

This means that when the bubbles pop, we are left holding a whole lot more than those investors gripping on to their bit of cardboard with a picture of a baseball player on it.

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A stock picker’s take on striking gold

Markets are in good shape, and as expected, the new-issue market cranked back into gear last month – an opportunity to find good quality cash flows for our portfolios.

What can be astonishing (and pleasing) in this market is the difference in relative valuations between companies in a sector. Take, for example Equinix versus SoftBank.

Internet storage provider Equinix came to the market last month with a euro new issue. While we are typically cautious about the fast-changing nature of tech companies, we see structural demand for server space and connectivity between different organisations and Equinix benefits from this as a market-leading data centre operator.

As the old saying goes, we would rather sell shovels to prospectors during a gold rush rather than join in the prospecting ourselves – and these bonds offer cash flows, regardless of which online business gains or loses.

Equinix also has a very well-diversified client list (the largest customer is under 3% of revenues) across very different industries and can host its customers’ servers in multiple locations. This increases the stickiness of its customer base.

This high quality story was offered at a spread of almost 3%, which we think compares very favourably against better-known SoftBank. That is despite the lack of fundamental certainty over SoftBank’s long-term cash flows, as it spends huge amounts on highly uncertain early-stage tech investments – in effect trying to join the prospecting herd.

It seems that the yield penalty for choosing quality over quantity is at historic lows, in a market that is more concerned with all-in yield than differentiating between company fundamentals. This is the stock picker’s idea of striking gold.

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Not so (Pet)Smart

Revenues mean nothing if the company in question loses money with every sale made. While this may seem obvious, the high yield market has been reminded of this in a painful way over the last few months.

The company in question is PetSmart – a large American pet store operator. It recently borrowed a grand total of $2bn in order to purchase Chewy, an online pet retailer. Theoretically buying a digital retailer to capture customers moving online makes sense. But PetSmart’s acquisition of Chewy is negative for one very important reason – once all the operating costs are factored in, Chewy doesn’t actually make any money from the sales it generates.

While PetSmart’s physical stores have very healthy profit margins, Chewy’s are negative. In effect what PetSmart is doing in buying Chewy is gaining loss-making online sales as a way to offset the loss of profitable offline sales. While there is a chance that the business can cut costs and restore some of that ever-decreasing pie of profit, the odds are stacked against them.

In contrast one business that we can get excited about is the 100%-online grocer Ocado. Whereas PetSmart’s online acquisition is loss-making, Ocado’s online grocery business is highly profitable, with better margins than all of the listed offline grocers and a very strong structural growth story. On top of its own online success, the business is well-positioned to benefit from other supermarkets attempting to move online through its platform-provision business – which effectively allows other retailers to establish an online business without the huge operational headache that starting from scratch would entail. Morrisons are currently using Ocado for this, which has been successful for both companies.

Overall this is a story of fundamentals. One company is scratching around trying desperately to defend a crumbling offline retail empire by loading up on more debt and buying a loss-making online retailer, while another company has a steady and sensible long-term plan to expand its already highly profitable business even further.

When these two companies came to the debt market earlier this year, the choice was relatively easy for us. As shown below, the subsequent performance has borne out our thesis.

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Boring is good

In our experience, some of the best high yield bonds reflect those of us who invest in them; low-key, reliable, and often profoundly boring. The ‘monotony’ of a business that reliably posts juicy but safe cash flows? Sign me up! Some of our fondest positions are in glamorous industries such as cardboard boxes, funeral care, tin can making, and the gel-like casings your headache tablets come in. Glitz and a good story is more often found in the equity market, and that’s the way we like it.

A test to this rule came recently when US electric car maker, Tesla, issued its maiden, conventional high yield bond. Tesla is unquestionably an impressive company. Their cars are technological marvels that outperform their peers on almost every metric, and to be sure, our friends in the equity market have certainly not been shy in reflecting such wonder. Tesla’s current share price implies an enterprise value (that is the total value of Tesla’s debt and equity) of some 96x its Earnings Before Interest, Tax, Depreciation and Amortisation.EBITDA is the HY market’s imperfect (but convenient) shorthand for cash flow, and illustrates the cash earnings a firm produces from its assets, stripped of as much accounting chicanery as possible. Now, 96x is a lot. A cynic might suggest that all the good things that have ever or could ever happen to this company are currently ‘in the price’.

By way of reference, BMW is a reasonably well-known car maker that has both a very strong position in conventional premium cars, as well as making significant inroads into electrification of cars via the impressive i3 and i8 models. We would be the first to admit that wherever the auto industry is going, Tesla will be part of it, but so too will BMW. In the meantime, they have a significant and highly profitable conventional car business, as well as decades of embedded know-how in the sector and a cash flow profile that can support significant investment in research and development.

Conveniently, BMW ($61 billion) and Tesla ($60.7b) have almost identical equity market valuations. However in terms of cash flow and scale, they are worlds apart. Last year Tesla produced just over 76,000 vehicles to BMW’s 2,360,000; a factor of some 31:1. Cash flow is where the real difference lies however. BMW’s cash flow is such that the company is valued by the market at only 7.5x the EBITDA it can produce today versus the 96x at Tesla. Clearly, the market believes Tesla ‘should’ grow significantly in the future.

Given Tesla’s ambition currently far exceeds its cash flow, it has turned to the high yield market to plug the gap between what it needs to spend to grow into its valuation, and what it can generate currently. For us, this is the antithesis of what a high yield bond is for. By investing in Tesla bonds you are providing growth equity capital with all the potential downside that entails, but with the upside profile of, well, a bond. Regardless of our admiration for Tesla, we don’t like that risk reward profile and we declined to buy the new deal. We prefer businesses that ‘do’ rather than ‘should’ produce the cash flow we need to pay our coupons and principal back. In the good times it can be easy to have one’s head turned by new and dynamic companies; however at Kames we don’t believe that our clients’ interests are served by such an approach, when indeed the opposite is usually far more rewarding for bondholders. If that makes our presentations a little less electric then so be it.

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Duration risk – a valid concern, but not one of mine

Mark Benbow warns of the growing duration risk in the bond market and how clients should be mindful of facing more risk by default, rather than design

One of the biggest concerns that bond investors face right now is duration risk – the risk that a rise in interest rates creates a fall in bond prices. Considering that the duration of bond benchmarks has been rising for the past 20 years, investors are wise to be mindful of this risk.

Source: Bloomberg as at 30 June 2017

We’ve experienced a long-term trend of falling bond yields, thanks in part to the extremely accommodative monetary policy implemented globally by central banks. As yields have continued to fall, the behaviour of debt issuers has started to change. Debt issuers are taking advantage of this low-rate environment to lock in an all-time low cost of debt for as long as possible, by issuing long-dated bonds. Just last month Argentina issued a bond with a maturity of 100 years, just three years after its last default! Is 8% a tempting enough income to lend to Argentina for 100 years, considering the five defaults it has faced in the last century alone?

The merits of individual issuers aside, the importance of this change in behaviour is that as issuers borrow for longer periods, the level of duration in bond benchmarks rises.

This is at the same time as lower yields are forcing investors into lower-rated or longer-dated bonds to generate income in their portfolios. And certainly the demand for yield in the market is proving insatiable at this stage of the cycle. Factors such as rising pension deficits and the need for retirement liability matching have driven the demand for longer-dated bonds as yields continue to fall.

This is a noteworthy combination: ever-lower yields means more supply (and greater demand) of longer-dated bonds, but for investors’ bond portfolios it can mean more duration risk for less return potential – this is reflected in the chart below.


Source: Bloomberg as at 30 June 2017

Index-based investors in particular face the risk of following this trend and being forced into longer duration than desired in response to the changing characteristics of fixed income markets. Indeed many fixed income portfolio managers are being dragged longer in duration as their underlying benchmark duration has increased, therefore exposing the end investor to additional interest rate risk by default rather than design.

At Kames we do not simply chase benchmark duration as we do not believe debt indices are the basis for a successful investment. In our experience, concentrating our efforts on identifying alpha-generating ideas is the best starting point for building portfolios – not what an index provider tells us.

As a high yield fund manager I take additional comfort in the different characteristics offered by the high yield asset class. Unlike in other markets, duration has been falling over the last 20 years. This offers us significant opportunities to invest in shorter-dated, higher yielding assets and build concentrated, high conviction portfolios to the benefit of our clients.

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Kames Keeps up with the Kardashians

Reality television production might not immediately appear to be the strongest credit proposition – but appearances can be deceptive. A new bond issue from Banijay Group (responsible for many well-known hits including ‘Keeping up with the Kardashians’ and ‘Location, Location, Location’) actually exemplifies a number of the key business model characteristics that we’re looking for when selecting bonds for our high yield portfolios.

The business model characteristics in question are: diversity, predictability and cash-generation.

Banijay has diversity on a number of measures: by television genre, by television show, by geography and by customer. The value of this from a credit perspective is that problems in any one area are insufficient on their own to undermine the business as a whole.

On predictability, much of Banijay’s revenue is generated from enduring hit shows that run for multiple seasons, meaning that the bulk of this year’s budget is already under contract, and we can be highly confident that the company will continue to deliver in the years to come as big hits are re-commissioned.

Finally, it is cash generative because no large upfront capital investment is required – Banijay pitches to the television networks using scripts, storyboards, trailers and occasionally a full pilot episode. The full cost of producing a television series is not incurred until a television network has committed to broadcasting the show. In an environment where the entry of Netflix and Amazon Prime is forcing the traditional television networks to increase their content spending, we believe Banijay is well-positioned to benefit from this growing demand.

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Holmes moans about loans

As a high yield fund manager it has been interesting to watch leveraged loans become something of an investor darling this year – almost $13bn has flowed into US loans over the year to date. Investors have sought out loans as a place to hide from a Fed that is raising interest rates, and with the perception that they are a “safer” income provider than conventional bonds.

But is this logic sound? How do loans perform in hiking cycles?

US leveraged loans underperformed US high yield by almost 2% per annum over the 2004-2006 hiking cycle. In a hiking cycle, high yield bonds tend to perform well due to their positive exposure to economic growth, while loans offer far less opportunity for capital appreciation.

And how much safer are leveraged loans? The peak-to-trough drawdown was 95% of that seen in high yield during the financial crisis, while high yield has produced 123% more total return over the last 15 years. In other words, investment in leveraged loans over the past decade and a half has resulted in almost as much drawdown while sacrificing the large profits that could have been made by a long-term investment in high yield (a topic my colleague David Ennett has discussed previously http://bondtalk.co.uk/high-yield/carry-me-home-the-source-of-high-yield-returns/).

 


Source: Bloomberg as at 31 May 2017

Leveraged loans are also more exposed to problem sectors than high yield. Retailers that are mortally threatened by Amazon make up more of the investable universe in loans than in the high yield universe. Leveraged loans are getting riskier too – in Europe the average secured indebtedness for new loans is almost 70% higher than at the end of 2010. In contrast, European high yield leverage has actually fallen over this period.

From my perspective a well-managed high yield portfolio provides a much better way to generate strong sustainable income versus alternatives such as loans. By investing with high yield teams focused on finding defensively-positioned companies with strong business models, attractive risk-adjusted total returns can be generated. Whether the same can be said for loans remains to be seen…

 

 

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Carry me home – the source of high yield returns

To say the past decade has been an eventful one for the high yield market is putting it somewhat mildly. The first half of 2007 was a golden time: markets were in rude health making pre-crisis highs, politicians were for the most part sane, competent, normal human beings, and a eurozone crisis involved accidentally skiing to a Swiss après-ski bar. The following decade has not been quite as smooth, enduring as we have the global financial (2008/9), eurozone (2011), and energy and commodity crises (2014/15) of recent years.

Yes – those were happy days indeed, but with the benefit of hindsight, a seemingly terrible time to buy any risk asset. Within high yield, valuations in 2007 were at their most extreme with the additional yield on offer from high yield bonds (versus similar maturity government bonds) at its all-time low of 2.3%, versus around 4% today.

Taking a closer look at how the asset class has actually performed from this ‘terrible’ entry point illustrates much about the source of returns within high yield.

Global High Yield: 10-year returns

Source: BoAML Global High Yield Index, Bloomberg.  USD. 31/03/2007 to 31/03/2017.

A few things stand out. First is the impressive total return of 110%. To be sure, there were some hugely volatile periods, none more so than the dramatic – albeit brief – near 40% drawdown in early 2009, as well as of course 2011 and 2015. These periods can have a big impact on the short-term price performance of the asset class. But in the context of long-term total returns, we can see that price volatility is dwarfed by one, compelling source of return – carry.

Of the 110% you have made in high yield over the past decade, some 112% of it came from income, and recall that this was from a ‘terrible’ time to buy!

The key to exploiting the carry in high yield is to stay invested – sorry, no carry for day traders – and adopt an active approach to selecting the companies you wish to lend to. Remember, high yield is at its core a mechanism for transforming the real-world cash flows of cash generative companies into coupon flow for investors who provide debt financing. Given we have long known this about the high yield market, it is why we emphasise these very cash flows when selecting companies to invest in.

Perhaps it is asking too much for financial journalists to lead with ‘Massive Coupon Income Hits HY Market’; but we do think investors should keep this in mind when they next read about the ever-present impending doom of the high yield market.

Netflix launches Billions

OK, so “Billions” is actually produced by Netflix competitor Showtime, owned by CBS and broadcast in the UK by Sky Atlantic. However, yesterday, Netflix issued its debut bond into the Euro market with €1bn of 3.625% 10 year bonds using its B1 rating.  What is unusual with Netflix is its vast market capitalisation at $63bn is often associated with materially better rated companies.

Netflix being one of the FANGs (The new tech stock of Facebook – Amazon – Netflix – Google) is still in build-out phase as it aggressively invests overseas to capture market share.  Whilst subscription revenues are evenly divided between the US and the rest of the world, US profits subsidise overseas expansion with top line growth of up to 30% – which is a key ingredient to its huge market capitalisation.  The pricing was fairly aggressive for a B1 issuer, but the halo effect of being a FANG means the deal isn’t breaking bad as it is around ¾ point higher today. The Crown in yesterday’s European high yield market.

The Sleepy High Yield New Issue Market

  • The chart shows the proportion of new debt raised in the high yield market that is used to refinance existing borrowings, rather than for more speculative purposes such as capital projects, mergers & acquisitions, and returns to shareholders.
  • Refinancing is the safest kind of high yield bond transaction for an investor to participate in because the company’s operational and financial situation is unchanged by the deal – in all the other cases operational and/or financial fundamental risk is increased as a direct result of the transaction.
  • We can see that as a proportion of total new issuance in the US high yield bond market, refinancing transactions reached over 60% of total issuance in the twelve months to March 2017, the highest level since 2002.
  • We believe that this, combined with the steady upward drift in the average ratings quality of the market, is suggestive that underlying fundamental conditions are much more robust than at many times in the past.

  • The riskiest kind of high yield transactions are dividend (or share buyback) deals. In this case the money raised does not do anything productive – it goes straight out of the door to shareholders. The company is then left with a larger debt burden to service.
  • We can see that the dividend deal boom of 2013 and 2014 has now substantially faded.
  • This is a lead indicator of risk in the high yield bond market and is suggestive that issuers are becoming more conservative in their financing decisions.

UK high yield retail – are you being served?

UK retailers are facing significant pressures over the coming years – from the rise in business rates, higher supplier costs due to weaker sterling, and the new national living wage; to the expected continued growth of online retailers like Amazon and Asos. Given all that is facing these companies anyway, investing in the more indebted end of the sector seems to us a costly mistake at present. We would argue that retailers in general tend to have high fixed costs and variable top lines, so adding a large fixed debt service cost generally doesn’t stack up. Interestingly though, the market doesn’t seem to agree with what we would regard as common sense, as the median UK high yield retailer has debt worth almost six times their earnings – significantly above the European high yield average of just over four times.

Despite the fact that UK high yield retailers are facing huge operational headwinds alongside significantly more indebtedness than the wider high yield universe, the bonds on offer do not trade at a discount – in fact when we checked on Friday the median UK high yield retail bond traded with exactly the same spread over government bonds as the wider European high yield market!

In short the bonds of UK high yield retailers offer significant operational risks; large levels of indebtedness; and absolutely no discount to the wider market. We’re quite happy to let the benchmarked funds and ETFs play away in these, and think that our clients are getting far better service by looking at other more attractive parts of the high yield market.

The high yield stopped clock reporter mistakes indigestion for something more serious

A certain newspaper that has pink coloured pages seems to have an editorial stance that hates high yield.  The sub investment grade market, or even speculative grade bonds, are always referred to in a derogatory way as “junk”.  The proverbial stopped clock does tell the correct time twice a day or so whenever high yield has a dip there follows rapid editorial copy.  The focus today is on the ETF outflows last week; the $3.1bn outflow coupled with a heavy week for supply ($18bn) has led to an increase in yields in the US market of 0.50%.  Decomposing this, about 40% comes from the increase in the underlying government bond market and 60% from corporate bond spreads widening.

However, one should not overstate the long term impact of high yield ETF flows – they make a lot of noise and are a rapid asset allocators’ tool of choice, but they only impact the flow in the market in the short term and represent a very small proportion of the long term stock.  What usually happens is the most liquid bonds, which the ETFs are exposed to, sell off and the smaller less liquid bond issues’ prices remain static.  We view these distortions as short term in nature and use them to top up positions in our favoured credits or do relative value switches.  I think last week was merely a case of some much needed market indigestion and not a harbinger of anything more serious.