Years of a beta-driven market rally have let some get away with forgetting about corporate fundamentals. But central banks are no longer buying corporate bonds en masse, liquidity is being withdrawn, and interest rates are beginning to rise. It seems that the markets will soon remind those who have forgotten the old lesson: fundamentals really do matter.
Our focus remains on businesses that we are happy to hold throughout the cycle. While calling the exact peak or trough of the cycle is near-impossible, a sense of where we are in the pendulum swing is important. We’re certainly much closer to the end than the beginning, and with quantitative easing being slowly but surely unwound, conditions will be unfavourable to businesses with weak fundamentals.
The chart below demonstrates that when complacency in the market fades away, like in the sell-off we saw at the end of last year, fundamentals matter. Companies with the weakest free cash flow, a key metric for us in credit analysis, were punished much more than those with strong fundamentals.
Chart: Consistent FCF weakness priced in a lot more from November
(Average z-spread of representative bonds for ten weakest and ten strongest ranked issuers in terms of five different FCF measures over several time periods, e.g. FCF/gross debt over five years and LTM FCF/EBITDA)
Source: Company Information, Bloomberg, BofA Merrill Lynch Global Research estimates
Last November, we participated in a new European high yield issue from a company called Intertrust. It’s a great example of the kind of business we like to lend to. They provide administrative services globally to other firms; for example, if a company wants to open a new corporate entity, Intertrust will set it up. Then they can provide ongoing services like legal and tax compliance, accounting etc. If the customer decides to close that entity, Intertrust closes it for them.
While 90% of Intertrust’s revenues are from recurring, non-discretionary services, the ability to open and close corporate entities for their customers helps create an incredibly non-cyclical business. In an economic upswing, businesses expand to operate in new jurisdictions or to undertake M&A, so they open new entities. In a downturn, they might close entities and consolidate their footprint. Intertrust can do these things for them. This creates a very stable revenue profile and a business that is able to weather cyclical storms – regardless of how their customers do.
Intertrust also has high margins, a sensible amount of leverage, very strong interest coverage metrics and significant free cash flow. Combine that with the attractive business profile and you can see why we like this business. It’s possible that rating agencies could upgrade them to investment grade in the future. Furthermore, this operating profile has been rewarded in the recently volatile market. In EUR terms, since new issue-to-date, Intertrust has outperformed the Bloomberg Barclays Pan-European High Yield index by 0.65%.
A key cornerstone of our philosophy is that you can’t day-trade carry. Kames focuses on fundamentally sound businesses that will persist through the cycle, and deliver to our clients a steady income stream with minimal capital losses. So we are cautiously optimistic for 2019, a year that will provide ample opportunity for us to demonstrate our ‘stock picking first’ approach and deliver positive outcomes for our investors.