Guess what stock this is?

Sep 16, 2019 | About Bonds, Current Investments, Economic Commentary, Investment Philosophy, Investment Soapbox

Our belief resides in the fact that economies grow through productive means – not monetary stimulus.

Imagine if you had this in your portfolio one year ago – you would be up 100%!

Wish you had bought it back in 2018, right?  Well, it isn’t a stock – it is a bond.  And it illustrates what is wrong with our global financial system.  I would have used ‘capital markets’ but didn’t want to affiliate the word ‘capital’ aka true capitalism with today’s market place that determines the price of money since the system of setting the price for money today is the furthest thing from a free market.  Today’s marketplace unfortunately is controlled and manipulated by a handful of central banks around the world.  Within the walls of these institutions likely are bright people but it might be that when separated from a text book or classroom, they struggle with common sense.

Maybe we are missing something – but to us the reality today is that our monetary system is out of control.  If monetary policy of forcing rates to 1 or 2% didn’t create the growth they were looking for, what makes them think that zero (or negative) will.  Our belief resides in the fact that economies grow through productive means – not monetary stimulus.  Maybe stimulus encourages investment in productive assets – supporting future economic growth – but it seems that today’s central planners believe monetary stimulus equals growth – which isn’t true.  In fact – unintended consequence are bubbles and the misallocation of capital.

What has the past 10 years of extreme monetary policy (cheap money) generated? 

First and foremost – it generated $16 TRILLION of ‘assets’ (we would call liabilities) that no one who values their capital should touch in a million years…

Here is a chart showing the market value of negative yielding debt around the world.   Five years ago – it was about zero.  Today – $16 TRILLION.  And global GDP has grown by $10 trillion over that time frame.    Not a good return in our opinion and creates a larger problem of how to get out of this addiction.  Our thoughts were summed up well in this Forbes article.

Second – Unicorns (private companies valued over $1 billion).

When money in your pocket costs you to hold it – then you are incented to put it ‘to work’.  Unfortunately, cheap money has no value and results in malinvestment.  Similar to the late 90s – when companies focused on ‘clicks’ – it seems today it is more important to focus on revenue growth than profit growth – which to us is illogical.  However, GS (Bloomberg article) tells its clients as much – focus on revenue growth and not profits – now – their incentive is about 4.4% in fees per IPO – with having done close to $6B in IPOs – they have earned close to $262 million selling new IPOs just this year alone.  So – they made $262mm selling companies they are telling their clients to buy – maybe they should roll that $262mm of fees into all those money losing companies for 10 years – since it is such a good deal. (Bloomberg League Table – 9/4/2019)

WeWork – IPO announced.  The last valuation of WeWork was done at a $50 billion valuation by SoftBank.  Today IPO price talk of WeWork is $10-15 billion.  How does the value of an asset decline by $35 or $40 billion in such a short time frame?  Well some examples that come to mind are Enron and WorldCom in early 2000s – but these were both frauds.  Others would be CSCO, MSFT and many other Tech companies in FY00 – but these are all in a bubble.  Well – today you can include WeWork, UBER, WORK, LYFT and many other multi-billion companies that don’t make money, may never make money, but the reason to buy it was growth at any cost.  Well, once the market wants a return on its capital, the downside is treacherous (remember when people paid for ‘eyeballs’ and ‘clicks’ in late 90s).  But how should one determine a return on capital or how to assess what their returns should be?  It comes back to our philosophy of knowing what you own.  This philosophy leads us to our final symptom of crazy monetary policy – the rapid growth of passive investing.

Third – Passive Investing –  Talk about being as far away from knowing what you own. 

If you want a market return – that is fine but just don’t pay anyone for it. Go do it yourself and pay about 5 bps in low cost ETFs.  However, if you actually want to know what you own – like where you put your money, how much is it earning and what is the thesis around why the value of the asset you own is supposed to grow over time – then passive investing is one of the worst ideas ever.  It reminds us of all the water cooler conversations in the late 90s where the topic was someone’s great stocking picking abilities – don’t confuse a bull market with investment skills – the results can be devastating to your capital.

Go capture Beta (passive investing) just don’t pay for it. If you want a portfolio constructed from the bottom up – then pay for it.  But in doing so – know what you are paying for and if you look at your statement and it consists of 8-12 funds or a hodgepodge of stocks, then you might want to think long and hard about what you are paying for – you may have just paid for something that could have been free.

 

 

 

 

 

The ABCCC’s of Bond Investing

Mar 5, 2018 | About Bonds

A bond’s total return comes from a number of factors, but the three largest are Coupon, Credit and Curve.  If you can remember these, you can help your chance of buying the right bond at the right time.

Coupon –

Coupon is the rate that the borrower agrees to pay you, and historically, it is the largest contributor to total return (See graph on Left).  The coupon on a bond is determined at the time the loan is originated.  Most bonds are issued with a fixed coupon.  This coupon defines the cash flow you receive over the life of the loan.  Since this coupon is set at the time the company issues the bond, the coupon reflects the credit worthiness of the company when it issued the bond.  Obviously, credit worthiness of companies improves or deteriorates over time – but the coupon doesn’t change (in some rare instances bonds have coupon steps where the coupon increases based on a rating agency’s rating, but these are few and far between).  Therefore, the way the market adjusts for any changes in a companies’ credit worthiness is through the price.  If a company was very credit worthy at the time of issuance but has declined in credit worthiness, an investor probably will expect a higher return (lower price) for that stream of future coupon payments.

Credit –

Credit refers to the ability to repay a loan.  Rating agencies have a rating system where the highest (most credit worthy) companies are triple A (Aaa  for Moodys and AAA for S&P & Fitch) and moves lower to AA, then A then BBB.  These ratings represent companies that have strong metrics in categories such as their business position, operating margins, leverage, management financial policy and whatnot.   If a company has a very strong ability to repay you, you would expect them to borrow at a lower rate versus a credit where repayment risk is higher.  The most credit worthy companies are grouped in a category called ‘investment grade’.  Less credit worthy borrowers are in a category called ‘high yield’.  High yield borrowers might have strong metrics in some categories, but they may have less credit worthy metrics in others.

 

This ‘C’ is the most important C of the bunch – since it doesn’t matter what your coupon is unless you have confidence your principal is being repaid.  The last thing you want is to generate 4% – 5% in income for 2 or 3 years – and then lose 50% of your capital.

Curve –

Curve refers to the length of maturity of the bond.  The treasury curve is usually positively sloped – which means that a borrower can expect to pay a higher rate if they want to borrow your money for a longer period of time.  The longer the maturity, the more time there is for something to go wrong with the company.  Therefore, when lending money for a long period, we prefer either to ‘move up in credit’ (which is lend to companies that have a bigger safety margin to their risk profile) or move down in price (find bonds that trade at steep discounts [see below] that mitigate the risk of principal loss but provide some upside opportunity).

 

This C is out of your control, and as treasury rates move (‘yield curve’), the price off the bond will move up and down.  However, our philosophy in Core Fixed Income is to buy bonds and hold until maturity. Therefore, we are less concerned with this factor as long as we get the right coupon and right credit.

What does all this mean?  For Ballast, it means a couple things:

  • Targeting Yield – We can control the yield on a portfolio by a number levers – a couple of which are ‘down in credit’ (1) lend to more risky companies or (2) ‘go out on the curve’ and buy a 10 year bond versus a 5 year bond. In either case, the yield is higher.  However, since at Ballast we control exactly what bonds go into a portfolio, we can solve for a number of different cash flow requirements.  Unlike a bond fund (which tends to own all the bonds in an index – or at a minimum tries to mirror that index), it ends up owning a lot of bonds that as a lender you likely would not have chosen.  For example, we had one client who transferred in a bond fund, and the fund owned a negative yielding bond.  We are not big believers in paying others to hold your money – regardless of what academic literature might say.
  • Finding Opportunity – Since credit quality changes over time AND a rating agencies’ ratings affect not only the price of bonds (borrower) but also the economics of those who own them (regulated investors like banks, insurance and index managers) – the price sometimes reflects other factors besides the credit worthiness of the issuer. For example, if a bond gets downgraded from investment grade (IG) to high yield (HY), it likely means that the corporation has become riskier due to some fundamental reason.  However, it also means that accounts that owned the bond when it was IG could be forced to liquidate, or they are charged more to hold that bond (risk based capital).  In both scenarios, you have what we call ‘forced selling’.  We believe – and research supports this belief – that forced selling presents opportunities.  Therefore, we constantly scour the capital markets for this type of situation. See Study here.

The three C’s of bonds are simple things to think about, but below the surface there is quite a bit that goes on. However, that is why finding an investment advisor with experience in the capital markets is valuable, and it can make a very big difference on one’s portfolio.

Contact us to find out more

Bond Bubble?

Dec 6, 2017 | About Bonds

Given we are close to the anniversary date of Alan Greenspan’s famous ‘irrational exuberance’ quote on Dec 5, 1996 – we thought we would discuss the topic which has been brought up by many clients over the past few months,  which is  “Are we in a bond bubble?”.  Back in 1996, Greenspan addressed what was happening in equity markets, and despite his inclination that equities were ahead of themselves, it was another 4 years before the bubble inflated to an unsustainable valuation and popped.  Although he was intellectually correct, his timing was a bit off.

When we think about bubbles, a couple things immediately come to mind –  (1) What is a bubble? and (2) How does Ballast manage portfolios to mitigate damage should there be one?

(1) What is a bubble? It seems a bubble forms when the price of an asset far exceeds the value of that asset.  Value of an asset is anchored in cash flow or economic purpose in the case of things that may not have distributable cash flow (think gold, insurance, house, growth companies).  When the price of that asset extends beyond the economic value, economic gravity kicks in and asset price deflation takes hold.  However, as in Greenspan’s case, one can be intellectually accurate, BUT the market, as a voting proxy (not valuation proxy), can disagree for a fairly long time.

 

How do bubbles form?  Well, we have read many people’s writing on what they believe to be the answer to this question, and it tends to depend on the circumstances. In the securities markets (equities), the first reason might be founded in irrational exuberance (Irrational Exuberance by Robert Shiller). In new discoveries (South Sea) or Tulips, it might be the fear of missing out – a.k.a madness of crowds (Extraordinary Popular Delusions & Madness of Crowds – Mackay). Finally, in rates/currencies, it might be government or policy errors (This Time is Different – Rogoff/ Why Nations Fail –  Acemoglu).

 

(2) How does Ballast manage portfolios to mitigate damage should there be one? Whatever the reason, it seems that one should only be concerned about being in a bubble if one doesn’t have a very firm fundamental economic reason and understanding of what he/she owns.  If the value of what one owns serves a purpose and is not a function of what someone else is willing to pay – then to some degree, one should hope there is a bubble – since all popping bubbles bring investment opportunities.

At the end of the day, it would be silly to try and predict the timing of a bubble (See Greenspan), but it does pay to be vigilant and prudent when prices seem to deviate too far away from economic gravity.**  We are indifferent – but hopeful – for lower prices for a couple reasons:  First, lower prices are a great deal for investors (remember those with capital want more value at a lower price).  Second, we are highly confident in the purpose and value of what we currently own at the prices we paid (TDW write-up) – [Sample question – if NFLX went down 50% in value tomorrow, how many people would confidently hold on, knowing it is worth what they paid for it?  Our guess is not many (see NFLX write up). Third, since our process is similar to an institutional investment department, each day we are active in the markets and know that we will have access to the myriad capital opportunities available in the aftermath of a bubble.

Therefore, whether we are in a bond, equity, dollar or bitcoin bubble, remains to be seen.  However, we are confident that as opportunities arise from deflating asset classes (think distress RMBS in spring of 2009, energy/basic bonds in 2015/2016) or happen one at a time (EFX, TEVA, TDW write-up), we are paying attention.

** For those who have more patience and some inquisitiveness, see below–

 

 

 

As it pertains to bond or equity bubbles – let’s look at some interesting data:

The S&P 500 – if truly an indicator of equity valuation – should be driven by earnings.  You hear Wall Street talking “heads-on” TV speak about earnings growth ad nauseum.  Here is an interesting chart –S&P 500 quarterly earnings plotted against the price of the S&P 500.

Bloomberg

The orange line is S&P 500.  The white line is the S&P 500 quarterly earnings as reported.    What is interesting is that it appears that in aggregate – the companies in the S&P 500 –  are not earning any more for their shareholders this year than they were in 2014.  So, what could be different?  Below is another chart where we added one more data set.

Bloomberg

This chart includes monetary stimulus as represented by the ECB and Federal Reserve banks’ balance sheets. One interesting observation to note is that the bold orange line nicely overlays the S&P 500 price since 2015.  We question what happens when that bold orange line goes from the $8.5 trillion (today) back to the less than $2 trillion (prior to the global financial crisis).  Given that we don’t know, we would much rather own stuff that we do know.

Contact us to find out more