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.

 

 

 

 

 

We Buy Assets Not Stories

Jun 19, 2019 | Current Investments, Investment Philosophy, Investment Soapbox

Ever watch a movie that had a bad ending?  

One negative aspect of watching a movie with a bad ending is that you spent a couple precious hours of time that you can’t recoup.  Investing in stories with bad endings causes damage similar to that of lost time – in your case – you lose capital – and if you are working, you need to then spend more hours working to recoup the capital lost.  This is a simple analogy that illustrates why our investment philosophy is to prefer buying assets and not stories with bad endings.

How does Ballast define a story versus an asset? An asset is something that most of the time has cash flow or a clear path to terminal cash flow.  A story tends to have negligible or negative cash flow with the promise that a happy ending provides a cash windfall.  Given these definitions – it becomes clear why we don’t spend much time in the public equities market looking for ideas – most of the time we find stories – whose ending is unclear and uncontrollable.

Lending to an established business with a stated return – that is an asset.  Investing in a crazy uncle’s idea on how to revolutionize the automobile industry – that is a story.

Let’s investigate with some concrete examples since at Ballast our philosophy is to openly share ideas.  Side note – If you have to invest in something to find out what is in it – that is like paying to watch a movie with a bad ending and not even getting to see the movie trailer.  By definition a bad idea (whether it turns out well or not!).

Two assets we have recently acquired for qualified clients:  

  1. A dairy loan in Idaho where we lent money with a projected IRR of 18% over 2 years.  Here we are secured with collateral that exceeds the value of our note, receive monthly interest and have line of sight to a terminal value.
  2. Another was a trade based on the Hong Kong Dollar – this is as much a story as an asset – but the beauty is that you get a full refund (note matures) in the scenario the movie has a bad ending.  What more could you ask for? Here you have a note with an imbedded currency option from a high quality bank – in the end, receive par plus a multiple on the favorable performance of the currency. Watch a movie for free – if it has a good ending, you could make 3 or 4x your money, but if it has a bad ending, the movie theatre refunds your money.

What are some bad ending movies Ballast has watched but not participated in? Clearly one “movie” we love to watch is Tesla – A Tall Tale.  They don’t pay dividends and the business consumes cash – so clearly more of a story.  What will be the ending? We don’t know but even with a good ending there is no guarantee the price of admission was worth it. Over the past two years they have been up 50% as well as down 50% on your story (Bloomberg) with not certainty of the ending.

Ballast buys assets not stories.  Sure there are always good stories – but stories are where capital most likely goes to get destroyed. Assets are what builds capital. Most investments have both an asset and a story component – and the key is making sure that the asset doesn’t get destroyed in an event the story has a bad ending.

Math and The Capital Markets

Apr 15, 2019 | Current Investments, Economic Commentary

You may not realize it, but because of how index investing works, you may have some negative yielding bonds in funds you own.

Despite soundbites from Washington DC and the Fed about how great things are – this blog entry attempts to frame the capital markets with a different perspective. Let’s look at some facts and figures that support our view –  under the surface, the capital markets are not what they appear to be.

To start, we provide this definition: Capital markets is defined as the intersection where those with capital (buy side) and those seeking capital (sell side) intersect.  On the surface of that intersection things appear good.

Our thesis: Things are good in large part because the Fed (and other central banks) have artificially kept the price of money low – which makes the job of those with capital treacherous.

Recently the Fed changed their stance on monetary policy, reminding us of an old adage – when it comes to other people making recommendations about your money –  do as they do, not as they say. Despite calming words from the Fed, their actions speak louder than words. The past 10 years of global central bank experimentation indicates under the surface all is not well.  Artificially suppressing the price of money results in unintended consequences and an illusion of prosperity.

Prosperity is easily seen in some graphs – such as unemployment at decade lows – back to where it was in 2006 and 2000:

Stocks at all time highs (more good news):

Inflation tame (and not deflating):

Looking at these pictures and it seems things are rosy and prosperity if widespread. Why not invest for the long term – put all your eggs in equity and just don’t worry?

How about this chart (above) – which we believe is the elephant in the room.  This is the total amount of negative yielding global debt outstanding– the 9.142M stands for $9.142 TRILLION dollars of securities around the world that have negative yields.  You might ask – why do we not show the years 2000 and 2006 for this chart? Well, it didn’t exist in 2000 and 2006. Not until global central banks started their mad monetary experiment did negative yields come into existence – it was actually over $13 Trillion at one point during this recovery.

(You may not realize it, but because of how index investing works, you may have some of these negative yielding bonds in funds you own. Funds managed by Blackrock, PIMCO, and Vanguard, for example, own billions of these negative yielding bonds.)

Prosperity shouldn’t be dependent on suppressing the price on 9 Trillion dollars of capital. The artificial price on that $9 trillion trickles down to impact the price on all assets – whether it is Investment Grade, High Yield, Equity or Real Estate.  

When the price of borrowing money is negligible – the cost of taking on debt or investing capital  is minimal. Furthermore, being paid to hold someone’s money is a great situation for borrowers (governments) – but not so much for savers and people trying to invest capital.  US Government has $22 Trillion of debt outstanding and investment grade US denominated debt totals $5 Trillion.

Although that is a lot of debt, the cost to service that debt (interest coverage) is healthy.  The example is Uncle Sam – The US Government had $10 trillion of debt in 2008 and paid $451mm of interest – for an implied coupon of 4.50%.  Today, the US Government has $22 trillion of debt but paid $458mm in 2017 for an approximate average coupon of 2.25%. So debt service cost looks good – we pay $450 billion of debt service – and receipts are higher – so the US Treasury is in good shape.  However, if rates were 200bps higher – back to where they were in 2006/07 – debt service would be $1.02 Trillion. Imagine the budget cuts of government programs should rates go back to where they were in 2006. Don’t even ask about rates in 2000.

Bottom line – we can’t afford higher rates.  So despite Fed speak about ‘getting back to a neutral rate’ – they know and we know – Uncle Sam nor our economy can afford that.

In conclusion – our economy can’t afford higher rates – even though it seems prosperity is all around us and the monetary experiment of global central banks have painted us into a corner of unicorns and negative rates.  If rates go higher – things slow down (dramatically) and the Fed will resort to additional measures of monetary stimulus.

Current Investments – January

Jan 14, 2019 | Current Investments

One goal we have for 2019 is to shed light on our investment process as it pertains to investing your hard-earned capital. Just like how we disclosed some investment ideas we had back in November, we wanted to share a current idea with you.

Sirius International

What we looked to buy: Sirius International (not the radio station – but the re-insurer)

Security – SIRINT 4.6 2026

Why we bought it:

Patrick has covered the insurance industry for many years, so he brings a deep background in knowledge on the management teams and business models of many insurance companies.  Sirius is a company we have followed for a while.  Recently, their bonds have traded lower – which is in parallel with the risk-off mentality that the market has experienced over the past 6 weeks.

However, the price decline with this credit seemed overdone (if, in fact, the company didn’t have any material financial potholes in their business OR any unforeseen credit negative corporate actions occurring).  To investigate this further, we took two steps:

  1. We called Sirius and spoke with their investor relations. We came away from that call with the impression that their insurance book, financial policy and near-term financial performance was sound – which is what we expected.
  2. We chose to verify Sirius’ opinion through third party sources. To do this, we called a relationship we have – a person who is a senior executive at a competing specialty reinsurer and who knows the players (equity sponsors and C-suite management teams) in that space.  This conversation affirmed our conclusions we had made after speaking with Sirius.

Therefore, as a result, we look to add to our position in the bonds – which are now clipping a healthy 5.3% yield with a YTM north of 6.8%.

Contact us to find out more

Current Investments – November

Dec 5, 2018 | Current Investments

This post discloses two investment ideas we had this past month.  We hope this communication 1) helps you understand how your hard-earned capital gets invested in today’s turbulent marketplace and 2) sheds light on how our process and activity is quite different than traditional retails advisors. Whenever headlines grab our attention, we investigate and tend to look for opportunities.  Two such headlines occurred recently, one pertaining to General Electric and the other Pacific Gas & Electric.  Below are our thoughts and how we transacted in each scenario.

General Electric - A Go

What we bought:  GE 4.125 34 @ +275/olb.

Why did we buy it?

General Electric is a company whose products or services we likely encounter every single day – whether turning on the lights, turning up the heat (here in Iowa’s winter), or flying on a plane.  However, it seems lately the market is turning out the lights on GE.

 

No question – GE has a lot of debt (about $115 billion outstanding).  The company also has a lot of cash ($35 billion) and a lot of assets (think Baker Hughes, lights, jet engines, gas turbines, etc). Unfortunately, GE also has a lot of liabilities – both known and unknown.  In our opinion, they will be spending a lot of time shedding assets over the coming years to pay down the debt and fix those liabilities.

 

The question is: Do they have time?  GE currently has $20B of undrawn bank lines, which provides liquidity out to 2020.  They also have positive cash flow, and since, they have cut the dividend.  So, how much do they have to deleverage?

 

The company’s forecasted EBITDA is about $14 billion, and its goal is to achieve a 2.5x Net Debt/EBITDA ratio – a respectable ratio for a low investment grade credit (BBB tier).  This means it needs to reduce net debt to about $35B – or gross debt to $70B (adding back the $35B of cash).  That is a lot of assets to sell.

 

Consider this –  a sum of parts analysis. Well, at the time of this article, GE was at $9 – which gives you a 22% gain.  We are buying GE debt at $82. If the stock is worth anything positive, the bonds are worth par (only at maturity), and they are still subject to spread and rate risk.  However, the bonds were at $97 before this episode. Hence, there would be about an 18% gain if they go back to where they were (spread and rate wise).  Add in the $4.4 of coupon payments, and you are at 22%.  Would you rather achieve 22% by lending to GE or achieve 22% by owning the equity?  The answer to us is obvious for many reasons…

 

We legged into the GE bonds during the initial downdraft.  We have room to add, and we have flexibility to optimize economics and tax outcomes.  And while we wait, we are clipping a 5.3% current yield. Oh how the mighty have fallen.

Pacific Gas & Electric - A No

What we looked to buy:  PCG senior debt or preferreds.

Why didn’t we buy it?

Many are aware of the tragic wildfires in California. As some of you might remember, PG&E went bankrupt in early 2000s. At the time, they were short electricity, while Enron was manipulating the wholesale market.  PCG’s investable securities presented many attractive investment opportunities.

 

Early in the process when outcomes were uncertain, you could have bought the first mortgage bonds in the high 70s/low $80s (remember these are $100 par value).  These securities never missed a coupon payment during the bankruptcy process.  On the other hand, later in the process, you could have bought preferred stock (5% Series C) in the low teens ($25 par) when PCG had disclosed they would pay the accumulated accrued interest (about 3 years worth).   Pacfic Gas filed its plan in January 2003 and emerged in April 2004.  See the $4 payment below for that payment:

Today, the company has only unsecured debt, and there is not much information on the liability.  Based on estimates from Wall Street and California politicians, the liability for PG&E clearly exceeds their financial ability to meet that liability. In other words, they are at risk of bankruptcy.  PCG drew down their bank lines and don’t have a dividend to cut, leaving PCG without liquidity levers. Liquidity is the number one reason companies go b/k. If there were FMB to purchase, we might be inclined to start a position. However, anything besides a secured piece of paper in a company facing imminent threat of bankruptcy is just gambling.  That is something we choose not to do.

 

Contact us to find out more