Combining our experience and daily focus, we aim to process, distill, and comment on various activities in the market place here in the Market Commentary section. In our opinion, a great deal of time and energy from sell-side economists is spent addressing unemployment, ISM Index, payrolls and all the other monthly economic releases, speaking to facts without necessarily instilling wisdom. To us, this is an outcome of the age of Google – anyone now has the ability to quickly search the internet for facts and information (and now disinformation). But knowing facts and information is different than having knowledge and wisdom.
Here are some insights from August events to highlight some of the things we have worked on and thought about on behalf of our clients:
Teva
We’ve talked about Teva pharmaceuticals in a past newsletter, highlighting challenges to investing in Teva. The risks finally became pronounced in early August when the company released earnings and surprised investors with weak revenue and poor income results. They took a write-down of $6.1 billion on the $35.8 billion Actavis Plc acquisition completed just 12-months prior. That’s 17% of the value paid. Someone got the acquisition valuation terribly wrong, and that helps to explain why Teva is currently without a CEO, a CFO, and some other key personnel. Needless to say, stock investors reacted by sending the stock price lower [from low $30s on the earnings release date to $18 in a matter of few short days (that’s -44%) and to a recent low of $15.22.]
We were negative in the June newsletter and remain somewhat negative on Teva today. Why, you may ask, do we bring Teva up if we are negative still? – Because Teva is the world’s largest generic pharmaceuticals manufacturer, and we like the fundamentals of that business over the long-term. We would expect the credit to eventually stabilize and provide generous yield to patient and watchful investors. We understood (back in June and earlier) that investors were poised for a very big surprise, and that the reaction would be a very good investment opportunity for prepared investors. That surprise for investors came in early August with the earnings release noted above.
Our focus has been on the credit side – the debt issued by Teva. Teva funded the majority of the acquisition of Actavis with debt, and that debt remains on the balance sheet today. Now Teva’s resources for repaying debt are much lower than investors initially anticipated, and this makes the credit riskier than before. As a result, the price and yield of the bonds are rapidly approaching levels we think appropriate.
The last piece of the investment thesis is the anticipation of the credit-rating agencies (Moody’s, S&P, and Fitch) to cut Teva’s credit ratings from investment grade (“IG”) to below investment grade (high yield, or “HY”). This is still developing, but we remain convinced Teva cannot retain IG ratings for long, given the problems we spelled out in June. If (or when) Teva credit ratings do shift from IG to HY, such a move typically carries major implications for bond trading, which tends to create some of the most attractive technical trading opportunities in credit investing. This happens because many institutional credit investors operate under investment mandates or regulatory capital requirements that limit their ability to own HY credits. This creates “fire sale” situations in the event that a credit rapidly deteriorates due to these institutional investors being forced to sell following the credit downgrade with no ready buyers. As we all know, if there are no ready buyers, then price must fall until enough buyers come forward.
Somewhat unique to Teva, assuming it crosses into HY – and what we think will be additive to the technical trading opportunity – is its $35bn in debt outstanding. This is somewhat large for the HY market. Such a shift from IG to HY would, for a period of time, be too big to digest in the HY markets, and it could potentially create pricing well below intrinsic value. One final technical factor unique to Teva is that it has 30-year bonds outstanding and that issuance a large $2 billion. The HY market tends to invest at less than 10-years. Crossing over to HY would mean the 30-year bonds may need to be significantly discounted to find a home, and that is the crux of our interest in this Teva story.
Finally, from a trade implementation standpoint, an investor never knows the exact path, lowest price, supply on bonds, etc. over the course of a thesis playing out. With this in mind, our approach is to invest several times over the assumed investment time horizon with the objective of averaging into a strong position. This can mean initial or early trades showing mark-to-market losses for a period time until the credit stabilizes.
These multiple dimensions to the Teva story have us salivating over the potential opportunity. We continue to monitor this situation, as well as others, in order to provide you with strong investment opportunities.
Harvey
Hurricane Harvey came with much destruction. Our thoughts and prayers are with those left in the storm’s wake.
Much to the dismay of residents and business owners, insurance and reinsurance companies will incur a small portion of the ultimate economic tab. The storm is estimated to have caused as much as $90 billion in economic losses while insurance claims are expected to cover as little as $10 billion.
While catastrophes are undesirable, they do create investment opportunities, especially within the insurance and reinsurance industry. It’s a cyclical industry, and the recent two years are widely characterized as a late cycle. The reinsurance industry has been flush with capital in recent years, causing higher competition – which also results in insurance underwriting being underpriced and unattractive from an investment standpoint – in our opinion. This can be seen through lower ROEs (Return on Equity) throughout the industry. Catastrophe events tend to cause the cycle to turn by reducing industry capital to a deficit, which leads to attractive prospective returns on business – that is, insurance and reinsurance companies begin to price policies more appropriately to rebuild capital. We are now monitoring these industries for opportunities that may arise from a year of numerous (and large) insurance and reinsurance loss events – wild fires, earthquakes, hurricanes, etc.
Oil Market
We noticed an article discussing an oil bull gambling on $100/barrel oil. Incredible. We see this as unlikely over the intermediate term, barring some natural catastrophe or geopolitical event. As we mentioned last month, our opinion is for status quo or lower near-term.
Segueing to energy sector investing, the pain of 2014-2015 oil price declines continue to work its way through businesses. Seadrill, a large Norwegian-based company that conducts offshore drilling, has filed for bankruptcy after struggling for as many years.
Bitcoin
Bitcoin has surged above equivalent $4,000 US dollars. This is astonishing. We remain skeptical and would encourage you to read any of the following great books if you need to check your pulse or sanity: Devil Take the Hindmost, Extraordinary Popular Delusions and The Madness of Crowds, or A Random Walk Down Wall Street. These books do a good job of documenting and discussing historical incidents of investor excesses. While we entertain arguments for some fundamental value to Bitcoin, we think the current exchange value puts price well ahead of currency fundamentals – namely usability. How many retailers or banks do you know that accept Bitcoin?
North Korea
Throughout the month of August, North Korea has rattled sabers with many nations, which is a major geopolitical risk. It presents existential risk for many and an investment risk for all. And so, it baffles us when the stock market sells off by 2% in a day or when interest rates move 5 basis points lower (hundredths of a percent), as well as when pundits talk about markets reacting to the threat of war. War, especially nuclear, would move bond and equity market prices dramatically lower. Such recent movements hardly begin to discount real outcomes or assign suitable probabilities given the missile launches, H-bomb test, and harsh rhetoric. We continue to invest where we think it makes sense, but as with most other things we look at, talk and price regarding North Korea do not correspond.
