Permanent Loss of Capital

At Ballast, hopefully you have seen many blog entries talking about our investment philosophy, investment ideas and portfolio construction.  These are things we talk about daily on the investment desk.


However, one thing that we have yet to discuss (which runs through our veins and is likely why we have overlooked writing about) is permanent loss of capital.  Permanent loss of capital is exactly what it sounds like – a permanent loss of capital.  If you pay $10,000 for a new widget only to discover that the best anyone will pay for that widget is $5,000 (and there is no alternative economic value exceeding $5,000), then you have permanently lost 50% of your capital.   There is no way to replace that $5,000 loss unless you find another asset that can create $5,000 of incremental value.


This might be overly simplified, but this thought process is core to constructing a portfolio that will meet a return goal while also mitigating risk.


To us, risk is the chance of permanently losing capital. It is not correlations, volatility, diversity of funds. It is making sure we have a reason why something is in your portfolio and sizing that opinion to make sure any bad decision doesn’t affect your overall portfolio as it pertains to permanent loss of capital.  We want cash flow to always move a portfolio forward each year, and we will make investments with growth in mind but ensure that any one investment doesn’t ruin a whole year’s worth of effort.


What many don’t understand or appreciate is that to effectively and properly execute this process, there are multiple hours on investment function required daily. Whether that is analyzing fundamentals of an asset, evaluating types of securities or evaluating a portfolio’s goal with the investment opportunity at hand, there is a great deal of time required.  Every day is spent – in some capacity – on the front lines of your portfolio in order to avoid this permanent loss of capital.



About Assets

Purchasing a good asset at a good price is an ideal investment proposition.

Purchasing a good asset at a bad price can be an investment that works out over time.

Purchasing a bad asset at any price tends to destroy one’s capital.


These three statements seem to be some simple rules to invest by – buy good assets, stay away from bad ones and get the best price possible.  How hard can this be? Every purchase decision requires the investment team to assess both the quality of the asset and the proper price to be paid for that asset.  Ballast spends time on this every day.


In today’s capital markets, it seems (actually it is more of a reality) that a lot of capital acquires assets without paying much attention to either the price being paid or the quality of asset being acquired.   Approximately 30% of money gets invested into the capital markets via a passive/allocation investment process.  Think of 401(k) contributions where RIAs method is to ‘asset allocate’ people into a model portfolio or some other passive investing strategy.  If you are in an ‘asset allocation’ you effectively are buying large swaths of assets regardless of the underlying value of those assets nor any assessment of the value of those assets. However, you are merely betting that (in aggregate) the group of underlying assets will achieve returns and perhaps (more accurately) the correlations of returns that repeat themselves.


An example of someone acquiring an asset whose underlying value has nothing to do with your personal investment objective is the Japanese 10 year bond.  This bond yields a negative 0.54%, which means you pay Japan 54 bps per year to hold your money for 10 years.  Ballast expects to be paid for others to use your money – not the other way around.  However, if your fixed income allocation is one of the Blackrock, PIMCO, Janus or American bond funds, you own something you wouldn’t likely own if you were more thoughtful.

These are the top holders of a Japanese bond that has a negative yield to it.  Some of the more widely known fund manager names are Blackrock #2, PIMCO #3, Janus #14, and American Funds #18.  Our point is when you own funds, you often own securities that you would never buy for yourself (since in this particular case we would not pay Japan 50 bps of yield per year to hold our money) and we don’t think you should either.


This leaves a lot of questions in our mind. What if history doesn’t repeat itself?  What if my starting point along that timeline is the wrong point in time? Is my investment objective then really just a function of broad asset classes?   In our humble but firm opinion, these questions are valid. Our answers to these questions suggest that acquiring an asset (security selection) and building a portfolio (institutional investing) is more intellectually thoughtful – and time intensive – than a simple mathematical model. 

At Ballast, we focus on not only acquiring assets, but also managing them. It means taking the time to analyze both the quality and the price of the asset itself. That is our method.

Our Year in Review

What a great year 2017 was for Ballast. We began operations in April, with goals of providing clients with security, stability, and innovative investment strategies. The year brought many unanticipated events – some investable, others not – and we tried to comment in our newsletter and blog on ones we found more noteworthy. As the year closes, we wanted to take the opportunity to reflect more wholly on what we did during the year.



Core Investment Strategy

Among other client constraints, return requirement remains top-of-mind as we build and maintain investment portfolios. The bedrock with which Ballast portfolios are built upon is core, yielding investments. The average investor requires a well-diversified portfolio, and so, investment positions within are numerous. These core holdings provide relatively low-risk return and cash flow for clients in fulfilling their investment objectives.


Credit – Credit provides the bulk of the yield allocation for achieving desired cash flow and return within an investment portfolio. The risk premium, or credit spread, is typically higher than comparable maturity securities because of risk considerations like collateral, degree of leverage, management, credit ratings, et cetera. Nevertheless, with a little bit of analysis and monitoring, there are high-quality credits worthy of investment. Here we list some examples of core yielding bonds put into Ballast clients’ portfolios during 2017: Abbott Laboratories, Aetna, Anheuser-Busch Inbev, Kraft Foods, and Thermo Fisher Scientific. Our clients may recognize these as high-quality, household names. Other high-quality names enter the portfolio through one-off market events to contribute incremental yield within what Ballast views as core:

Kroger – Amazon announced the acquisition of Whole Foods Market and set the grocery industry into a whirlwind. Grocer stock prices fell and bond spreads widened in knee-jerk reaction. We assessed the industry and found opportunity in Kroger bonds with spreads 40 bps wider on the news alone. Spreads have since returned to pre-announcement levels.

Equifax – Equifax announced a data breach of record size. The data also happened to include critical personal information of most US citizens. Capital markets were harsh and devalued the company by billions over a short period of time. Our focus turned to the Equifax bonds. There, spreads widened more than 100 bps over two weeks. We assessed the liability and determined the market reaction was well overblown. Spreads have since narrowed to within 10 bps of the pre-breach levels.

ABS – Asset-Backed Securities provide yield with substantial risk protection through strong collateral or structure. United Airlines and American Airlines are examples of investments many Ballast clients would recognize. The bonds are highly rated and secured with the airlines’ aircraft. Another example of ABS investments includes agency residential mortgage-backed securities (RMBS).

CMBS – Commercial Mortgage-Backed Securities are used by Ballast to generate incremental yield for short-term, or cash-like, allocations within client accounts. CMBS are pools of loans backed by properties such as Office, Multi-family, Retail and Industrial properties.  These securities are structured to provide short-term or long-term cash flow and credit characteristics for buyers.  Ballast acquires the short-term (“front-end sequentials”) to acquire decent yield without much principal or credit risk.

Non-core Investment Strategy

For many clients, especially in the current market, core investments do not provide sufficient returns alone. Ballast adds incremental yield to client portfolios by investing in non-core opportunities. These include credits of high- and low-quality and strategies of high yield and total return. What is common of these non-core opportunities is they require Ballast’s vigilance, patience, and analysis. Here we list some examples of investments made during 2017:


Kohl’s – Amazon and Kohl’s announced a couple of test partnerships, effectively using Kohl’s “brick and mortar” for certain sales and returns. Markets did nothing. We viewed Kohl’s as top of a difficult sector and viewed the Amazon announcements as optionality on Kohl’s. After all, look at Whole Foods Market. We saw Kohl’s bonds as the best way of investing. The bonds offer attractive yield on a BBB, investment grade credit with real option on acquisition by a stronger peer.

Teva – The thesis continues to play out. Teva is a pharmaceutical company that needs to repay debt with smaller cash flow and fewer assets than when debt was incurred. The credit ratings are migrating lower, and credit spreads continue to widen. We’ve taken the approach of cost averaging, and we are in a good position. We anticipate making one or two more critical additions.

Pitney Bowes – The mail industry is in decline because of the digital world, yet in demand from e-commerce. Parcel shipping appears to be the future, and Pitney Bowes is finding its way. In the meantime, we found an attractive entry into the bonds. Credit spreads gapped significantly wider over the course of the week as financial results were reported. Spreads have narrowed since. Although the position has performed well, it is relatively new, and we positioned for (and anticipate) opportunity to add.

Tidewater – A broker came knocking, and we listened. We were re-introduced to Tidewater and diligently got comfortable with the bonds. This position is providing good yield in a tough yield environment.

Clients may recognize some of these company names. Non-core holdings provide higher return for clients in fulfilling their return objectives. Non-core positions generally arise infrequently, and therefore, require patience. Extra analysis is also required of non-core because the positions may carry more relative risk. Risk management plays an important function in the Ballast investment process, especially with non-core investments. A primary layer of risk management comes from position sizing, which limits the impact of any investment on the overall portfolio. Of course, Ballast’s first layer of risk management is analysis – understand and evaluate the investment.

Other Interests

Each day investing is busy and brings a new rock to turn over. With all the things Ballast examines and thinks about during the year it is difficult to note them all, but there were a couple of areas we found interest in during the year. Although we have not acted on them, we continue to monitor each.


One area of interest for us was the property/casualty insurance and reinsurance industry. The year 2017 brought significant economic loss due to natural disasters in North America. With these economic losses came significant insurance losses. Although stock prices of many insurance companies suffered meaningful decline due to capital erosion, we found limited opportunity to invest, so we did not. No good opportunities appeared in credit of the insurers either. If industry losses are elevated again in 2018, good opportunity may arise, but we expect the status quo of generally soft market in absence of additional losses.


Another area of interest was offshore drill rig companies. Some of the biggest names in the industry include Diamond Offshore, Transocean, and Ensco. The industry has suffered as oil price declines led to drill fleets being underutilized. As an asset intensive industry, leverage use was (and is) high. As the oil market downturn took hold, the offshore drillers fell to financial distress and were forced to deleverage.  After a couple of years of some oil price recovery and deleveraging & refinancing, we think at least some of the industry has de-risked enough for our interest.


The new year always brings with it more challenges and opportunities. This new year brings new tax law, low interest rates, record equity market prices, and plenty of unknowns. With more insight into what Ballast did during 2017, clients can expect the same commitment in the year ahead. We look forward to navigating the challenges and providing our clients with security, stability, and innovative investment strategies in 2018.

Ballast Capital Advisors, LLC is a Registered Investment Adviser with its principal place of business in the State of Iowa. Please do not send orders via e-mail as they are not binding and cannot be acted upon. Please be advised it remains the responsibility of our clients to inform Ballast Capital Advisors, LLC of any changes in their investment objectives and/or financial situation. This message, including any attachments, is confidential and intended for the recipient(s) above. Past performance is no assurance of future results. This email/newsletter is limited to the dissemination of general information pertaining to investment advisory/management services. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year.   It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.  Opinions expressed are those of Ballast Capital Advisors, LLC and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security.


A look at our investment process –

We were recently introduced to exploration and production services provider, Tidewater, and we purchased their bonds. There were appealing qualities and circumstances about the company that recently emerged from bankruptcy. First, the bankruptcy process tends to understate the enterprise value of the company before the judge in order to improve recovery-of-value lost as a result of bankruptcy. Second, the fresh-start accounting and financial proforma tend to be based on the economic value of the underlying assets – with intent to not attract outside equity capital (hence no need to over-promise).  So, the other day we were shown to Tidewater bonds (TDW 8% 8/1/22).  What attracted us is that the bonds were unrated, which creates opportunity by limiting buyer base, as many bond market participants are constrained by credit ratings.  Also, perhaps most importantly, the bonds are senior (high-ranking of legal claim) AND they are secured – with all the company’s assets.

For any investment decision, we tend to go through the process outlined below.  Our process starts with information gathering – both business and financial.  In this case, we had three primary sources of information:

1. Company presentations – Specifically, TDW management’s presentation to investors on Sept 15, 2017


2. Court filings – In particular, there are two documents, which are the Plan of Reorganization and Disclosure Statement. – The latter walks through the financial model and assumptions around each financial category


3. SEC Filings – here we look at 10Q (quarterly report) and 10Ks (annual report)

After spending some time in these documents and putting together some notes and spreadsheets, we like to test our thoughts against other opinions. We do this, not only to test our understanding of the business side, but to also test ourselves on the security side as well – does this security provide the protection we think it does, is there a better point in the capital structure to invest, et cetera.  To conduct this test on a small and somewhat obscure company, we made one call. We spoke with a street analyst. (Street analysts tend to cover the company, but they also speak with investors, such as insurance accounts, money managers and funds.) In this case, we spoke with Patrick Fitzgerald, a distressed credit analyst at R.W. Baird, which is a large bank.  The reason we spoke with him is that we have a relationship with Baird, and the distressed debt trader who was showing us the bonds was a Baird trader.  Therefore, the analyst had reason to speak with us (he would otherwise be difficult to engage with), but also an incentive to get a transaction done. To the latter point, we critically evaluate the analyst’s assessments and ask questions to root-out incentive from knowledge.

After the analyst conversation, we regroup and discuss three things – (1) the company’s business, (2) the security which attaches us to the company and (3) the price at which the security can be purchased.

Here are some high-level thoughts from that perspective:

1. Business: TDW is among the world’s largest off-shore service providers. Its customers include RD Shell, Saudi Aramco, Petrobras, and other major oil companies. It provides services around the world (think Gulf of Mexico, North Sea, Persian Gulf, West coast of Africa, etc.).  Customers contract with TDW to shuttle people and supplies to off-shore rigs – both for exploration and production (think people, drill bits, large pipes, etc.).  The ships that perform these services are $50mm new, and TDW owns about 240 of these boats. 


2. Security: The security at hand is an unrated, first-lien security and is issued to former creditors as part of the bankruptcy process.  The amount outstanding is $350 million, and it carries an 8% coupon that pays quarterly.  The common stock trades publicly (ticker: TDW) at around $25 per share, implying an equity market cap of $750mm.  Therefore, you basically have a company with $1.2 billion capitalization comprised of $750mm of equity and with $450mm of debt. The company owns about $800mm (GAAP basis) long-term assets. At the recent quarter, TDW had $460mn of cash on-hand – this represents a net cash position, or cash balance exceeding debt outstanding.  Therefore, we think of the debt as fairly secured from a downside protection standpoint.


3. Price: The bonds were offered just above $103 price, which is approximately a 7.5% yield.  So, earning 7.5%, we could own a secured interest in the ships, or we could own the stock which pays no dividend (and may or may not be worth $25 because it is secured by nothing).  Of course, management forecast is for improving conditions several years out, but this is difficult to accept as base-case, especially given the cap that onshore shale production seems to have placed on the price of oil. Offshore market activity and relevant operating statistics are so far off previous highs [and remain in relative oversupply (weak utilization rates)] that it is difficult to assess exactly when the market (and TDW) will re-establish baseline and support higher equity prices.

Many of our clients will notice Tidewater 8% 8/1/22 as a new line-item in their accounts. There was additional analysis done prior to making the final decision. However, this write-up is intended to illustrate, at a high level, our process in regard to sourcing, analyzing and purchasing an investment. This is the type of process and thinking Ballast does on behalf of our clients.


We discussed Business, Security, and Price, above, but for those of you that are intrigued and want a little bit more to think about, continue reading for the fourth point we are considering for Tidewater.

A fourth item discussed (and one that we continue to evaluate) is using the publicly traded warrants of TDW as a potential return enhancement. Warrants act like stock options in that for a low upfront “premium” the holder effectively has the option to capture future price appreciation above a stated strike-price and before an expiration date. An investor in the warrants could conceivably earn a multiple of return on a low cost basis if the underlying stock appreciates substantially. If the stock price does not appreciate substantially (to above the strike price), the warrant expires worthless. For this reason, investing in warrants (and options) on their own can be dangerous. The trade we are evaluating, as relates to TDW, would be to enhance the bond position by buying the Series A warrants to add TDW equity upside exposure – without taking direct equity risk (buying the stock), which includes substantial downside risk. For 2-points of first year bond cash flow, the investor would hold the bond yielding 7.5%, as well as the warrant, to buy the stock at $57.06 (currently around $25). Given our confidence in the bonds, we view the downside scenario of this full position as a net 7.0% yield to maturity, where the warrants expire worthless. In an upside scenario – and this is purely hypothetical – if the stock price appreciates to $87, the warrants would be worth $30, and this would take the overall position return to 12%. The cost would be 0.50% of downside (the yield consumed by the warrant from the bond) for some return greater than 7.0% (not necessarily the 12% presented). The greatest consideration for this fourth point (and we continue to evaluate this) is whether it is reasonable to expect the stock price to exceed the strike price by expiration date in July 2023. If it is unreasonable then it is simply not worth the two points of cash flow (0.50% yield) for the option. Stay tuned.

A Common Conversation

Institutional Investing for Individual Accounts –

Ballast Advisor –       “What are your savings invested in today?”

Prospective Client“ETF’s, mutual funds, and some individual stocks.”

Ballast Advisor –       “What kind of funds, and what kind of stocks?”

Prospective Client –  “S&P 500 index funds, bond funds for fixed income, emerging markets for more opportunity for better returns” – “My broker puts me in stocks that have growth potential and/or pay a decent dividend yield.”

Ballast Advisor –      “What are your reasons for putting your savings into investments like individual stocks and the other types of funds you mentioned?”

Prospective Client – “Well, I’m in funds to have diversification in my portfolio, and I’m in individual stocks to have the opportunity for better-than market returns.”

Sounds pretty typical, right? A recurring topic when we talk to people about what we do here at Ballast is the concept of institutional investing…more descriptively referred to by Ballast as functional investing. We have talked to a number of people about changing their mindset, asking them to remember that when they are in these types of investments, especially emerging markets and individual stocks, they have the opportunity for worse-than market losses just like they have the opportunity for better-than market gains.


What if there was a different way? 


What if there was a way to have diversification in an individual portfolio, while not having to own a bunch of positions (via your ownership of funds) that you don’t even know about (and if you did know about them you wouldn’t ever invest in that particular position personally)?


In addition, what if you had a way to invest in the opportunity for better-than equity gains WITHOUT having to take the risk of investing in stocks – where the only things you know about the company are what management wants you to know (which is really what the SEC says they have to tell you)?


I [Steve Harms] personally never knew of a better, more responsible method to managing and growing wealth than the “diversify your funds among mutual funds and ETF’s” – until I started working for an institution.  I worked for an insurance company, and I saw how they took the money they collected from policyholders, putting it into work so that they (the insurance company) could perform/pay on those policies when the time came at some point in the future.  Insurance companies, pension funds, etc. invest their funds using a very systematic approach that attempts to match their assets and their liabilities. This means the cash flow from their assets (returns and maturities) needs to match the cash flow needed to service their liabilities.  They invest in assets that they analyze regularly, and they protect themselves from losses.


Why don’t we as individuals use this same methodology?  Why don’t we manage our savings with the goal of accumulating a portfolio of assets that produces enough cash flow return to [more than] support our cash flow needs?

That is exactly what we do at Ballast Capital Advisors.  We protect the wealth you want/need to protect by investing in assets that at some point in time pay you back your initial investment PLUS a reasonable rate of interest along the way.  Depending on the amount of wealth that you are willing to grow, we find either distressed assets or equity-type investments, where we know the risks and are able to devise a strategy around the risk of ownership.  It’s a very functional method, and in my opinion, it is the most responsible and effective way to manage your wealth.