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.




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.

Cutting Out the Middlemen

When it comes to getting solid investment advice and learning where to put your money to grow your ‘nest egg’ for retirement, most of your options are not efficient. Mutual funds, financial advisors, insurance agents, etc. all claim they can manage your money and provide for your financial security when you no longer have an earned income. The options seem limitless, so let’s take a look at a couple of the more popular models available. In doing so, we hope to highlight the difference in service that Ballast can provide.

First, consider the financial advisor that sells you his/her services by laying out a financial plan after assessing your risk profile and determining how much longer you are going to work.  Typically, the process leads to building a portfolio of individual stocks and mutual funds – or ETF’s – that you will put money into every month or every other week (dollar-cost averaging).  This service will typically cost you 1.0% to 1.5% of the amount you have invested with that financial advisor to pay for his/her services.  You also will get charged annual service fees for each mutual fund that are as high as 2.5%, but that are typically only between 0.5% and 1.0%.  These fees pay for the mutual fund managers and their employees, while also giving the owners of the mutual fund a nice return on their investment.  In addition, you are charged with brokerage fees when you buy or sell individual stocks.  In other words, there are a lot of individuals and institutions that get paid by you putting your money into this model.

Second, consider annuities, which are another popular option in today’s world when it comes to principal protection and “guaranteed” returns. Annuities can be complicated – so let’s just keep it simple.  Say you purchase an annuity from a life insurance agent.  That agent is going to get a commission of at least 5% on the day you sign your contract.  So only 95% of your money actually gets put to work by the insurance company.  The insurance company will typically put your money to work in investment grade corporate debt securities or structured securities.  The insurance company needs to earn enough return to pay you back the 5% they paid the agent on day 1, but they also need to cover their cost of operations to generate a large enough return on equities.

Here at Ballast we ask ourselves, why not cut out all of the middlemen? Why not find an investment firm that will put your money to work in assets that a mutual fund or an insurance company invests in and keep more the return on those assets to YOURSELF?  There are investment professionals that provide these services for a flat fee.  With them, YOUR investment portfolio will be structured in a way to fit YOUR needs…not the needs of the thousands of others. THAT is efficiency.