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.

“Decumulation” as a last-resort Option

If you follow financial planning and wealth management experts online, then you may have seen a lot of advice and strategies regarding retirement, as well as how to manage your personal finances so that you can decumulate your savings effectively.  Whenever we see an article that makes reference to decumulation of your wealth, it makes the hairs on our necks stand up. The reason for that is that we believe there is another option that everyone should become conscious of. (And not only do we believe it should be an option everyone is aware of, but we believe it should be everyone’s goal to achieve when entering retirement.) – Why not plan and save enough along the way so that you can have true financial health? We believe true financial health is not decumulating your savings at all, but it is continuing to accumulate wealth in your retired years so that you do not have to worry about whether or not you’re going to outlive your savings, or decumulate to zero.


If you are participating in company 401(k) plans, contributing to your own Individual Retirement Account, or accumulating tax deferred savings in some similar type of plan or instrument, the IRS requires you to distribute those funds at some point in your life in the form of Required Minimum Distributions (RMD).  Thus, for certain reasons, you must take money out of certain funds, but if you have enough cash flow from all of your savings and reinvest those RMD’s so that you don’t have to reduce your principal, you have true financial security. With that type of strategy, you can sleep at night and truly enjoy retirement living!  However, we recently read one article that stated the method of managing your finances in retirement where you can rely on only the earnings from your investments and not reducing your principal savings has fallen out of favor.  If that is true, there are probably a lot of reasons for this method falling out of favor, but it is our opinion that this method should be the one to strive for.


One of the ways to accomplish that goal of never having to enter a decumulation phase is to partner with a really good investment advisor.  A true investment advisor is aware of what your cash outflow needs are going to be (when you are no longer working and earning a paycheck). They are also capable of designing an effective portfolio – a portfolio that does not rely on the S&P 500 appreciating by 8% annually, for example.  An true investment advisor has adequate lead time to solve for cash needs (given enough savings) and can design a portfolio so that the client won’t have to worry about the market crashing or living too long.


At Ballast, that is what we like our goal to be for all of our clients.  We strive to formulate a plan for clients to work from that will allow them true financial security as they reach the phase of their life where they would like to not have to rely on earned income.  Through a mix of strategic fixed income and fully vetted alternative investments, we feel our strategy is reliable and sustainable through any type of economic environment.

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.