Conventional wisdom holds that credit markets are “smart institutional money” that sees problems faster than equity markets that are full of less sophisticated retail investors. I question whether that is still empirically true. Retail investors now own large portions of the credit market, including high yield. Credit markets appear to be distorted by a combination of indexation and a reach for yield. Its possible that bonds trading at par can be a false comfort signal for an equity investor looking at a highly leveraged company, because in many recent cases equity markets have been faster to react to bad news.
Retail ownership of credit markets.
However you slice and dice the data, there is clearly a lot more retail money in credit than there was a decade ago. The media mostly reports on noisy weekly or monthly flows, even though there has been a clear long term change.
Bond funds in general have experienced dramatic inflows over the past decade:
Source: ICI Fact Book 2017
The issues becomes more serious when you look just at the high yield part of the market. Boaz Weinstein of Saba Capital estimated that between ½ or ⅓ of junk bonds are owned by retail investors in the current market. The WSJ cited Lipper data that says mutual fund ownership of high yield bonds/loans is $97 billion today vs $18 billion a decade ago. ICI slices the data differently, and comes up with a much nosier data set for just floating rate unds, indicating large outflows in 2014 and 2015. However it shows net assets in high yield bond funds up 3x compared to 2007, and the total number of funds up over 2x during that time.
Source: ICI Fact Book 2017
Its not just mutual funds either- there are now more closed end type fund structures that market towards retail investors. BDCs experienced a fundraising renaissance through 2014, and are now active in all parts of the high yield credit markets- from large syndicated loans to lower middle market. Closely related, before the last financial crisis, ago there was minimal retail ownership of CLO equity tranches, but now there are a few specialist funds, and a lot of BDCs have big chunks of it as well. Oxford Lane and Eagle Point were sort of pioneers in marketing CLO investments to retail investors but many others have followed. Interval funds are a tiny niche, but over half the funds in registration are focused on credit. It seems just about every asset manager is cooking up a direct lending strategy. The illiquid parts of the credit market are harder to quantify, but there has been a clear uptick in retail investor exposure since before the financial crisis. The marginal buyer impacting pricing is increasingly likely to be a retail investor rather than an institution.
Retail investors to exhibit more extreme herding behavior. According to Ellington Management Group:
This feedback loop between asset returns and asset flows has magnified the growth of the high yield bubble.
Its pretty easy to make a loan, its much harder to get paid back.
…shareholder activism can be put to good use and bad. It challenges inefficient corporations that waste valuable assets, but it can also foster destructive and destabilizing short-term strategic decisions. The key issue in an activist campaign often boils down to who will do a better job running the company—a professional management team and board with little accountability, or a financial investor looking out for his or her own interests.
Elliott Management is a prominent hedge hedge fund with a succesful 4 decade track record, perhaps most infamous for seizing a ship from Argentina’s Navy during a debt dispute back in 2012. Elliott has become a most widely known as an activist investor in recent years. Its impact has also been important because it has shaken up large companies previously thought immune to activists. Furthermore, Elliott has been a successful activist in Europe and Asia, where conventional wisdom once held that activism didn’t really work.
Elliott’s tactics are extreme, and controversial, but they work. Although sometimes there are unintended consequences- Elliott has indirectly affected regime change in two different sovereign nations. Fortune’s latest issue has an in depth profile of Elliott Management that is well worth reading.
For more on the history of corporate activism, and its impact on the history of capitalism, Dear Chairman is a definitive guide.
Business history teaches us that the pursuit of profit brings out an extreme and obsessive side of people. When we harness it well, we get Wal-Mart, Les Schwab Tires, Southwest Airlines, and Apple. When we don’t, we get salad oil swindles, junk bond manipulations, and Steak ’n Shake funneling its cash to its CEO’s hedge fund. The publicly owned corporation has been a remarkable engine engine for progress and economic gowth because it can place large amounts of capital in the hands of the right people with the right ideas. Without proper oversight, however, public companies can squander unimaginable amounts o money and inflict great harm on everything around them. The emergence of the shareholder as the dominant force in corporate governance has bestowed a tremendous amount of power and responsibility on investors….
“Always take a company seriously, even if its financials are knee-slapping, hoot-promoting drivel”
I’m about halfway through The Art of Short Selling. It has some incredible short selling case studies. One accounting issue that comes up is where accounts receivables spikes without a proportionate increase in actual cash sales. Tracking the ratio between accounts receivable and sales is a way to track a pretty simple trick that company accountants can pull. The example used is that of the a corporate/government training company with a famous politician on the board. It ended badly for shareholders. This happens a lot in questionable companies getting “out over their skis.”
“Receivables can be up by more than sales for several reasons:
1. The company acquired a company, and the acquisition is not yet under control-collections do not have the same billing cycle or terms for sales, for example. If the acquisition was a large one relative to sales, the relationship of year versus year in receivables is not comparable.
2. The company is booking revenues too aggressively-for example, a three-year contract recognized at the front end, so that receivables stay high because the rate of payment is slow.
3. The company changed its credit policy to easier terms or is giving incentives for sales, thereby jeopardizing future sales.
4. The company is having trouble collecting from customers. Building accounts receivables is a cost to the company because investing in business already booked hurts cash flow. Timely collections are sensible in a growing business because growth eats money by definition.”
How companies book revenues is a particularly quarrelsome issue for analysts: There are many ways to fool around, and technology and training companies are two categories of regular abusers. Revenues booked should have a consistent relationship with collection-if a company ships now and collects in 60 days, the accounts receivable schedule should consistently mirror that policy. So rising receivables versus sales or a lengthening number of days in receivables should always trigger a question: Something has changed, it says.
If your screener sets of an alarm due to a spike in receivables relative to sales, running through this list might help you find the answer. Understanding this question gets back to the basic question: how does this company make(or fail to make) money?
One more quote to top it off:
“For the last week I’ve been carrying “The Art of Short Selling” around with me just about everywhere. Every time I get a break, I just open to a chapter. Doesn’t matter if I’ve already read it. I just read it again.”
I recently reread Common Stocks and Uncommon Profits by Phil Fisher, while I was flaneuring in Morocco. Fisher held stocks for years and even decades, and focused on situations where he could get a several hundred percent gain over his holding period. His process focused on “Fifteen Points” to look for in a common stock. Not every investment was positive on every point, but good long term investments would need to exhibit many of them.
Here are my notes on the Fifteen Points.
- Does the company have products or services with sufficient market potential to make a possible sizable increase in sales for at least several years?
Fisher didn’t spend time on “cigar butts”- he wasn’t interested in squeezing cash out of a dying business, even though it could be lucrative for certain investors. Likewise, he acknowledges that its possible to make a quick profit from one time cost cuts in an inefficient business, although that wasn’t his niche. Notably Buffett described himself as 85% Graham and 15% Fisher, and the Fisher component arguably made him more money over the long term.
It’s important to consider what the limits of growth might be- once every potential customer has purchased once, then what? During Fisher’s time he focused on a lot of high-tech product companies. In modern times, there are a lot more service focused companies which can potentially generate recurring revenue streams.
A company with massive long term growth potential may have lumpy sales growth. Annual comparisons generally don’t mean that much, instead investors should compare multiple years.
If management is decent and lucky they might find themselves with a long run growth opportunity. If their truly good and lucky, they’ll find a way to creat it.
If a Company’s management is outstanding and the industry is subject to technological change and development research, the shrewd investor should stay alert to the possibility that management might handle company affairs to produce in the future exactly the type of sales curve that is the first step to consider in choosing an outstanding investment.
One of the key examples is Motorola.
Dead Companies Walking, by Scott Fearon is one of the most fascinating business books I’ve ever read. The author is a talented hedge fund manager with a great track record on both the long and the short side. His ability to spot “Dead Companies Walking” is a key part of his edge. Even for long only investors, the tales of what to avoid are valuable. The book describes 6 main reasons why companies fail:
1) Historical myopia: learning from only the recent past.
This seems to be most prevalent in cyclical industries, such as energy. The author’s formative experience was starting at a Texas bank right before the oil bust of the 1980s. People looked at charts going back only a couple decades, and assumed that prices would drop only to a certain level. Equally absurd assumptions can be applied to all sorts of metrics that people use in the investment decision making process.
2) Relying too heavily on a formula.
If a company follows a strict formula or metric, such as adding a certain number of stores annually, they can quickly find themselves making illogical decisions. Value Merchants, a retailer is an example used in this chapter.
Investors that rely too much on formulas can end up investing in zombie companies on the cusp of obsolescence. Various yellow page companies, for example, looked extremely cheap on an EBITDA basis in the early 2000s.
Relying too much on formulas an result in errors of omission. For example, investors may that relied on a strict valuation formula would have turned down Starbucks and Costco in their early days.
I posted on Seeking Alpha about my investment in Crossroads Capital (XRDC), a busted venture capital BDC trading at ~60% of book value, with 70% of market cap in cash. It has a messy portfolio, but not a lot needs to go right for signficant upside. For those with the means and/or the investment mandate, getting an NDA and buying the individual portfolio companies from XRDC might be the better option. Crossroads Capital hired Setter Capital to market its holdings. Setter Capital specializes in the fascinating private equity secondary market.
Here are a few residual thoughts on deep value investing in the busted BDC/private equity/venture capital space.
There is a bit of irony in a deep value liquidation play with assets that consist of preferred shares in growth oriented venture capital investments. Venture capitalists bet big on change, while value investors generally focus on mean reversion, yet as Marc Andreessen pointed out, there are actually similarities between the philosophies underpinning value investing and venture capital. Both styles of investing emphasize fundamental analysis, long term thinking, and ignoring market noise, while taking advantage of some sort of mispricing.
However, a lot of venture capital investments are preferred equity with quite favorable liquidation preferences. The prospective buyer will conduct due diligence on the operations of the business, and the rights of the particular security. With an investment in XRDC one can determine the aggregate valuation paid by an outside investor(about 3x EBITDA after subtracting out all the excess cash in the BDC), and can compare valuations with other BDCs holding the same security (top holding is marked over 20% higher by another BDC), but there is limited public information on each individual security. Based on research of public sources, several of the portfolio companies appear to be doing pretty well, but a couple are also in trouble. My working hypothesis is that the absurdly large discount creates a “heads I win, tails I don’t lose that much” scenario. However, cherry picking the best companies out of XRDC’s portfolio and buying them directly would be even better.
I look forward to more opportunities like this.
In the The Art of War, Sun Tzu wrote that those who excel in warfare do so because they seek out battles that are easy to win. Similarly, Warren Buffett wrote that he likes to look for one foot hurdles to step over, rather than trying to jump over seven hurdles. Of course actually finding easy battles, and one foot hurdles is itself quite challenging. If it was easy market forces would ensure that it quickly becomes hard. With so much brain and computer power dedicated to financial markets, there are few areas of opportunity left worth exploiting. However, by developing a behavioral and structural edge, one can act on the rare opportunities, and perform better than those that theoretically have an analytical and informational edge.
How can one develop a behavioral edge? Cultivating the right habits in order to be physically and mentally healthy goes a long way. Considering carefully what media to read is important to avoid being overwhelmed by noise. Finding time to think requires excellent resource management. It requires discipline to be willing to work on a name for months, only to pass on it, or to wait for months or even years for the right business to become cheap enough. Some might not enjoy spending hours reading about obscure nanocaps or corporate transactions, while ignoring popular stocks in the news. Some people seem naturally more willing to be contrarian, but I doubt anyone finds it easy all the time, especially during drawdowns. Being fearful when others are greedy, and greedy when others are fearful is harder than it sounds. Checking oneself for cognitive biases before any major financial decision is important. This is not an easy process, since cognitive biases have biological roots. I like to take a “red cell” approach, and try to understand potential short arguments for any stock I own. The connection between action and consequence is usually delayed in markets. It requires a lot of discipline, double checking and introspection to make your way through the vicissitudes of investing.
The cultivation of a structural edge is also nuanced. If you have developed a behavioral edge, then you can probably manage your personal finances in a way that allows your personal accounts to be invested for the long term. This requires maintaining excess liquidity at most times. If you manage money for other people, you have to be really careful who you take on as a client. If a client has a shorter time horizon than you, or are likely to need to pull money suddenly, the impact can be devastating. This is a difficult tradeoff, especially for small funds, since more AUM means more fees right away. With the right clients a capital markets disruption is a major opportunity, with the wrong clients it is a disaster. Whether in a personal account or a fund, simply having a long time horizon and a liquidity cushion can be a major source of long term alpha.
If one chooses to look at what other’s don’t one may actually end up with an analytical and informational edge in areas with less competition. I like to invest in things that are uninvestable for most investors with better resources, whether due to “headline” risk, illiquidity, or other institutional constraints. For example liquidations, delistings, and anything nanocap are fertile grounds for bargains. There are also interesting opportunities in distressed debt, and bankruptcies. I also like to look for situations where statistical services(Bloomberg, YCharts, Yahoo Finance, etc) are likely to have misleading or incomplete data, and companies that don’t fit in a comfortable category. Sometimes consolidated financials can be deceptive because of accounting rules, especially if a company has made acquisitions, holds real estate and/or holds a portfolio of securities. I also always make sure to adjust for material events that occurred after the 10-Q or 10-K date in determining a valuation. Judging by occasional market behavior I don’t think everyone does this. In any case there is always a gap between accounting reality and economic reality. The financial statements are just a starting point.
An ideal long term holding is a business that has a major competitive advantage and can easily earn a high return on capital over the long term, even if management screws up. These businesses are hard to find, and they’re sometimes hidden in a group of weak businesses that screened poorly, or attached to an old business that didn’t work. Thrift conversions are ignored by many, and easy to understand. Although the upside for thrift conversions is rarely large, the risk/reward tradeoff is phenomenal. Key information is often found on the OCC and FDIC websites, rather than in Edgar. Most OTC securities are ignored by sophisticated and large investors(plus the messiness of sorting through hundreds means you aren’t competing as much against computers). Sometimes I can get an informational edge by actually bothering to go to the company’s website and/or buying a token share and calling the company to ask for financials, which one has a legal right to access as a shareholder.
Whatever the investment, I’m only interested in buying if a lot can go wrong before I lose, and just a little going right provides a nice gain. Finding the right security is hard, but it should be easy to win once its in the portfolio. “Sifting through the debris of financial wreckage, out-of-favor securities and asset classes in which there is limited competition”, as Seth Klarman has called it does requires intense discipline and dedication, but provides ample rewards.
The extraordinary delusions and madness of crowds also serves up huge bargains from time to time, but the analysis is much harder. In all transactions, one must ask, why is someone willing to take the other side? I suspect there is more benefit to carefully analyzing my own psychology than to trying to outsmart others. I’d rather buy from a “non-economic” seller, when possible. Funds with industry or market cap mandates sell spinoffs indiscriminately. Funds that manage to an index dump companies kicked out indiscriminately. Delistings and liquidations are also sometimes forbidden by investment mandates regardless of the actual condition of the business or quality of the assets. I like to look at the portfolios of large concentrated funds that are facing massive redemption or shutting down, or from investors otherwise desperate for liquidity(oops did I say that out loud?). Sometimes people sell securities for reasons that make sense from the perspective of their job security, but are actually unrelated to the merits of the security being sold. Of course it takes a lot of searching to find where the right sellers are.
Charlie Munger told Howard Marks: “its not supposed to be easy, anyone who thinks its easy is stupid.” Indeed, finding easy things is hard.
BDCS qualify as BDCs under the tax code. BDCs by tradition also happen to usually be RICs under the tax code. REITs qualify as REITs under the tax code. RICs and REITs have very similar requirements in terms of distributing income, and nearly identical benefits in terms of avoiding corporate level taxation. However, investment limitations are different.
BDC is an SEC construct. REIT is an IRS construct. These categories are not mutually exclusive. Mackenzie Realty Capital is a BDC that is also a REIT under the tax code.
From the 10-K:
MacKenzie Realty Capital, Inc. (“MRC,” “we” or “us“) is an externally managed non-diversified company that has elected to be treated as a business development company (“BDC“) under the Investment Company Act of 1940 (the “1940 Act“). Our investment objective is to generate both current income and capital appreciation through investments in real estate companies (as defined below). We are advised by MCM Advisers, LP (“the Adviser” or “MCM Advisers“). MacKenzie Capital Management, LP (“MacKenzie“) provides us with non-investment management services and administrative services necessary for us to operate. MRC was formed with the intention of qualifying to be taxed as a real estate investment trust (“REIT”) as defined under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). We qualified to be taxed as a REIT beginning with the tax year ended December 31, 2014, and made our REIT election in our 2014 tax return.
Anyways, Mackenzie Capital’s group of funds are fascinating on many levels. Mackenzie Sponsors/advises non-traded funds that specialize in exploiting inefficiencies in the market for illiquid retail programs. Basically they buy non-traded retail programs at steep discounts via tender offers and then either hold them through liquidation, or sell them at a higher price on auction sites. They will sometimes puts out deep discount tender offers right after a non-traded program suspends its stock repurchase program. The suspension of the share repurchase program generally indicates either the fund is in trouble, or it is pursuing strategic alternatives. It doesn’t take long for a literate person to figure out which. Mackenzie trades with and provides liquidity to uninformed unsophisticated counterparties that have extreme desire for liquidity (in most cases they buy from retail investors who actually bought fully loaded shares during the offering)
Mackenzie’s funds appear to follow the “no bad assets， just bad prices” school of investing. An illiquid non-traded REIT, BDC or LP that is managed by a parasitic external advisor deserves a NAV discount. Yet, in most cases they are worth more than zero. Mackenzie in the illiquid space is sort of like the Bulldog Investors /Special Opportunities Fund is in the traded space, except on steroids without the activism. There are a few other groups that follow a similar strategy, such as CMG Investments, although mainly via personal account or LP structures.
Remember when Third Avenue’s distressed debt fund had a liquidity mismatch problem and had to suspend redemptions？ Mackenzie’s funds bid on the shares at a 61% discount to NAV. The offer letter reminds me of a vulture eating a vulture .