Concrete Concepts for High Yield Research: Part 2
Last week, I introduced the idea of ten concrete concepts that our high yield research team uses to help summarize the many interacting factors and variables that make high yield a unique and challenging asset class. In my previous blog post, I covered the first five: cash flow, capital, cushion, cyclicality, and competition. To finish up this thought, here are the last five:
- Cost Structure – A company can’t provide products and services to customers without incurring some costs. Within a particular sector, many companies face similar cost pressures, but not always. For instance, there is a currently great disparity between the cost of natural gas in Europe (high prices) and in the United States (low). This has created a tremendous opportunity for companies in the chemical sector that use natural gas as an input to their production process.
- The ones located in the U.S. have a tremendous cost advantage at the moment. In our investment research, these types of disparities and trends are important in determining relative fundamental performance between companies and sectors.
- Control – It’s a rough and tumble world out there, and it’s important to know who’s pulling the strings. In high yield, we like to know who owns and controls (not always the same) the companies we invest in. We like to understand how those owners have behaved in the past with their other investments. Even knowing the types of investors who own the high yield bonds and bank loans can be an important determinant of predicting a likely course of action for a particular company. Behavioral predictions based on who controls various parts of a company’s capital structure can be a critical component of a high yield investment decision.
- Collateral – This concept ties closely to our Cushion discussion from my last post. Just like a personal auto loan is backed by the car, some high yield bonds, and most leveraged loans, are backed by assets (called collateral). If the company fails to pay on time, lenders can claim those assets as recompense for the lost income. Therefore, we need to have an estimate of collateral values before we invest to give us comfort that we will get our investment back. However, knowing the value isn’t enough. We also need to know how difficult or easy it might be to get our hands on the collateral. Is the collateral a fleet of ships sailing outside of U.S. territorial waters or a satellite floating in outer space? Neither would be easy to recover. These are important questions that we incorporate into our evaluation of any collateral being proposed as backing for our investments.
- Covenants – Always read the fine print. Each bond and loan we invest in has some set of legal agreements (called covenants) associated with it, and within those agreements are the rules by which the issuer agrees to play. There is often a blueprint in those covenants on how the issuing company intends to operate in terms of maximum amounts of debt or how much cash they are allowed to return to shareholders. Most of the time, companies don’t push these limits, but when times get tough, they often start looking at the covenants and wishing they hadn’t agreed to them. It’s times like this where it pays to have a good understanding of how aggressive a company is allowed to be before they need to come knocking on a lender’s door for some relief. Understanding an investment’s covenants and marrying that understanding with our knowledge of a company’s strategy and strategic position can give us an investment advantage.
- Common Sense – When all else fails, use your common sense. If it looks too good to be true, assume it’s too good to be true until you can prove otherwise. Just like in everything else, there is no free lunch in the high yield market and the only way to outperform is to work hard and use all the tools and Concepts at your disposal.