As part of reviewing my personal investing tactics year-to-date, I try to think about what is (and is not) being rewarded in the equity and credit markets. Looking at the Sector SPDRs, only technology and materials are positive on the year; financials, industrials, and utilities are down double-digits.
The big question on many minds is whether or not the recent resilience of the stock market is a sign that the bottom is in. Last week, I gave a presentation (will be posted soon) about the process of creating a market bottom – one not focused on valuation, which is useful on a company basis, but seems to have no predictive power for broader market turning points. If you follow the running debate among macro forecasters, they will claim the earnings multiple at “the bottom” should range from about 5x to 12x earnings, depending on how you quantify “earnings.” Once that kind of range is accepted, and added to the variability of earnings estimates, the futility of using valuation to pick a bottom should be apparent from the range such a method yields. Instead, I have tried to focus on the more important qualitative elements – we know that many numbers will look ugly, so other questions should be considered:
- Are corporate strategies workable?
- Do companies have the balance sheet strength to execute on their strategies?
- Is investor sentiment poor enough to yield strong forward returns?
I view these as a proxy for three incredibly important questions when applied to individual companies:
- Is the business going to be profitable over the long term?
- Will the business be able to survive to see that future?
- Have investors in the space already competed away the benefits that will accrue to business owners?
There is a correlation between the three issues above, but for brevity’s sake (and this will be a longer article) I focus mainly on sentiment and future returns here. A central thesis to this is which party holds the bargaining power in terms of raising capital; call this my attempt to apply Porter’s Forces to questions of capital allocation. While not perfect, it is a lens to view questions of whether or not the market for risk assets is in favor of investors or not. During a bull market, companies have the upper hand in that they can raise capital on favorable terms. It is easy to sell equity, the IPO market is willing to digest new shares, and insiders are happy to cash out their stakes. Likewise, credit is available on terms favorable to companies, who can use the cheap financing to expand capacity and meet growing demand.
In a bear market, this changes – and that is a good thing for investors. As holes in company balance sheets are exposed, the demand for capital exceeds the availability of capital. With the supply/demand equation working in favor of investors, secondary equity offerings occur at steep discounts to the existing stock price, and new debt issuances come with much wider credit spreads. What recent data is here to suggest this is happening?
- Hutchison Whampoa (rated A3) sold $1.5 billion in 10-year, dollar-denominated notes at 475 bps over Treasuries (via Bloomberg)
- HSBC sold out a $19 billion rights offering at a 40% discount (via Bloomberg)
- On average, companies are issuing convertible bonds with smaller conversion premiums; recent issuers include Ingersoll-Rand (IR) at $300 million, Alcoa (AA) at $575 million, Newmont Mining (NEM) at $517.5 million, and Johnson Controls (JCI) at $852 million. This area was particularly hard-hit last year, as it was one of the worst-performing hedge fund strategies (via Bloomberg).
More healthy companies can raise fresh capital, but at a higher price. Others have problems servicing their existing obligations, and are forced to negotiate with lenders. This presents lenders an option to try cutting losses at present, or extract a pound of flesh and continue to extend a lifeline with the expectation that route will prove more profitable - via Bloomberg.
Lenders charged an average 2.04 percentage points more in interest in exchange for easing loan terms, up from the previous high of 2.02 percentage points in the fourth quarter, S&P LCD said…
Spreads on the average actively traded loan have soared to 9.4 percentage points more than Libor from a margin of 1.87 percent more than the lending benchmark in June 2007, before prices fell below face value, according to S&P LCD. Libor was set at 5.36 percent on June 6, 2007.
Another line from the above article that caught my eye:
“They’re sticking it back to them in the same way the companies were sticking it to them a couple of years ago,” said [Steven] Bavaria, who started loan and recovery ratings at S&P in 1995 and moved to the Canadian rating company DBRS two years ago. “Banks have long memories.”
Again, this is one of those infrequent times where bargaining power has generally been in favor of those with capital. Why is this? In my presentation on market bottoms, I discussed the abilities of industries to recapitalize themselves through profitable operations. At the top of the cycle, too much capacity is chasing too little business, resulting in negative long-term returns. The poor resulting ROI causes some firms to close, until the remaining players turn profitable. Just as it works in industry, so it works in investing. As investors pull back, or leave the scene completely, those who stuck around and have preserved their capital in the interim are left with better opportunities.
What is common about those with capital to invest at market bottoms? The buyers use little to no leverage, and this enables them to have a long-term time horizon and realize the economic value of assets. (Tell this to those who oppose mark-to-market, and how financial institutions could avoid those marks if they had the balance sheet strength to classify their assets as held-to-maturity). At the end of February – within a week of the most recent low – margin debt on the NYSE hit its lowest point since 2004. Deleveraging may not be complete, as that amount is still 30% above the levels from the Fall 2002 lows (not adjusted for the differences in price, either), but it’s a sign that we’re getting closer and some progress is being made in terms of restoring health to the markets. Another upside of long-term, underleveraged holders is that their purchases can function to reduce effective supply – their strategy is not to seek quick gains, and they will not be pushed into forced selling.
The end result? Eventually, risk premiums will be large enough – without the actual risk of equity ownership being very high – to attract sufficient interest from the strong hands. The hot money is off pursuing other asset classes (I would suspect/have suspected gold this time; the lack of a move has been puzzling but shows that irrationality may not have completely taken over) or implementing the real end-of-the-world trade: long only canned goods and ammunition in a bunker – and quietly letting great future returns from equities pass them by.
There are many indicators one can use in an attempt to quantify sentiment; elsewhere I’ve pointed to a pair of Bespoke polls showing that 90% of investors at the November 2008 and March 2009 lows expected stocks to decline from there (most common expected decline: 20% or more). Both times public opinion has reached those levels, stocks have bounced – so though I’m not saying a definitive bottom has been put in, I think prudent investors have been looking at the quality of corporate risk assets throughout the last six months, and judging the potential returns against the risk of buying into situations that could get materially worse. This kind of analysis goes to the other two questions at the beginning of the article – on business models and balance sheets – and those will be the focus of the next article.