Portfolio Reshuffle: Not All Debt Is Bad

Includes: EPR, PRD, PRSG
by: James Cullen

What an opening to the year. After a -26% decline on the S&P 500 to the start of March, a 20% rally leaves the index down at “only” -11%. All in all though, it was a successful quarter for my own small portfolio; taking off some risk in early February before my positions sold off allowed me to have a large cash balance and make an opportunistic purchase the day the S&P 500 printed its intra-day low. Overall, a focus on well-financed (note: this does not mean debt-free) companies paid off during the quarter, and enabled me to post a gain of better than 50%.

Note: This is not a perfect representation of day-to-day results, because of a slight delay in inputting trades, but the end result is correct.

Thinking back over the last few months, you have probably heard many people (at least, those not bearish on all stocks) talk about the need to buy debt-free companies, or companies with large excess cash balances (I am probably guilty of that at some point as well).

But all debt is not created equal, and that means not all debt is bad. Why does debt cause problems? The main reason we have seen on the financial side stems from a mismatch in the life of assets and the life of liabilities; further, the liquidity of the assets has evaporated, and the liabilities have remained plenty liquid. This is when being a borrower is a dangerous position to be in.

In the case of Primus Guaranty (NYSE:PRS), the company has survived while being short a large portfolio of credit default swaps in part because its debt funding (NYSE:PRD) is longer in duration than any of its assets. Additionally, the company’s liabilities do not display the positive optionality that comes with having to post collateral – by minimizing surprises, the company weathered a time that brought down many less well-financed companies.

There is something to be said for owning companies with little or no debt, and if I were managed a portfolio of a size that prevented me from concentrating on smaller-scale opportunities, I would certainly have a number of companies like that. That is not my position, however, and in a time where having leverage can create a substantial discount in price to likely value, it does not make sense to simply throw out a company because it has a certain amount of debt. Rules of thumb are useful, but should not be a substitute for a little rigorous research.

Staying with Primus for another moment, Q1 of 2009 saw no credit losses from defaults on its corporate CDS portfolio. Having modeled in nearly $65 million of losses for the quarter, this places the company significantly ahead of where I had it in my amortization valuation model. This does not necessarily mean the peak loss rates from investment grade defaults have been seen, but it does offer some small hope that the overall default rate will be contained. My stress-test loss rate still extends through the middle of 2010, but if I bring the more benign period’s expectations to present, the implied value for the stock is in excess of $9/share.

Below is the cost of credit protection on the lower-rated crossover index, which is looking to test lows last seen in late 2008.

What else fell into place? On the day of the March lows, I finally jumped into buying a REIT focused on movie theaters, Entertainment Properties Trust (NYSE:EPR). Having sized this company up for some time, I ended up purchasing the convertible preferred stock at a steep discount to par; the combination of a high yield and a reasonable buffer in the capital structure relative to the assets in place made this attractive. The company continues to work through some project-specific issues, but I do not see the ultimate value of the company being dependent on the success of any particular deal. The detailed rationale for this purchase is here.

The preference in my portfolio for issues higher in the capital structure is obvious, and the somewhat cruel irony of this has been relative underperformance during this rally, despite having upped my allocation close to the maximum at an ideal time. Such are the vagaries of the markets…

I continue to operate within the context that the bottom is not at hand, and that the markets are in for more pain. This forces me to stay on my toes, and keep a critical eye toward existing and potential holdings, even if it does not change my ultimate allocation, per se.

A short time ago, I gave a presentation about the process of creating a bottom in the market to the Boston College Investment Club. While a very difficult topic to condense and explain across levels of knowledge, it was enjoyable and sharpened my focus on a number of areas. Next time, I will focus more on a broader review of what progress (or lack thereof) was made in Q1.

UPDATE: Because I had to celebrate early, shortly after my posting this, Primus announced that they did have CDS written on Idearc, which recently filed for Chapter 11. The notional exposure is $10 million, and it will be counted for Q1 2009.

DISCLOSURE: I own Primus stock (PRS), Primus debt (PRD), and Entertainment Properties Trust (EPR) convertible preferred stock.