29th November 2015
Tom Becket, chief investment officer at Psigma looks at a dilemma facing investors as they seek value in unloved or even hated assets.
I was recently asked by an investment magazine to provide an answer to “what was my greatest investment mistake?” for a column they were creating. Now I’m sure regular readers will recognise that there are plenty to choose from; self-flagellation by pen is a regular occurrence on these blogs.
My response was that the two greatest perils to investors were timing and ‘value traps’. The first heartbreaker is obvious, while the second simply relates to buying assets that are optically cheap, which you believe will rise in value and recover, but instead they stay cheap for a long time (sometimes they get cheaper).
The value trap is most obviously applicable in equity markets. Japanese equities were a clear value trap for many periods in the last decade(s) before the leader became a laggard. In fact, markets only really started recovering in Japan after nearly all the long term bulls in Japan had decided they were stuck in a vicious and never-ending value trap (I bear the scars of others flagellating me from late 2011). Now as investors gaze around global markets in search of attractively valued assets, they could be forgiven for believing that markets like Brazil and sectors like mining are the new value traps; dirt cheap, much hated and potentially justifiable from a long term perspective. Currently scantily exposed to these areas, we will be reviewing our stance in the early part of next year (or before depending on market conditions).
As we look through our portfolios it is always worth thinking about whether there are value traps amongst our current selections. We’re pretty relaxed that the strategies of all our equity managers have an appropriate balance between value and growth and the vast majority have done a good job this year. The most obvious value traps potentially come in our US high yield credit positions, which, sceptics could rightly point out, had a poor end to 2014 and summer of 2015. Moreover, while equity markets have mostly recovered in healthy fashion over recent months, a recovery has still proven totally illusive in certain credit instruments.
To make clear we do not see such credit positions as value traps. This is not blind faith or wild optimism controlling my writing hand. While equities can obviously be cheap ad infinitum, puffing in all investors and harming them forever until the day of reckoning finally comes (or they get fired), credit simply recovers to par at maturity or it goes in to default, when the company runs out of cash to pay its coupon, files for bankruptcy or cannot refinance. Ultimately there is an endgame for each credit that comes to pass within a defined timeframe.
So what is the “endgame” for our credit positions? The biggest position we have (which did badly last year, before we increased our position and then it subsequently suffered again in the late summer) is in specialist small cap, lower rated credit. To make clear, just because a bond is lower rated by the ratings agencies (who have a pretty chequered record), it does not make it a bad company. In fact, we have specifically worked with an outside manager to build us an index-unaware fund solely focussing on a concentrated number of their universe’s highest quality companies. This part of the credit market has been hit extremely hard over the last year, as investors have sold their positions, believing them to be too high risk, and scared by a rising default rate in the energy sector. As assets came out of the high yield market, the parts our manager has focussed on were hit hardest. It is obvious that there is basically no secondary market appetite for such bonds at present; investors are either focussing on the highest quality bonds or the longest duration, illiquid bonds in investment trust structures. The parts of the market I am referring to here have basically become the “Squeezed Middle”. This now leaves us at an interesting crossroads.
As we have written excessively elsewhere, we strongly feel that the likely future economic and financial market environment should be perfectly suited to exploiting the attractive yields and price recovery in the US small cap high yield sector. Our view is that the ‘M&Ms’ (moderate growth, inflation, interest rates and returns on assets) environment ahead should ensure that companies can operate and survive, whilst interest rates do not need to go up aggressively, thereby making it still quite easy for companies to refinance. Moreover, outside of the stressed commodity sector and in certain specific situations (of which there should be very few), it is hard to see the default rate spiking ferociously from here. It would be naive to assume there will be no defaults going forward as areas of stress, particularly in energy, and ill-disciplined companies are punished.
However, we feel that the US high yield market has generally been excessively punished for the threat of an increase in defaults, particularly in the lower rated and more illiquid parts of the market. In simple terms, the excess return on offer from CCC rated bonds over BB rated bonds is now as wide as it was in 2009. The actual spreads on offer from CCC rated bonds over Treasuries (c900bps) is as wide as it was in 2009 and 2011, following which two outstanding years of outperformance followed from CCC rated bonds. There is a decent chance the same result could happen here, which is our central expectation.
Ultimately though we will find out soon enough, as the innovative structure of the fund we have designed has a fixed limit on the maturity of the bonds we own; either the bonds will default as they come towards maturity or at maturity when they can’t refinance, or they will pull back towards par. If the economy and markets track the path we assume or close to it, we believe that this strategy should offer us returns that other asset classes can only dream about (our base case, even assuming a probably unlikely sizeable rise in the default rate) is high single digits percent. We expect a positive outcome; at least if it’s not it won’t be the long and painful experience suffered by investors in Japanese equities over much of this century.