A Case for Value and Corporate Bonds Over Growth
I have been very fortunate to have played the recent rally in the stock and bond markets from the long side in all of my personal portfolios. My CAPS score has taken a beating lately because I am positioned much more conservatively both here and in real life than many of the top players currently are...and I am completely fine with that. I am not currently and have not been short anything in real-life and I'm short only a handful of stocks in CAPS, so I have escaped all of the punishment that the permabears who put their money where their mouths are have been forced to endure.
The recent rally has been a mixed blessing. It obviously was a positive because as someone who is long stocks I have made money. The downside is of the move is as an investor who often focuses on stocks that have attractive dividend yields or bonds that have attractive yields to maturity, the awesome deals that we saw at the beginning of the year when everyday names that are in decent shape financially like Dow Chemical, Amex, JPMorgan Chase, Alcoa, Textron, Caterpillar, Corning, and Reynolds American had bonds with relatively short maturities were yielding 8%, 9%, or even double digits are long gone. Today one has to work a lot harder to find decent yields. The bond market has healed so much that rates are even several points lower today than they were only a month or two ago. Deals are still out there, you just have to look harder.
I recently had Textron make a tender offer for several of its bonds that I purchased at the height of the credit craziness that ended up providing me with annualized yields of between 30% and 60%, which I gladly took them up on. I also was able to sell some AIG bonds on the open market for close to face value after having purchased them at a steep discount a while ago. As a result, I have some cash to redeploy. The question is, what to buy?
I can't talk about the specific companies, but I made one bond purchase today. I decided that in order to get the yield that I want, I had to dive into the sub-investment grade arena. These bonds are a little more difficult to trade than investment grade issues (particularly on Schwab), but as long as you plan on holding them to maturity their illiquidity is not a problem. Besides, the whole label "investment-grade" is fairly worthless anyhow because it relies upon the opinions of idiotic companies like Moody's and S&P. No thank you, I'll do the due diligence on my own. Why anyone would rely on these companies' ratings, when at best they have proven themselves to be consistently wrong over the past several years and at worst they are criminally negligent...intentionally misleading investors in an effort to boost their own profits is beyond me.
Anyhow, I found a bond from a major company with well-respected management that isn't in danger of going bankrupt that yields over 7.5% through 2013. That's not going to light anyone's pants on fire, but it's worlds better than the 4% or worse rates that one would find from companies that are in similar or worse shape but have "investment grade" ratings.
I've also been sniffing around MLP pipeline companies again. The 7%+ yields are just too attractive to ignore in the current environment. I also like the pharma sector. It is one of the few that has lagged in the recent rally. One can find solid companies there, with excellent dividend yields that I believe investors are overreacting to the dangers surrounding.
I'll stay on this crazy ride that Mr. Market has taken us on over the past several months, but I'll do it from the right lane rather than the fast lane. If I miss a little of the upside, so be it. I feel much better being positioned conservatively in a market that is trading at a crazy valuation to what I foresee as its current and future earnings.
On a related note, while I was looking around the letters to investors from an interesting investment manager that I came across today, Roumell Asset Management (its main fund has optperformed the S&P +158% to -10% since 1999), I came across the following excellent case for buying bonds:
Why buy stocks? The answer lies in the fact that fixed income investments often lock in low returns. Consequently, investors seeking a superior return attach themselves to a company’s earnings stream or asset conversion possibilities in the hope that they provide a better return than staid, boring fi xed income investments, aka bonds. However, we continue to find attractive absolute rates of return in the corporate bond market (principally high yield), particularly within a risk/reward context as compared to stocks (principally represented by the major market indices). Bonds, even high yield ones, are senior to common stock in a company’s capital structure...
Investors, the media and others have often repeated the mantra that for assuming the risks noted above, stocks return roughly 10% per annum over time. A savvy investor ought to ask, “Over what time?” Here things get dicey. Just going back 40 years, we now have several signifi cant periods of total return drought: from 1966 to 1982 market indices were essentially flat, a 16-year famine; and the 10-year return for the S&P 500 index ending June 30, 2009, is a negative 2% per annum inclusive of dividends. A more truthful mantra, which might result in fewer stocks being purchased, would be, “Stocks for the long, long, long term.” The reason stocks are so widely held in such large proportions to people’s net worth, even in the face of often common stocks themselves. What industry—with its attendant media chorus—rivals Wall Street in terms of marketing acumen? The truth is that stocks are most often sold, not bought. dismal results over long stretches of time, is that few things are as vigorously marketed on the planet as common stocks themselves. What industry—with its attendant media chorus—rivals Wall Street in terms of marketing acumen? The truth is that stocks are most often sold, not bought...
We now have about one-third of both our Balanced and Equity accounts in fixed income securities. Why?
Contrast a bond’s contract with a stock’s sensitivity. In bonds, so long as the company makes its interest payments and pays off at par ($1,000) upon maturity, we lock-in an annualized rate of return. (See Global Industries and Clayton Williams discussions below). Gone are overly sensitive common stock characteristics: estimating earnings with a fine tooth comb, determining an appropriate multiple to apply to those earnings, determining asset deflation possibilities, and viewing such numbers within the context of capital structure realities; i.e., how levered is this business. Bonds are contracts. Quoting our “Special Situation Fixed Income Opportunities” brochure sent out with our first quarter letter, “First and foremost, a corporation must meet its debt obligations…This is the legal right of the creditor that cannot be taken away unless the creditor either consents or Chapter 11 relief is granted under the Bankruptcy Code.” Put simply, the returns we locked-in (absent default) in the past several months have been mind-boggling (representing 10% to 30% annual rates of return for bonds maturing typically in eight years or less). Moreover, although credit spreads have contracted, we still find the corporate bond market (notably high yield) attractive as a whole, and particularly in specific instances. In our opinion, the corporate bond market is better priced than major stock market indices. To wit, even after a run-up, the high yield spread over Treasuries is still near an all-time pre-2008 high of roughly 800 basis points. The stock market P/E ratio (averaging trailing 10-year earnings as Graham and Dodd recommended) is at a very average multiple of 16x earnings. Can the risks currently present in the economy be described as being average?
There are three fundamental reasons why in today’s market we prefer to lock-in returns on high yield debt rather than speculate in the stock market in the main (aside from our unlevered special situation equity investments):
■ Difficulty in estimating corporate earnings given consumer retrenchment, credit contraction and rising unemployment.
■ Government intervention is increasingly making it diffi cult to “see” what is really occurring in the economy. Further, national debt levels are problematic, necessary as this debt may, in fact, be.
■ The yields available to us in select sectors of the corporate bond market are historically high and quite attractive on an absolute basis...
The letter goes on, and on, and on, but you get the idea. Here's a link to the rest: Roumell Asset Management Q2 Letter. Definitely make sure to check it out. It's an excellent read and it even contains some excellent investment ideas at the end.