Having Fun Yet...Part II

John Hempton wrote today that he believes the current rout in the global stock market can be partially attributed to margin calls. And I believe him.

Below is a chart of the Bloomberg designed index MARGDEBT, which tracks the amount of debt balances in margin accounts at the NYSE. Here is the chart going back 20 years:

You will notice that margin balances decrease dramatically in market downturns and increase dramatically in market run ups. This chart runs through June 30th, 2011 - You may notice we were veering into bubble territory at that point.

More to Hempton's point: Large liquid names were moving like people HAD to get out. Forced and uneconomic selling is a gift to value investors. While playing in large cap, high quality names may not give you the BEST returns in a market correction to the upside, the risk to the downside is minimized, and some of the valuations out there are very very compelling. If you want a place to start looking, look at the Dividend Aristocrat Index which is made up of companies in the S&P 500 that have increased their dividend for each of the past 25 years. With the 10 year bond at 2.3% and the DJIA dividend yield at 2.8%, it's where I'm sticking capital in the face of the abyss. I also find some merger arbitrage deals (LZ for instance) fairly compelling despite only an 8% annualized spread - feels like some of these names are also getting the boot b/c of the out performance (essentially flat) relative to a down 15% market.

I also think certain areas of the market just have not corrected enough. Buying protection on a basket of defense names that are still trading ULTRA tight given the outlook for defense spending in the medium term is an interesting hedge with asymmetric upside / downside characteristics.

And distressed is coming back folks. Here is the Bloomberg chart, that I love to show, with the number of issuers trading at 1000 basis points over the benchmark treasury:

Unfortunately, let's put a little context to this. The chart above only goes back through 2010. Here is the chart going back 4 years:

It still feels like to me that high yield credit just hasn't felt near the pain of equities on the aggregate or on a single name basis. To be honest, I do not know why that is. Here are some opinions:
  1. High yield bonds are relatively illiquid - real money sellers are tapping the more liquid equity markets to fund margin calls and fund redemptions
  2. Demand for high yield paper was incredibly robust from 1Q 2010 through seemingly a few weeks ago - accounts that never got filled on deals are topping up positions making a more reasonable two sided market relative to equities
  3. Corporate balance sheets are stellar and given the maturity schedule of high yield bonds and levered loans, no large default spikes are imminent
  4. HY returns is still positive on the year - retail flows will start allocating towards the better returning asset classes.
None of these could be right - I just don't know. I think everyone has an opinion; and my opinion is there is better value in equities right now than credit. When on the run bank debt trades into the 600s and 70s (avoid buying in the low 80s / high 70s because the CLO rule of 80 really hurts technical around the 80 price level), I'll definitely find some value there.

Thought and opinions are always appreciated. Looks like tomorrow (futures down 270 points at midnight) will be another wild ride.

One final note: Warren Buffett, in his Annual Letter for Fiscal Year 1987, recounted Ben Graham's analogy of Mr. Market first outlined in Intelligent Investor. I think it offers some perspective on the current market:
"Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can
see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-
depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day
in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr.
Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."


Anonymous,  8/09/2011  

Wonderingif you could tell me the Bloomberg symbol for the number of issuers trading 1000 bps over. Or if it is not a direct symbol, where the data is on Bloomberg.

Anonymous,  8/09/2011  

Data is on DIS.

Wharton_RestructuringGuy,  8/09/2011  

Check out LCD's flow name composite - price dropped to 90.77% of par today, with a bid ask spread of 120 bps. Primary issue will be dry for some time (flight to safety?) Credit markets movement slowing down, probably the best short term return is equities/ETFs.

Anonymous,  8/10/2011  

Hunter, you said:
"Buying protection on a basket of defense names that are still trading ULTRA tight given the outlook for defense spending in the medium term is an interesting hedge with asymmetric upside / downside characteristics."

I'm not sure where the asymmetric upside of this bet is. I assume you mean that you should buy low and perhaps people panic and the protection trades higher. Because I don't think fundamentals on any of these names merit anything BUT tight spreads. Check out LMT, NOC, GD, and RTN - the four pure-play defense primes (I exclude BA here simply because their commercial business is, at this point, significantly more important than defense). GD has more cash than total debt, RTN and NOC can get to 0 net debt in less than two months' worth of operations, and LMT can get there in less than 6 months, but if you count their massive pension receivable that doesn't currently show up on their balance sheet due to accounting peculiarities, they have no net debt. So fundamentally, I don't see the case for buying protection on defense names. Granted, I am in the tank for these guys because I won a bunch of their stocks - that's my full disclosure...

Investanomics 8/14/2011  

Interesting article. I agree that equities are starting to show some great value opportunities. I have a few cyclical names in my list that have some compelling valuations.


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.