This weekend I read Elliott Management's Quarterly Letter for the period ending June 30th, 2012. The letter was penned a few weeks ago, amd I think it has some pretty interesting takeaways on the market climate investors are dealing with on a day to day basis. Here's an introductory paragraph:
"Global financial markets currently feel like they are in a period of calm before a storm, possibly centered on the European situation. The problem is that no one can foresee when the storm will make landfall, or how severe it will be. However, if history is any guide, serious economic and market disturbances are likely to provide us with a variety of complicated restructuring and other trading opportunities, so we are ready to don our foul weather gear. In the meantime, we are concentrating on adding some positions in real estate securities and structured products. In those markets, there still seems to be a sweet spot of labor intensive, complex, small- to medium-size situations which we are taking on at attractive prices, despite the general overpricing of mainstream or trophy properties."I wrote about this in the past, but is "hope" an investment strategy? I am not sure. I often hear strategists using the central bank "put" to get long the market as the tide of never-ending stimulus continues to roll on in prompting investors to bid up financial assets to levels where the risk / return spectrum doesn't make sense. What is fascinating about this dynamic is that in the end, the pain is just going to be so much worth for the entire system. Except of course for distressed investors that know how to navigate through the choppy water of situations that other investors decry as too ugly or too complicated. The choice words: "complicated restructuring" always brings a smile to my face.
I try to distinguish distressed situations into a few buckets. Some are very valuation oriented in the sense that ultimate exit multiple will be the ultimate determinant of recovery. Some are very legal in nature where a few choice rulings by a judge can tilt recoveries dramatically. Some are a combination of both. And others are just simply situations where you have to be in the weeds, working diligently with all parties involved to even come close to having an idea of intrinsic value of securities. This year some of the best performing distressed assets are part of these last groups and specifically surplus notes and holdco notes of some of the financial guarantors. I would wager that if 50 funds were spending a significant amount of time on ATPG, 5 of those 50 had the capacity and capability to look at an Ambac or Syncora.
On government bonds:
"Safe haven" could be the two most expensive and painful words for investors in the financial lexicon this year. Indeed, long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward."I wish there was a way to measure this but I generally believe that the market will hurt the most investors at any one time. It is the contrarian in me. If everyone is long tech in 99, the market will crush tech. If everyone is long real estate in 2005, the market will crush real estate. Ben Graham and Warren Buffett uses the analogy of Mr. Market, a manic depressant business department that will sell to you at high prices in times of glee and at low prices in times of gloom. I think of this manic depressant to also be a serial killer that enjoys pain and suffering of his counterparties.
Fixed income investors in long term government bonds have so many structural issues to contend with that pain is on the horizon. These investors are the opposite side of the same coin of the investors that get long the market due to hope of central bank actions. Both are relying on an third party to control their destiny, just in different fashions. I do understand the argument about being long treasuries as a disaster hedge, but a hedge is very different than an investment. I personally would never put money to work in SPY 100 puts as an investment, but I am long them as part of a holistic view on the portfolio (think portfolio insurance).
Final quote from Elliott's letter:
"Of course Elliott’s goal at all times is to construct a portfolio which is protected against both the foreseeable and the unpredictable adverse forces and surprises that afflict long term trading strategies and firms. That is what we have tried to do for 35 years, and for the most part we have been reasonably successful and consistent. One of the ways we accomplish this is to pursue a mix of activities which have different drivers of risk and reward than just assessing future business values or interest rate and inflation trends. We also seek a staggered profile for exits and cash-out events. That is why we especially favor “uncorrelated” positions which require lots of manual effort, as well as situations in which we have substantial degrees of control over our destiny. For this reason, it is often the case that substantial portions of our portfolio generate some exits and inflection points at times when many firms’ books are stuck."I unfortunately have no idea how Elliott constructs their portfolio for the tail scenarios I spoke about above. In fact, I wish I knew more of their distressed analysts to be frank (contact if you ever want to chat ideas).
What I do like about this quote is the commentary on hard catalysts (exits and cash-out events). A friend once told me the difference between a value trap and a good investment is a catalyst. For distressed investors the number of catalysts are numerous. For example, entering bankruptcy itself could be a catalyst for either a long or short position. Let's say a company with a senior bond and a sub bond files for bankruptcy. Those senior bonds may rally as left value is flowing to sub bond coupons. A judges ruling itself could be a catalyst where the market might be pricing in a ruling far different than you anticipate. Patriot Coal's venue change ruling will be an interesting one in that sort of vein.
I talk to a lot of people on the buy side. Everyone is so blah now. Maybe its because its August and I don't particularly spend a lot of time looking at European situations which has been the Garden of Eden for distressed fund raising in the past year. More maybe its because the markets a bit a head of itself. If I had to rate it on Oaktree's risk scale I'd say we are approaching a 4. Not quite there yet, but very close.
One statistic thrown around often is how under invested funds are right now. And when funds are under invested, they under perform en masse. And that's whats happening right now. Especially on the long / short side. And with high yield being up nearly 10% this year, many credit / distressed funds are under performing there as well. Does that mean market participants will bid up various risk assets throughout the 3rd and 4th quarter trying to chase performance? I'm note sure. I've always struggled with that argument because liquidity can turn on a dime and funds that were chasing can turn out to be the greater fool in hoping to sell to a greater fool.
This is a very very difficult market to be an active participant in. Every day you could wake up and Greece could have defaulted, or the Middle East could break out into a scuffle, or China's economic data could be worse. And as the markets bid up risk assets and push credit spreads down, its just going to be more painful on the other-side. So like Elliott I am looking for off the radar, complicated distressed situations (I've spent a ton of time on PMI, and less off the radar, but fascinating: EIX/EME) and protecting the gains I've made using way out of the money puts as well as spending a whole lot of time on the short side selling call spreads and buying puts when volatility isn't too high. And as usual, working on projects that I'll announce to readers shortly.