Stock Market’s Strong Performance Could Be Masking Major Risks for Investor
Investors Must Be Willing to Trade Potential Equity Homeruns
NEW YORK, NY–(Marketwired – Nov 13, 2013) – A downside of the strong performance of the U.S. equity market could be that it is making investors complacent — leading them to expect similar returns to continue or fail to recognize the likelihood of significant equity market declines. With interest rates held so low by the Fed for so long, many investors have been forced to reach for yield — and for greater risk. The eventual — and inevitable — tapering, with or without a concurrent slowing of the economy, could pound valuations and multiples in a short timeframe.
However, good returns with much lower risk can be found in the debt of selected highly leveraged U.S. companies, and especially smaller companies, according to Phillip Schaeffer, senior portfolio manager at Scott’s Cove Management, an event-driven corporate-credit-focused investment manager.
“Here’s something we think about every day: Seven years ago, to get a 10% return, an investor had to take on risk equal to about 2 times LIBOR. Today, that same 10% return requires the investor to take on risk equal to 40 times LIBOR. Many investors may not appreciate the significance of the risk they’re taking on.
So what do you do, in any environment, but especially one like this, to get a respectable return with an acceptable risk level? For more than 20 years, we have turned to the unsexy realm of event-driven, senior and secured high-yield debt of middle-market U.S. companies. A lot of these companies are often overlooked, even by many professionals in the high-yield market, but we think that doing the work to search them out can reward investors by providing higher risk-adjusted returns,” Schaeffer said.
To move successfully in this niche of the corporate credit market, one has to adopt a different perspective from traditional stock investors. “Our clients aren’t thinking about homerun sort of returns when they allocate to us; the notion of a sky-high win doesn’t come into play. They expect a high likelihood of not losing money, along with good, consistent returns,” Schaeffer said. “We’re playing cricket, compared with the equity market’s Formula One car racing.”
Importantly, one can’t simply pick any high-yield bond (or high-yield ETF fund) and get the low-correlation, low volatility and “steady Eddie” performance that many investors desire, according to Schaeffer.
He said strong risk-adjusted performance depends on the discipline to:
- Focus on smaller, less-followed companies and sectors and do the fundamental analysis and deep due diligence to be able to recognize where the true risk/reward profile is misunderstood or misperceived by the market. This might include inefficiencies such as bonds that have comparatively little sell-side research and trading support — compared with popular equities — or corporations that don’t file financials with the SEC.
- Get to know the companies really well. “We’ll sometimes follow a company and its securities closely for over a year before we make that investment,” Schaeffer said.
- Search out event-driven opportunities, e.g., securities that are the result of restructurings, bankruptcies or liquidations; refinancings or corporate activities like acquisitions, asset/division sales, litigation, tax issues or other types of extraordinary events.
- Emphasize secured and senior debt (which can be less volatile and carry less risk than junior debt tranches, and certainly less than equities) and interest-paying bonds. The interest provides income stability and contributes to consistency of returns.
- Employ rigorous sell discipline. “If we wouldn’t buy a security we own at its current price, we sell it,” said Schaeffer.
- Go mainly for shorter duration securities — i.e., shorter maturity and higher coupon — which help to mitigate interest rate risk.
- Go short when interesting overpriced opportunities arise, and judiciously use hedging to manage macro risks.
- Be nimble enough to find, and go in and out of, relatively small deals. “Smaller funds that can make $5 million to $25 million investments — versus the $50 million to $100 million that larger funds have to invest in each situation — are at an advantage,” he said.
- Spread the risk. Run a reasonably diversified book that moderates the risks of any individual position, but don’t be afraid to have a few more concentrated positions to benefit from your fundamental position.
- Know when to swing for the fences. “Home run performance usually comes with strikeouts. With most debt securities, you don’t get the unlimited upside of stocks, so why take the downside risk? But when you have equity-like upside with bond-like downside, it’s okay to take a reasonable risk.”
“There are times when markets favor expert stock/bond pickers. Every market — especially this one — favors expert credit analysts. Finding the right bond is more technical and ‘in the weeds’ than playing the hot stock of the week, and may not provide the same adrenaline rush. But we think the results of consistent, corporate-credit focused strategies, combined with a constant focus on capital protection, may serve investors better, especially over the long run,” Schaeffer said.
About Scott’s Cove Management LLC
Scott’s Cove Management LLC (SCM) is an event-driven long-short, credit-focused investment manager whose objective is to protect capital and generate compelling absolute returns in all market environments. On the long side, SCM focuses primarily on senior and secured debt of lesser-followed high-yield corporate issuers, including distressed situations. On the short side, SCM seeks fundamentally overvalued and economically deteriorating issuers as a hedge to protect the portfolio. SCM (including its predecessor firms) was founded in 1991 and is based in New York. For more information, please visit www.scottscove.com.