Thursday, July 16, 2015
To see just how much of a game changer regulators’ crackdown on risky lending has been, take a look at a loan Vista Equity Partners arranged for one of its companies this year.
When the Austin-based private-equity firm shopped for a lender to arrange more than $200 million for tax-software firm Sovos Compliance, it passed on three banks, including one of the biggest underwriters of such debt, according to Kevin Sofield, Vista’s director of capital markets.
Instead, it opted to go with Golub Capital, a Chicago-based asset manager that charged a higher rate but allowed Vista to load the company with a level of debt that’s been deemed too risky by banking regulators. That meant Vista needed to put up less equity for Sovos to acquire another software company, Sofield said.
“Getting a greater quantum of debt is worth whatever that extra cost might be,” he said in a telephone interview.
Private-equity firms are increasingly turning to smaller lenders and asset managers to fund buyouts they’d normally have arranged by banks. That’s pushing more lending beyond the purview of regulators and disrupting the $822 billion market for leveraged loans that’s long been dominated by lenders including Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co.
Direct-lending funds, which raise money from institutional investors such as pension funds and insurance companies, surged to a record $29.9 billion worldwide last year, according to data provider Preqin.
Banks have been backing away from the riskiest deals as regulators demand higher levels of capital and discourage them from underwriting loans that would load a company with too much debt.
The Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. introduced guidelines in 2013 to curb excessive risk-taking in a market where total outstanding debt has ballooned more than six-fold since 2001, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.
The Fed on Wednesday noted that issuance of leveraged loans declined in the first half of 2015, compared with the level a year earlier.
“Market participants continue to point to the leveraged lending guidance as having affected the market,” according to the Federal Reserve Board’s Monetary Policy Report delivered to Congress. “The share of loans -- mostly those for middle-market companies -- originated by non-bank lenders reportedly has increased a bit further.”
The report said that the underwriting quality of leveraged loans had shown a “modest improvement, but overall, underwriting standards remain weak.”
The regulators have specifically raised concern over debt that pushes a company’s borrowings to more than six times its earnings before interest, taxes, depreciation and amortization. Sovos’s acquisition of ShipCompliant pushed the company’s leverage to seven times that measure, Sofield said. Golub shared the deal with Guggenheim Partners LLC.
Golub wrapped up its best six-month period for lending since it entered the business 20 years ago, said David Golub, the firm’s president. It originated 58 financings in the first half of the year, with a total volume of $4.7 billion. About a quarter of the deals were for companies where the debt-to-earnings ratio was above the level recommended by regulators, he said.
“The growth in our originations in the first half was despite a relatively slow middle-market M&A environment,” Golub said. “The single-biggest factor is the leveraged-lending guidance.”
Some companies also are turning to smaller lenders because they are perceived as more nimble, said Greg Hackman, chief financial officer of retailer Boot Barn Holdings Inc. The company, which is 48 percent owned by Los Angeles-based private equity firm Freeman Spogli & Co., turned to Golub to fund its acquisition of Sheplers Inc. last month.
“We considered a syndicated deal” through a Wall Street bank, Hackman said, but decided the process would be too lengthy. “In the end, Golub allowed us to be more competitive because we were able to get our financing in order very quickly.”
Other firms that aren’t beholden to the same regulations have benefited from the lending crackdown. They include Jefferies Group LLC and Guggenheim. Even private-equity firms including KKR & Co. have seized on the retreat by beefing up their lending operations.
JPMorgan, Bank of America, Credit Suisse Group AG, Deutsche Bank AG, Barclays Plc and Morgan Stanley are among banks that have passed on deals in the past year because they would have run afoul of the rules, people with knowledge of the situations have said.
“In years past you used to be able to invite three or four or five regulated banks into a financing process and be confident you could get 90 percent if not 100 percent hit rate on folks getting the approval for your deal,” Vista’s Sofield said. “Now with the regulatory guidelines, it becomes much less certain how many, if any, will be able to do it.”
Posted by Bud Fox at 12:24 PM
Friday, July 10, 2015
Ray Dalio's argument on China's market movements
He makes the argument that China’s market movements are not significantly reflective of, or influential on, the Chinese economy, nor are they extremely impactful on investors in China and abroad. Instead, what is currently happening is typical for a newly developing equity market that is dominated by what he calls “unsophisticated speculators.”
A lot of people think that the direction of a stock market is indicative of the direction of an economy. That is because a) the prices of stocks normally reflect the conditions of the companies, and the mix of stocks reflects the economy; and b) changes in stock prices have a wealth effect that affects economic activity. As we will show in this Observations, that is much less true for China than for other countries. That’s because 1) the liberalization of the financial system and all that is going on is not connected to the growth rate and normal economic linkages, and 2) the complexion of stocks is not representative of the economy. As a result, China can have a bull market or a bear market at the same time it has the opposite behavior in its economy. So don’t bet on those linkages.
The Chinese equity market has experienced an enormous meltdown in recent weeks, losing about a quarter of its value since peaking in mid-June. Hundreds of stocks have halted trading.
Chinese authorities have taken increasingly drastic measures to prop up shares. The government has lent billions of dollars to brokerage firms to buy blue chip stocks, put a stop on IPOs and barred controlling shareholders and board members from selling for six months.
Analysts at Societe Generale offered an analysis of the Chinese government’s actions in a note on Thursday. “While the Chinese government continues to battle with the falling stock market, we are concerned that asking big financial situations to catch the falling knife is not helping lower systematic risk,” they wrote. They added that as more measures are taking in the coming days, they believe the policy focus should be on the real economy and the general liquidity level in the overall financial system.
Ray Dalio's assessment puts focus on equities in the context of the greater economy as well.
The billionaire hedge fund manager points out in the July 2 publication that the recent fall in the Chinese stock market has been small in relation to its gains. “The recent 20% decline in the A-Share market came after the 140% prior rise that has occurred since last summer,” he writes. “The vast majority of the price moves have been driven by changes in stock multiples, while corporate earnings have gradually glided higher over the past few years.”
Also driving the Chinese market higher has been the increased participation of new and inexperienced retail investors. Around two-thirds of those opening new brokerage accounts in recent year have less than a high school education.
The explosion of unseasoned investors in the market contributes to volatility, and as Ray Dalio points out, many will get burned as prices rise and fall.
Adding fuel to the fire is the fact that larger, more sustainable buyers have not yet participated significantly in Chinese equities. Ray Dalio writes:
In the process of developing China’s equity market, policy makers are moving to broaden institutional participation, both by opening up their markets to foreign participation and also strengthening domestic institutional savings pools. But we are still early in the process and, at this stage, institutional participation by both foreign and domestic institutions is still limited.
And while China has been making reforms in order to open up its domestic markets to foreign institutional investors, it still has a long way to go.The Chinese stock market appears to be in a perilous situation, but Ray Dalio holds that its linkage to the actual economy is limited. Simply put, the role of the country’s equity market in the economy is still low, as evidenced by a number of measures.
“Equity market development and liberalization are happening independent of one another, so the changing nature of flows in the equity market and the gyrations in return aren’t necessarily representative of what’s going on in the economy, like they might be in a more developed market,” Ray Dalio writes.
For instance, the sector composition of China’s equity market departs from what is happening in its actual economy (for example, financials are more heavily represented in the market than in the overall economy). Moreover, the equity market is a picture of what Ray Dalio calls the “old economy,” which is dominated by state-owned enterprises and industrials, instead of new, high-growth emerging sectors that have increasing economic importance.
Ray Dalio also notes that Chinese households remain underexposed to equity markets and instead have much higher holdings of cash when compared to more developed markets. In other words, the equity market’s plunge isn’t hitting the Chinese people as hard as it would their counterparts in other parts of the world.
While the situation in China is certainly worth monitoring, according to the Bridgewater Associates team, its impact should be entirely manageable both domestically and abroad.
Ray Dalio notes that equity holdings in China are only about 20% of the country’s GDP. The government and corporations own the majority of the market cap, and their spending is typically less sensitive to wealth and stock prices. “Since household equity positions are so much smaller than is typical, the wealth effect will work differently and be much more modest than one would expect in more developed markets, where equity holdings are more significant in size,” he writes.
He adds that the ripple to the global economy is also likely small:
We are just at the beginning of the process of opening up Chinese capital markets to the world, and global investors’ positions are still relatively modest in the context of overall global equity portfolios, especially for A-Share positions that have had most volatile market action.
Bridgewater Associates representatives declined to comment.
Posted by Bud Fox at 5:27 AM
Value investment specialist James Montier of US asset manager GMO has reduced risk to levels not seen in his fund since 2008.
Montier, who previously voiced concerns to Citywire Global about the difficulties facing asset allocators, said market challenges had intensified.
‘This is definitely the most difficult time to be an asset allocator. It’s very hard to find value,’ Montier told Citywire at the Value Intelligence Conference in Munich, an event hosted by Value Intelligence Advisors (VIA).
The fund manager recently cut his equity exposure to US ‘quality’ names and, as such, has upped cash in his Global Real Return fund. He currently holds 20% in liquid assets, i.e. cash and derivatives, while a further 30% is invested in fixed income.
‘2007 and 2008 we had about 80% of the fund in non-risky assets. This has been the first time since that we have had over 50% in very liquid assets,’ he said.
His recent cut in US equities included exiting stocks such as Proctor & Gamble and Microsoft, which he sold on valuation grounds.
‘We still see these names as a relatively good option for equity investors but as we are value investors, we decided to cut them back a bit as they were getting expensive and so we’d rather hold cash.’
One area where Montier thinks there is still opportunity to select find value is in the emerging market space. Here he has added to names such as Russian oil and gas major Lukoil and Korean telecoms group Samsung.
Montier said he is currently breaking up his market view into three different ‘hellish’ situations.
Firstly, there is a kind of ‘stable’ hell, for Montier this is the worst and least likely situation, where rates stay low over a long period and volatility and as such entry opportunities are minimal.
Then he describes something near to purgatory, which, Montier said, is the most helpful environment for investors. This is where he sees the market still moving between a low interest rate and a rising interest rate scenario.
The final of the three scenarios is an ‘unstable’ hell, where the market goes in one direction but keeps getting back off of course.
‘I can’t tell you exactly how it is going to work. We may see US rates rise in the autumn but I wouldn’t take it for a given.’
‘Investors are constantly asking me how long I’m going to keep the cash position and what is going to be the ultimate trigger for reducing. I can’t say that, it does worry me if we are in this stable hell environment but at the moment, I think it’s best to stand a bit and hold onto some dry powder.’
Posted by Bud Fox at 5:25 AM
Wednesday, July 08, 2015
Every few years, people start to question whether value investing is dead. A recent Google search along these lines generated 3.1 million results:
Likewise, people sometimes question whether the size effect is permanently going away. For instance, during the dotcom craze in the late 90s, large-cap growth investors made small-cap value investors look foolish. People jumped on the bandwagon, and embraced the “new paradigm” for investing.
In “New Paradigm or Same Old Hype in Equity Investing?” Chan, Karceski, and Lakonishok (a copy is here) examine equity returns across the growth/value and large-cap/small-cap spectrum during this era. I went ahead and cherry-picked some key data that illustrates the big picture trends explored by the authors.
In the academic world, market returns during the 1970s and particularly in the 1980s were fertile grounds for researchers studying the cross-section of market returns, and variables that explained them.
For instance, as can be seen from the panel below (from the paper, as are the other data below), during the 80s, value stocks earned more across the board than growth stocks, and small-cap value stocks beat small-cap growth stocks by 9% per year.
This 1980s sample period was influential in the establishment of the “size anomaly” and the “value premium.” The evidence seemed clear – you should go forth and buy small-cap value stocks.
But then something strange happened–Both of these anomalies seemed to show elements of reversal!
1. First, large-cap began to outperform. Note below how from 1984 through 1998, large cap beats small cap:
And the large-cap trend only accelerated in the late 90s:
2. Second, growth also seemed to outperform value, particularly for large-caps. From 1990-1998, large-cap growth beat large-cap value:
And again, as with the large-cap outperformance above in #1 above , by the late 90s the trend in growth also appeared to accelerate:
Indeed, in general, growth began to look like the better overall bet than value. Based on value weightings, growth stocks beat value stocks by 1.1% from 1990-1998 (although small and mid cap value still beat growth over the period).
Particularly in the late 90s, large-cap growth just hammered small-cap value. In 1998, for example, large cap growth earned 41%, while small cap value earned -1.2%. Value investors began to look like idiots.
During this period, even the king of value investors — Warren Buffett — began to feel the pain. In their paper, “Buffett’s Alpha,” (a copy is here) Frazzini et al. observe that from June 30, 1998 to February 29, 2000, Berkshire Hathaway lost 44% of its value while the overall stock market gained 32%. Thus, over this ~1.5 year period, Warren Buffett underperformed the market by an astonishing 76%. At the tail end of this stretch, Barron’s published a piece entitled, “What’s Wrong, Warren?” From the article:
After more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch.
Huh? What was going on here? Was Warren Buffett no longer a guru, was value investing dead, and had the small-cap premium disappeared forever?
Some seemed to think so.
Yet, if this were the case, how could you explain why these anomalies would do a 180 degree turn, and perform in a way that was the opposite of how they had performed previously?
The paper examines three potential explanations for why this could be the case:
Under this view, the outperformance of large-cap growth was driven by a series of unexpected positive shocks for large caps, and negative shocks for small caps, perhaps due to new technology, or investor expectations. If this were true, then the performance edge of small-cap value should reappear in the future.
Popularized during the dotcom bubble, this view argues that technology and the dynamics of large companies have altered the investing landscape. Technology will allow huge long-run returns, with high growth rates persisting in the future, and large-caps have sustainable advantages based on their scale and international presence. Therefore, the old paradigm, in which firms were priced based on historical returns, no longer applies, and new valuations might be low given the new high expected growth rates under these new-paradigm conditions. If this is true, then small-cap value may continue to lag large cap growth for a long time.
This view argues that investors overreacted to the growth potential of technological innovation, and prices became disconnected from underlying fundamentals. Additionally, as markets continued to march higher, and large cap growth continued to outperform, the trend was self-reinforcing. If this view is right, then small-cap value will in the future exhibit return patterns consistent with its historical performance.
We can test these explanations. Did large-caps experience excess profitability and small-caps experience depressed profitability? If this were true, that would support the Rational-Pricing and New-Paradigm interpretations. If we failed to see this evidence, that might support the Behavioral interpretation.
So what does the evidence say?
The authors examined performance data based on four accounting metrics: net sales revenue, operating income before depreciation, income, and cash dividends. We’re going focus on sales only since, as the authors point out, this data has no negative values, and is “smoother” (although you can read the paper to confirm that the other accounting metrics exhibited similar characterists). The authors examined the price-to-sales ratio of the various asset classes and found something surprising:
Note the extreme multiple expansion for price-to-sales that occurred for large-cap growth from 1997 through 1999. This expansion was obviously not duplicated by the other asset classes.
Yet was this expanded multiple justified by the fundamentals?
Note below how 1996-98 sales growth for large-cap growth was nothing special at 6%. In fact, growth badly lagged the 29 year average for large-cap sales growth of 10.3%.
Meanwhile, sales growth for small cap and mid cap showed no particular weakness; in fact, small-cap sales growth from 96-98 was 12.7%, versus its long term (70-98) average of 8.1% — much stronger than historically!
While we have only reviewed price-to-sales versus sales growth in detail here, again, the other profitability metrics reviewed in the paper are consistent with these observations.
We therefore have a reasonable basis for rejecting the Rational-Asset-Pricing argument, since we observed no unexpected fundamental shocks. Sales growth trends actually showed the opposite: it was weak for large-cap growth, and strong for small-cap value.
Similarly, we can (mostly) reject the New-Paradigm argument, since we weren’t able to identify any emerging trends in sales growth that would justify higher valuations. It’s possible that these dramatically higher growth rates would show up farther in the future, but again, you would expect to see at least some evidence that this was occurring.
Accordingly, it seems reasonable to embrace the third argument: Behavioral/Institutional. That is to say, the very high valuations of large-cap growth became disconnected from any reasonable assessment of future growth prospects, and this was driven by human bias, as investors overreacted to new technology and wild extrapolations of internet growth, and they chased anticipated returns.
Taking a Step Back
This observation is not especially revolutionary, in hindsight. By now, it’s obvious to everyone that during the dotcom years investors were caught up in “irrational exuberance” and bid up large-cap growth stocks to unsustainable highs. Yet it is still remarkable to see the actual fundamental data laid out so starkly and juxtaposed with equity prices.
One observation that emerges from this analysis is how broader trends and market distortions can cause certain historical patterns and relationships, such as the size anomaly the value premium, to break down. Yet, once these behaviorally-driven market trends recede, and internet fever subsides, it seems reasonable to think longer-term value and small-cap effect will take hold once again.
Of course, during this period in the 90s, people began to question value and size effects. As was demonstrated, Warren Buffet lagged the market by 76%! And people questioned him and his methods. Now that is the kind underperformance that can give you plenty of cover to argue that Buffett has lost his touch, that value investing is dead, and that only suckers believe in the size anomaly.
Yet we have a long history of returns that gives us confidence that value and size effects are persistent. So we should be realistic and recognize too that they are not consistent. That is, there are prolonged periods, such as this stretch in the late 90s, when large-cap growth looks like the smart way to bet going forward.
So when you see a broad reversal, say when large-cap growth has a stretch of outperformance, don’t be fooled. Consider that it’s pretty likely that you are getting fooled by “new paradigm” thinking that prevailed in the 90s.
Posted by Bud Fox at 8:06 AM
Friday, July 03, 2015
Thursday, July 02, 2015
Earlier this week we highlighted that we’d seen the first 2% down day in the S&P 500 since the 4th quarter of 2014. In that post we showed just how depressed volatility has been by showing that no rolling six month period since 2012 saw more than two or three 2% down days for the broad index. Chart below:
In this post we show a modified chart of the one above in which we simply count the number of 1% down days over the previous rolling six month period. This chart, as you would expect, is more volatile, but it’s also quicker to pick up turning points in the stock market. Since the end of 2014 the indicator has rather quietly moved from 5 to 13. The S&P 500 is still up on the year (just barely), but by this measure there is more volatility underneath the surface than we’ve see since 2012.
Posted by Bud Fox at 1:27 PM