Remember this series? Yep, I’m spending an unconscionable amount of time getting through it. FFS, I started last June, promising a closer look at my portfolio construction, allocation & metrics. ['Hitting The Century' as it was my 100th post. And 'Pretty Panties' because I was so bemused by the prior response to the phrase]. Instead, you get a bloody epic – like The Hobbit. Oh well, blog rules…how ’bout I try finish by next June?!
Honestly, I expected it to turn out like this. But I’m delighted at the great reader response – I guess I’ve been trying (ad nauseam) to pound the message home that portfolio construction/asset allocation is just as important as stock-picking. [Studies suggesting asset allocation accounts for 90% of returns have been debunked, but more recent studies certainly confirm an average/minimum 50% of returns are derived from this source]. Unfortunately, this is forgotten/ignored by a lot of investors, even great stock-pickers… Admittedly, they may (occasionally) practice some kind of ex-post allocation – better than nothing, but an ex-ante approach is vital if you really want to end up with a safer, more diversified & higher return portfolio.
OK, let’s trot on – here’s a familiar pie-chart as a quick reminder (sure, it’s a little out of date – but have you noticed my portfolio turnover?!):
This asset category remains unexploited by the majority of investors. I assume, first & foremost, natural investor optimism steers most people away. I mean, who really wants to invest in disaster? And why invest at all if you seriously think things are heading south? But I look at it v differently… First, I find distressed investors are laser focused on (discounted) assets – I’ve quite an affinity with that style of investing! Second, to avoid distressed investing is to miss out on i) a great portfolio hedge/diversification, and ii) perhaps an enduring source of potentially high return investments.
To explain, I need to expand on my idea of distressed investing. First & most obviously, it’s investing in distressed companies & securities. This is a specialist activity, and I’m happy to recognize my limitations – I prefer to invest via asset managers & investment vehicles. I’ve got a holding in Fortress Investment Group (FIG:US), a US alternative asset manager primarily focused on investing in leveraged & distressed companies, plus distressed assets & securities. I also had a holding in Colony Financial (CLNY:US), a Colony Capital vehicle investing in distressed property assets & securities. I’ve since replaced CLNY with Tetragon Financial Group (TFG:NA), an investment fund (& budding alternative asset manager) primarily investing in the residual equity tranches of US CLOs. I also have an (undisclosed) long-term holding in a distressed debt fund.
For most investors, investing in similar stocks will make the most sense. Lack of time, knowledge & experience mostly dictate against direct distressed investing. The preferred choice of instrument will also militate against most investors. Sure, investing in distressed equity can sometimes be incredibly tempting, but it’s pretty much a mug’s game:
i) Over-leveraged companies can seem wonderfully cheap. Investors happily dive in…and get crushed! Smart value investors do more analysis, make appropriate adjustments, invest cautiously…and get crushed! I’m amazed how ridiculously cheap such companies can eventually trade…
ii) Investing in distressed penny stocks can seem like a low-risk (‘How much can you lose, it only trades at X..!?‘, famous last words) & fun way to earn big profits. Yeah, it’s not… As most discover when they wake up to that (inevitable) overnight/weekend bankruptcy announcement.
iii) The US takes this to a piggish & idiotic extreme… Trading in bankrupt shares is permitted, even facilitated, for months or even years. Despite a success story or two (which is all you’ll ever hear about), realizing an investment profit from a bankrupt stock is about as likely as the bloody Pope resigning. Sorry, what…really?!
So, unless you’re clairvoyantly gifted, it’s usually best to avoid distressed equity & stick to the more senior instruments of the capital structure. Unfortunately, the scale of most investor’s portfolios, the quality of their information access, and their choice of broker, means they’re often poorly served. Buying bonds is often an ill-informed minefield – in fact, many investors don’t even get the opportunity, they’re essentially confined to investing in equities…
Regardless of whether you’re investing directly or indirectly, it’s a marvelous opportunity to add negatively/un-correlated exposure to your portfolio. When times are good, distressed just keeps its head down & acts more like an event-driven investor – churning out steady, if unspectacular, returns. Of course, pick the right managers & the right stocks (a nice NAV discount really helps!), and you can rack up v respectable returns.
Then, when things start turning sour, distressed really comes into its own. Opportunities multiply, prices fall & IRRs rise, and investors eventually clamour for this type of investment exposure. Think of Europe right now – ECB liquidity has created an illusion, masking the dire reality embedded in balance sheets across the banking sector. But from a distressed perspective, there’s perhaps a generational investment opportunity on offer – find the right investment vehicle or two, and you could definitely go all-in with that bet! Or just play it down the centre – take on that distressed exposure to hedge other parts of your portfolio which may desperately rely on European economic growth. However, if things really go tits up, distressed sometimes hurts just as badly as the rest of your portfolio. Bad times bring them ‘good‘ prices – but also potentially serious mark-downs on their existing assets.
[More to come, but consumer loan companies are a classic example. Good times: Good returns, based on v high rates & fees, and ideally an expanding market share. Bad times: Great returns, based on rates, market share & a huge expansion in clients/demand. Really bad times: Everything's rosy, 'til you wake up one day & they shit all over you with a whopping great write-down on their loan book. Oh, and suddenly everybody realizes they're wildly over-leveraged...].
But this is a risk all investment funds & managers face – developing a firm view of the economic outlook can help protect you in your timing. Bloody difficult homework that..! It’s probably far easier & safer to seek out distressed opportunities with low levels of debt, or even surplus cash on hand. This offers better protection and, more importantly, significant latent fire-power to bulk up & take advantage of better deals/prices when it’s the right time & place. [This may well apply to any investment - I'm often puzzled how under-rated strong balance sheets are in the market. Look to Buffett: He thinks of cash as the ultimate call option - a permanent option on all asset classes, with no set strike price].
What really excites me though is a much broader opportunity – one focused on the distressed consumer. Oh Lord, do you really want to invest in an industry that indulges in the immoral exploitation of the poverty-stricken? Oh please, we’re all bloody exploited now – welcome to the corporate-media-retail complex. [Ike warned of the military-industrial complex, ignoring the fact that over-spending/debt has likely crushed empires just as much as military defeat]. Millions of consumers are persuaded each year they desperately need to buy handbags (among countless other baubles) at a couple of grand a pop – surely those transactions are just as immoral, on the part of the buyer, as well as the seller?
In reality, the industry isn’t really about exploiting poor people. [OK, well, it is - kinda... But that particular demographic is inefficient to recruit, expensive & labour intensive to service, and (by necessity) the amounts involved are small]. It’s really much more focused on people who appear incapable of: a) spending within their means, and/or b) avoiding truly dumb financial decisions. Essentially, we’re talking about exploiting stupidity – which I think you’ll agree is an abiding human frailty. As an investor, that’s a bet I’ll always take, any hour any day. But I’m certainly not suggesting poverty implies stupidity (though the converse is quite likely true). All too often, stupidity is simply the great equalizer…
Let’s take how some people buy cars: First, the specific car is often far more incidental than you might think – Joe Bloggs’ objective is pretty simple: ‘I want the biggest & best car possible, but I can only afford a monthly payment of X’. So, what’s really being negotiated is the bloody car payment! And the dealer, after some appropriate hemming & hawing, is sure to pull a rabbit out of the hat. Yep, they end up buying that dream car – which originally seemed just out of reach – and the payment just scrapes in under their maxed out limit. So what if their payment term’s now doubled, and their rate’s jacked up sky high..?!
OK, confess, you’re kinda looking down your nose at that car buyer? Not something you, or your friends, would ever dream of doing – right? But let’s consider a slightly different example: Substitute John Smith (a slightly pompous middle-class professional) for Joe Bloggs, a real estate agency for the car dealership, and think about the usual house buying ordeal. Now tell me – in most instances, what’s the difference between that schmuck house buyer & the bozo buying the car? Yeah, very little..! Both just want the biggest & best they can afford for their monthly payment nut, and damn the bloody consequences. Which, of course, includes ignoring the risk of losing their job, and having a snowball’s chance of keeping up with the payments.
And that’s just the tip of the iceberg. Know any Sex and the City single gal pals who shop in discount stores & scrimp on groceries, and then blow it all on a Louis Vuitton handbag? That’s just financially idiotic, if not downright schizophrenic! What about the work colleague who you discovered genuinely believes they’re on top of their financial situation, simply because they keep up with their minimum credit card payment? What about the neighbours who always keep up with the Joneses, but are actually living just one payslip away from (genteel) poverty?
And what about the great unwashed unbanked - estimated at 20 mio adults in the US (& 1-2 mio in the UK)!? Who on earth is stupid enough to prefer living in a world where they pay to cash their pay-check, load money onto celebrity debit-cards with ridiculous fees, and who take out dodgy loans at incalculable interest rates? Perhaps the same people who absolutely must have a 50-60 inch TV – so they actually rent it for a few years, before they finally end up owning it for perhaps quadruple the original retail cost.
What about US students who fund 4 star hotel trips to Cancun on their student loans & credit cards? Or that family you know who hit the jackpot with their child’s missing limb – and promptly cashed it in for an up-front payment at a 25% discount rate? Let’s not even mention the financial travails of over-paid sports stars – far too stereotypical, but another reminder that stupid beats rich. And what about people buying anything from infomercials, or home shopping channels? Or people, in the US, who stroll into their local convenience store for a pack of smokes & then hit the store ATM for a few twenties (for a $3 fee) – there’s two dumb decisions in just 60 seconds! I could go on & on…and I haven’t even mentioned gambling! Or the eventual clean-up crews for all of this – yes, the debt collectors.
Of course, there’s a whole world of companies & services that exist to satisfy this insatiable demand. Some are considered (more or less) socially acceptable – tobacco, gambling, luxury goods, etc. – it’s really fascinating to see the multiples investors award those particular stocks! Others you may be completely unaware of, personally or as an investor. You’re not alone – not a single US friend I know has ever heard of Rent-A-Center (RCII:US), despite the fact they’ve got 3,000 bloody stores open across N. America?! And that spells opportunity…
Most listed companies servicing distressed consumers have grown out of what were originally real Mom & Pop businesses & sectors. Yes, they now face more robust & professional competitors, but they also share a wonderful customer base that’s woefully unprepared to evaluate their fees, rates, and terms & conditions. And they enjoy the fact that Western society, particularly the US, now seems hell-bent on persuading everybody they can – nay, that they’re entitled to live beyond their means. Read this report on US poverty today & weep…or not! Most importantly, they seem obviously neglected by a majority of investors & fund managers – consequently, they often appear way under-priced vs. their current level of profitability & their long-term revenue/earnings growth record.
Of course, the industry has plenty of failings too. This type of distressed investment may not be something you want to boast about at dinner parties…er, well, actually I do! Considering their potentially small-town/sleazy origins, there are operators who (despite being listed now) might best be avoided. Others have poor governance, and/or continue to have a controlling shareholder/family – something you may want to think twice about before investing. Then there’s the constant risk of political/regulatory interference. Quite honestly, this doesn’t seem to have any long-term impact (but it can cause some nasty earnings surprises). In reality, politicians are mostly paying lip-service – unfortunately, people who don’t contribute (or perhaps even vote) are usually far down their list of priorities. Anyway, you can’t regulate stupidity – when politicians/regulators change the rules, they’re often chagrined to discover people end up turning to far worse alternatives.
Many of these companies have been lulled by easy industry profits over the years, so they’ve never really been forced to attack their cost/income ratios, or the labour/property intensive nature of their business. As some now face more aggressive & professional competition (from their listed peers), they’ve taken on increasing levels of debt to maintain/boost returns. However, firms are now finally embracing internet lending to open up new markets & to reduce costs. Unfortunately, by its nature, this increases their exposure to unsecured lending, so this new development (along with more debt) has generally increased financial risk in the sector.
Not surprisingly, the US has the largest/most developed industry & the most listed companies – I have a nice holding in Asta Funding (ASFI:US), a US debt collector that’s now expanding into other areas of distressed finance. Continental Europe, on the other hand, is probably the largest untapped opportunity – so it’s rather frustrating to discover it appears to offer precious few listed investment opportunities. Otherwise, I’m kicking myself, as I’ve really only begun to appreciate the multiple attractions of this sector recently. And I’m still way behind on my (global) study of the sector. I’d happily increase my Distressed portfolio weighting to 20%+ on a semi-permanent basis, when/if I can determine the v best companies on offer in terms of value vs. opportunity.
I’ll return to this topic with my next post in the series – I hope to run-through a wide selection of sectors & companies that I’ve discovered to date, and which you may want to consider also as potential distressed investment opportunit
Filed Under: Value Investing,