Black Friday Sales in the Capital Markets
Everyone enjoys the satisfaction of getting a good deal or taking advantage of a sale. At this time of year, we are bombarded with messages about retailers offering deep discounts. My filtering process entails researching products, comparing offers and finding promo codes to secure the best deal. For most purchases, we save $50 here and $20 there, and the experience is exhilarating. The same can apply to investing, but the financial rewards can be much more lucrative. We are never short of stock ideas from financial news hosts and guests, but what about those areas of the market that fly below most investors’ radars and offer great returns? What are the hurdles to finding and investing in these areas? Why are they on sale now?
Current Market Environment
This year an exogenous shock crippled global economies. We didn’t experience a traditional business cycle, and the economic path we followed did not resemble the last two recessions, which were caused by overinvestment and a banking crisis. Additionally, the swift and robust monetary and fiscal policy responses to the economic disruption avoided a deepening of the economic damage and put us on a path to recovery sooner than most expected. The March carnage in equity and corporate bond markets was short-lived, and many investors missed capitalizing on the dislocation. We are confident that we will not see another fire sale of assets unless another shock hits the U.S. economy. Global economies have proved resilient, and a healthy banking system coupled with further stimulus should propel growth in 2021 and future years.
Equity markets have climbed back to all-time highs on vaccine news and optimism around economic reopening. Earnings growth will likely be strong in 2021 and 2022 as a result of cost-cutting measures and pent-up demand. With global interest rates stuck near 0%, we advocate an overweight to equities, using fixed income for liquidity and risk management. We have been evaluating other strategies to include in our portfolios for diversification and additional return. These strategies include distressed corporate credit, structured credit, private equity and real estate. Some feature Black Friday pricing currently, while we believe others will go on sale in 2021 and 2022.
Distressed Corporate Credit
Distressed corporate credit strategies focus on purchasing the debt of a financially stressed or bankrupt company with the goal of restructuring the company and exchanging the debt for a package of cash, debt and/or equity in the new business.
Two criteria have ignited our interest in distressed credit. First, default rates have increased, especially in sectors other than energy and retail. Second, the dollar amount of leveraged loans and high-yield bonds has more than doubled since 2008, thus creating a large supply of bonds for distressed investors. Prior to 2020, private equity buyouts of companies featured increasing leverage, and COVID-related revenue declines have pushed many good companies into financial stress. We forecast a multi-year opportunity in distressed credit as these overleveraged companies are forced to file for bankruptcy or seek rescue financing. When evaluating managers for investment, we are avoiding sector-specific themes and “falling knives” with low potential recovery values or binary outcomes. We have focused our attention on managers specializing in small and mid-cap situations.
Structured or securitized credit was created to redistribute risk from pools of assets into tranches to appeal to wider range of investors. In a securitization, each tranche has a different risk of loss and coupon. Riskier tranches have higher coupons and less subordination, so if a portion of the referenced asset pool defaults, the riskiest tranches may experience a loss of principal. The pools of assets can consist of residential mortgage loans, commercial loans, leveraged loans, bonds or other asset-backed securities.
Currently, the Federal Reserve is not buying lower rated or unrated securities, and many structured credit buyers had large redemptions in the spring. This vacuum of liquidity has improved since March, but the dearth of buyers has resulted in an attractive risk/reward profile relative to most fixed income securities. Currently, our favorite areas include pre-crisis residential mortgage backed securities (RMBS) and collateralized loan obligations (CLOs). Structured credit can be implemented through mutual funds with daily liquidity, hedge funds with quarterly liquidity and dislocation funds with a 2- to 7-year lock-up.
Previous private equity vintages around recessions performed well, and we believe this trend will continue. Companies’ valuations have largely recovered and now exceed those prior to March, but the multiple expansion in private equity has been in line with or below that of public equity markets. Private companies, in general, offer a discount to public comparisons, and we believe the opportunity set in restructured and impaired businesses offers substantial upside.
The opportunity in private equity secondaries has underwhelmed our expectations in the last few quarters. Unlike 2008, there will be fewer forced liquidations and significant pricing concessions, but we still find the asset class attractive. We advise investors to be aware of valuation methodology and timing and less caught up in the size of the discount to net asset value. Depending on the date of the valuation, discounts/premiums may vary widely.
In real estate we are taking a multi-year view and concentrating on three key themes: current cash flow, accelerating trends and dislocation. Currently, we are evaluating stable, cash-flow- producing multifamily and office properties. Prices have not declined substantially, but financing rates have plummeted, creating a historically large spread between the capitalization rate and the cost of debt.
We also believe recent trends in real estate will likely continue. Industrial and some retail properties will migrate into essential last-mile distribution facilities. Also, the tailwinds behind single family rental strategies have strengthened during the pandemic.
We do not believe we will see a sustained mass migration from large cities, nor will all companies move to a permanent work-from-home policy. However, we do believe assets will reprice over the next 3 years. Post financial crisis, many of the best real estate deals occurred in 2010 after owners could not sustain debt service or assets were valued at less than the debt on the property. Few assets have traded hands since March, but we will likely see opportunities to acquire office and hospitality properties at significant discounts to current valuations in 2021 and 2022.
Broadly, equities and interest-rate-sensitive investments have recovered to pre-pandemic pricing, and their relative value and future returns are less attractive. The disruption in the capital markets earlier this year provided numerous opportunities, many of which are still available. In most cases, the risk/return of these investments compares favorably to that of equities and fixed income, but investors may have to take on illiquidity in order to earn the extra return. We recommend investors create a roadmap with their advisers to evaluate and potentially take advantage of these “capital market sales” over the next 2-3 years.