Introduction

In our recent article on mercer.com, “Has the music stopped?" we suggested that the current market dislocation may have presented long term investors with a number of interesting, nay compelling, investment opportunities.

The Credit Suisse Global Risk Appetite Index (see below) confirms that markets have swung decisively from a state of euphoria to a state of panic.

With bond markets pricing in expectations of deflation (credit spreads being at highs not seen since the depression of the 1930s) the key issue for investors is whether to batten down the hatches by removing all risk from the table or to position themselves to take advantage of the opportunities being presented to them. 

This note reviews the background and highlights potential opportunities that investors can access in a calculated fashion allowing for “margins of safety”, per Benjamin Graham.

Market Opportunity or Valuation Trap?

Many asset managers believe that the current pricing of a wide range of assets is being driven by savage de-leveraging and is thereby highly distorted. The counter view is that unless the availability of credit normalises (among other things), prices of risky assets will continue to fall way past their rational floors, rather like Sisyphus’s boulder, as a severe and prolonged recession takes its toll. 

The extent of the dislocation appears substantial. The following examples illustrate the perceived distortion of current pricing: 

• Investment grade credit is pricing in five year cumulative defaults of about 37%.¹ This compares to the peak five year cumulative default rate in the mid 1930s of 5%.
  
  
• 57% of the convertible bond market is trading below their bond floors (i.e. convertibles are cheaper than the equivalent “straight” bonds). There are numerous examples of stock specific “anomalous” pricing – one example is Tata Steel which is trading at about 14% over Libor. The cost of insuring against Tata Steel default (the cost of the CDS) is about 2% and the convertible matures in 2012.²
  
  
• It is less straightforward to apply science to equity valuations but Tobin’s Q is below zero for the first time since 1991 and the Robert Schiller devised cyclically adjusted price earnings ratio is below average for the first time since 1988.³
  
  
• Equity market trailing dividend yields are higher than government bond yields (S&P dividend yield is about 0.4% in excess of the 10 year treasury yields, for UK equity the yield gap is about 1%, for Australia and Canada 2.5% and 1.3% respectively).⁴
  
  
• The current high levels of equity market volatility present investors in some markets with the ability to trade equity market gains in exchange for protection for equity market falls (for example in some markets gains in excess of about 40% can be traded for protection of the order of 20%).⁵

   

The reader will have heard of many other examples. 

A strong case can (and is) being made to support the contention that assets have been oversold and valuations are cheaper than rational pricing would suggest. Additional support for an allocation to some of these assets comes from concerted government actions to either provide specific support to certain sectors, to step in as the “spender of last resort” (the extent of support and stimulus program in the US government is estimated to be about $8 trillion⁶ and the Chinese government is expected to spend $600 billion) or to reduce interest rates, in some cases close to zero. Central to all the policy making is the hypothesis that the politicians and central bankers of today are well versed in the mistakes made in the 1930’s and are resolute in trying to make sure these mistakes are not repeated. 

Material risks remain however. The lack of credit availability to roll over existing debt is a source of real immediate concern for many companies, even those with sound businesses. Consumer debt remains at all-time highs (in the 1930s consumer debt as a percentage of net worth or household income was significantly lower) and we are told by the experts that consumer-led recessions tend to be more severe than other types of recessions. Asset prices may well suffer from further bouts of de-leveraging and negative feedback from the real economy. 

So valuations are attractive but the short term outlook is very cloudy. In this context Mercer’s view is that there are very real opportunities for long term investors but the associated risks need to be considered very carefully. 

In the context of the current market dynamics, being a lender has a number of advantages over being an owner. The credit environment is such that companies will be focusing even more acutely on balance sheet strength and cash-flow management (even equity analysts have become credit experts). At the micro level this will be beneficial for the credit of companies. Additionally these actions may be detrimental to equity holders – dividends may be reduced or cut, capital expenditure may be curtailed and the additional costs of refinancing debt will be a drag on the return on equity. Also at the macro level, policy actions will favour lenders (assistance to specific sectors and any new regulation of, for example, the banking sector will favour bond holders). 

Equities will also suffer from the headwinds of downward earnings pressure – although earnings have been downgraded the conviction levels of equity analysts would be expected to be at all time lows given the unknown negative feedback loop from the real economy. Having said this at the stock-specific level there will be companies which have defensive qualities and others which can benefit from the current environment. 

All of which suggests that moving up a company’s capital structure has the advantage of providing reasonable real returns even if spreads remain at current levels (based on current market conditions investors can expect a return of about 5% pa⁷) and equity-like (or even better) returns if spreads were to contract meaningfully as well as superior principal protection relative to equities. In other words credit opportunities have, in our view, additional margins of safety relative to equities. We would also favour short maturity bonds, this helps to protect against any inflationary risks resulting from the government stimuli and means that investors can harvest good returns via a hold to maturity strategy. 

Some of the rationale above also supports investing in convertibles. The additional advantage of investing in convertibles is having the opportunity to participate more on the upside, especially if equity markets recover quickly. The price of the optionality is low compared to straight options. 

Making an assessment of hedge fund investing is complex. Given the Darwinian nature of the industry and flexible business models, hedge fund managers may be well placed in the new environment. In addition some of the large and successful players are showing a greater interest in developing more strategic relationships with “sticky money” (typically pension funds). However hedge funds are faced with a number of headwinds – the cost of financing has gone up (in some instances materially so), many hedge funds depend on rapid trading for success, transaction costs have increased and the industry has a number of challenges to deal with in respect of liquidity. In aggregate the hurdle for alpha is higher and the fees charged have not changed materially as yet (although there is evidence they are starting to come down). 

Given the abundance of market, or beta, opportunities, and the comparatively low cost and ease of accessing them, hedge funds will have to fight for their allocation of investors’ assets. To the extent that investors wish to continue to allocate to hedge fund strategies we would propose that investors focus on areas where there is greatest opportunity and where funds have been less affected by de-leveraging, which will include equity long/short, market neutral, liquid trading strategies such as global macro, and specialist strategies requiring only modest leverage such as distressed debt. We feel that highly leveraged strategies (including several “arbitrage” strategies) will be less viable on a standalone basis, although could be accessed through multi-strategy funds. We are less enamoured of some traditional fund of funds approaches which we feel need to adapt to survive in the new environment. We do see some role for the minority of funds of funds that have a reasonable value proposition, especially for clients with smaller governance budgets. 

Historically, the secondary private equity market has been a source of liquidity and opportunity for investors to "tidy up" their private equity portfolios. With the strong growth in fund raising in the buyout sectors (globally) over the past few years, and the onset of the credit crisis, secondary investors are currently seeing increased deal volume as sellers look to reassess their positions and either free up balance sheets and /or manage allocations which are outside of the investor's strategic range. This has resulted in an element of "forced" sales which has created opportunities for investors with patient money. However, we believe the ability to source and assess the quality of the transactions is crucial. Also the value creation process will depend on finding either trade buyers and or successful exit via the public markets.

Potential Next Steps

Based on the above, in our view the opportunity set in essence consists of:

“Let the maths create the value”

Lenders have a greater margin of safety over owners. In addition, harvesting the opportunity in the credit/convertible area does not require a change in investor sentiment. Given that bonds return principal on maturing, investors comfortable with short term market fluctuations have a compelling opportunity, on a risk-adjusted basis, to invest in securities which have reasonable to strong return expectations and with (better than equity) principal protection characteristics. The additional advantage of this opportunity is that yields are higher than equities. The real opportunities are stock-specific and we would favour investing at the short maturity end, on a buy and hold basis with credit oversight (i.e. not a passive exposure).

“Benefit from the first wave of improved investor sentiment”

Certain parts of the developed equity markets (companies with strong balance sheets, no cash-flow issues, relatively free of debt) are attractively priced in our view. Value creation, however, will depend ultimately on sentiment changing. Although this opportunity has strong principal protection characteristics, performance will depend on the behaviour of other investors; principal is at risk and value will only emerge as investors return to buying securities.

"Opportunities once the dust has settled”

History suggests that periods of economic stress can result in opportunities in private equity investments. Specifically there are likely to be attractive opportunities in the private equity secondary markets but again value creation depends on the exit prices and is therefore to some extent hostage to equity market recovery. As such opportunities have a longer value creation process and are contingent on a return to some degree of normality. Access and management are more complex and the opportunities likely to be more idiosyncratic. 

A number of the narrow opportunities – such as mortgage backed securities or bank loans are, in our view, likely to be best accessed by extending the current bond managers’ investment guidelines.

Summary

Markets have swung from a state of euphoria to one of panic. The wholesale abandonment of “risky” assets has presented long term Investors with a number of potentially attractive investment opportunities. However material risks remain – lack of credit availability, excessive consumer indebtedness, rapid descent into recession and the potential for further bouts of de-leveraging. Investors therefore have the choice of ‘running for cover’ or taking advantage of the opportunities being presented. 

The key question for investors is whether the market is presenting them with a genuine market opportunity or are the opportunities really a “valuation” trap?

The key themes of this paper are: 

• That despite the efforts of governments, the short term outlook remains very cloudy.
  
  
• Being a “lender” may have advantages over being an “owner” – in practice, from an asset class perspective, this means that credit investment is likely to be less risky than equity. At the stock specific level there will be companies which can benefit from the current environment so the paper is not negative on equities per se.
  
  
• Given the abundance of market opportunities, which can be accessed relatively cheaply, higher cost and complex investment approaches (such as hedge funds) will have to fight for their allocation in investors’ asset allocations. This is not to say that they have no role.
  
  
• As far as possible credit opportunities should be harvested with margins of safety – in practice this means that we favour shorter maturity bonds, bonds which can be held to maturity on a largely buy and hold basis (but with active credit oversight) and are of the view that convertible bonds are also attractive.
  
  
• Active management may be increasingly important in this environment.
  
  
• For some clients there are opportunities to trade upside beyond a certain point in exchange for some downside protection. The change in the pay-off profile of the underlying equity exposure may be attractive for some clients with shorter term constraints. 

   

Overall Mercer’s view is that there are very real opportunities for long term investors in a number of areas, some traditional such as credit and some new, such as convertibles. Further we are of the view that is it possible for investors to position themselves to access these opportunities but with associated margins of safety to reflect the real risks which remain.

Footnotes