Another Minsky Moment in Income-Generating Securities?

Market Commentary

The goal of the Income Opportunity Strategy is to provide a high level of income through the ownership of undervalued, income-generating securities. As long-term investors, we don’t expect our holdings to appreciate in value in some smooth, linear fashion, but we hope to eventually see them converge with our assessment of intrinsic value. Under normal circumstances, we expect most of the return to come from the dividends and interest generated by the holdings, but we hope to generate a capital appreciation “kicker” if we are indeed buying undervalued assets.

It appeared as recently as April that we were on the right track. Since then, the Strategy has declined significantly, as credit spreads have widened and global growth has slowed. One would expect such a decline to come with falling cash flows and payouts, though we have seen the opposite across the portfolio. We noted in our Q2 ‘15 post that dividend increases outweighed dividend cuts, both in number and in weighted payout, which is a trend we have seen continue. The apparent lack of a fundamental reason for the portfolio’s swoon caused us to look elsewhere, and we have several ideas but no definitive answer. However, we remain more optimistic about the Strategy’s prospects than at any time in the past few years.

First, risk aversion today is incredibly high. An academic paper examined whether macroeconomic experiences affect risk-taking and investment behavior, and it concluded that market events experienced during one’s lifetime influence risk-taking much more than facts and historical data. Investors tend to like asset classes that they have seen perform well and dislike asset classes that have performed less well. Nowhere is this more apparent than in today’s equity risk premium, which is the extra return that investors demand to own stocks over the government bond. NYU’s Aswath Damodaran calculated that the equity risk premium at the end of 2015 was 6.1%, higher than all but two of the past 55 years – 1979 and 2008, both of which were very good times to buy stocks. While past is not necessarily prologue, high equity risk premiums have historically meant strong forward returns for stocks.

Second, spread widening among weaker credits, especially energy, metals and mining names, has contributed to headline risk and liquidity problems for some strategies. One manager’s “focused” credit fund recently froze redemptions and is liquidating, while another prominent manager has stopped publishing AUM figures, which leaves investors fearful about getting their money back and adds to the selling pressure. We believe the Income Opportunity Strategy’s small size and its positioning in liquid securities, predominantly equities today, enables us to meet redemption requests without difficulty. One other notable point is that less than 2% of the Strategy was in assets tied to the production or transportation of fossil fuels, as of the end of 2015.

Finally, we think that we may be experiencing a “Minsky moment” in some income-generating securities, meaning that their strong historical risk-adjusted returns may have ultimately led to today’s volatility and value decline. Minsky called this the financial instability hypothesis: long periods of stability create future instability. Higher-yielding securities including junk bonds and the highest-yielding 30% of equities have historically compounded at rates comparable to or greater than the overall market with far less volatility. Hedge funds and other investors looking to minimize risk helped fund a swath of new forced-payout financing vehicles over the past few years. The idea was to spin-off or separately list steadier parts of certain businesses to help lower their cost of capital and command a higher multiple. Examples include master limited partnerships (“MLPs”), “YieldCos” and “PropCo/OpCo” structures. The number and aggregate market capitalization of business development companies and specialty real estate investment trusts also ballooned over the past ten years, as investors rushed to fund steadier holdings while maximizing their returns. Still, these financing companies exist in a relatively obscure corner of the market, and poor market breadth and hedge fund redemptions are likely weighing heavily on these types of names.

We cannot say definitively that a supply/demand imbalance is a top culprit for the portfolio’s weakness, however, the price action and valuations across the portfolio seem to support this view. Book value serves as a reasonable estimate for the liquidation value of many capital-intensive, forced-payout companies. This has not stopped companies with very different, and often negatively correlated, profit-drivers from trading at sizable discounts to liquidation value while generating extremely high, yet stable, yields. Unfortunately for shareholders, management teams’ incentive compensation arrangements often work against their doing what would be most profitable for owners – namely, selling assets to fund share repurchases.

We don’t know when this malaise will end and neither does anyone else. As Bernard Baruch said, nobody buys at the low and sells at the high except liars. We do know we are happy with our portfolio, that we believe its ability to sustain and grow the dividend remains unimpaired. We remain optimistic about the Strategy’s prospects and intend on patiently collecting the cash flows generated by the Strategy’s holdings.

We realize that all investors in the market do not share our growing optimism when prices fall. We also know that investors tend to associate falling prices with growing risk, when just the opposite is true – true risk is highest when prices peak, and valuations are high, and true risk is lowest at the bottom, after prices have fallen and when valuations are attractive. As the largest investors in the Income Opportunity Strategy, we encourage our fellow investors to join us in this mindset.

As always, we thank you for your support and welcome your questions and comments.

Strategy Highlights

During the fourth quarter of 2015, the Income Opportunity Strategy generated a total return of -0.98%, net of fees.¹ In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned -2.17% and 7.04%, respectively.

The Strategy initiated two positions and eliminated five during the quarter, ending the quarter with 48 holdings.

Top Contributors

New Media Investment Group Inc. ended the fourth quarter up 28.29%. The company continued to make accretive acquisitions and announced a surprise divestiture, all of which bolstered investor confidence that the company is remaining thoughtful and disciplined with capital allocation.
Triangle Capital Corp. rebounded from the third quarter rising 19.03% over the period. Third quarter EPS was $0.56, six cents ahead of the consensus estimate thanks to stronger-than-expected loan growth. The Q3 earnings covered the $0.54 dividend (11.3% annualized yield), and management also declared a $0.05 special dividend.
Abengoa Yield PLC returned 23.04% during the quarter. Shares of the company jumped after strong third quarter results were released. The company generated $0.58 per share of cash available for distribution and hiked the dividend to $0.43 from $0.40 while also affirming its 2016 dividend guidance of between $2.10 and $2.15 (11.0% annualized yield at the midpoint). Investors also applauded the YieldCo’s continued efforts to distance itself from the embattled developer Abengoa SA.

Top Detractors

SunEdison Inc. 6.75% Preferred continued to decline over the quarter, ending the period down -47.83% as the company transitions to slower growth ambitions while focusing on cash flow generation. Investors grew increasingly concerned that management would not be able to meet its financial obligations, though the refinancing of its second-lien credit facility at the end of the quarter alleviated its near-term liquidity challenges.
William Lyon Homes Inc. 6.5% declined -26.90% over the quarter. WLH’s shares fell on a combination of weaker-than-anticipated housing data and earnings. The homebuilder reported Q3 EPS of $0.31, six cents shy of the consensus estimate; labor constraints and resulting longer build times seemed to cause the shortfall.
Arch Coal 9.875 6/19 was down 87.95% during the quarter as the company continued on the path to bankruptcy. Despite Arch’s ability to make the payments on this junior debt, senior debt holders’ refusal to grant a debt exchange combined with management’s preemptive bankruptcy filing led to a meaningful decline in the value of these bonds.

¹Income Opportunity Strategy performance reflects the deduction of an annual model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.