Shaky foundations – 4th quarter, 2017
Steinhoff International Holdings NV is a household goods company founded in 1964. It built a portfolio of 24 brands and over 12,000 global retail locations with a focus on furniture, appliances and housewares. Steinhoff used debt to fund an acquisition-hungry business model that Moody’s blessed with an investment grade rating. At the beginning of December, its auditors reported accounting irregularities that delayed the release of its results. The auditors cited a criminal and tax investigation from 2015, potentially uncovering a fraud of great proportion.
The scandal alone is fascinating, but more interesting is what happened to the price of its securities and one large holder of its debt. Steinhoff issued 800 million euro of debt six months ago with an annual interest rate fitting of a global retail roll up of just 1.875%. After the news from their auditor broke, these bonds traded as low as 41 cents on the dollar (or a 59% loss). The drop shocked many bond investors, including one of its largest reported bond holders – the European Central Bank (ECB).
The importance of home inspections
To help spur the Euro Zone economy, the ECB purchased over 100 billion euros of investment-grade corporate debt such as Steinhoff’s, or almost 18% of all European corporate bonds. When a buyer this large entered the market, the demand drove yields and credit spreads materially lower and moved the European high-yield market to all-time low yields of 1.9%.
No one knows how the Steinhoff situation will play out, but it brings up questions that an inquisitive credit investor would ask like:
Who was the ECB credit analyst responsible for following Steinhoff?
Did she think that an annual yield of 1.875% properly compensated them for a business model based on large amounts of debt?
Did he have a view on how the retail operations would defend against disruptive online competition from some of the largest companies in the world?
Can someone at the ECB negotiate with borrowers should the company need to restructure these bonds?
While I don’t know the details of the ECB investment team, I’m fairly confident they did almost zero analysis before buying these bonds. I highlight this specific case as I think it illustrates behaviour endemic of the attitude of many market participants these days. In an increasingly yield-hungry world, many investors seem to forget that higher yields generally come with higher risks. Until recently, a central bank wouldn’t invest in securities with credit risk. Central banks aren’t investors and generally aren’t set up to perform the analysis we believe is a requisite to any purchase.
Despite what we’ve seen since the financial crisis, corporate bonds can and will default in the future. These defaults will force losses on investors that will likely far outweigh the meager coupons that bond investments offer today. If the next credit cycle never comes, buying European high-yield bonds yielding ~3% or their U.S. counterparts at ~6.20% may be an attractive investment. Unfortunately, I simply don’t believe that this time is different. Cyclical business will cycle, competitors will steal market share and margins will compress at many companies whose debt load doesn’t provide them with the flexibility to respond to such threats. It’s an investors job to avoid these businesses, but that only comes with proper analysis.
I can’t help but draw a comparison to passive investment vehicles mandated to buy high-yield bonds. These vehicles didn’t exist in a material way pre-2007 and are now almost US$30 billion in assets. Like the ECB, passive indexes buy bonds without doing the research to determine whether they’re good investments.
The other side of supply and demand
Another important implication is what occurs if market sentiment changes? Large buyers that didn’t exist a decade ago (ETFs, central banks) have distorted prices due to their insatiable demand. If these buyers stop buying, or worse start selling, what happens to the markets they previously propped up? One can only imagine that the positive push upwards reverses and downside volatility occurs. The forces that created a difficult investing environment for active managers, i.e., a market that seems to only go up, suddenly becomes a source of volatility, an environment where we think we can excel. Nothing sets up a great investment opportunity like purchasing assets from a forced seller.
We can only sleep at night if we feel the investments we own properly compensate us for the risks we take. The only way to do that is performing deep credit analysis, something that we believe is one of our strengths. We’ll never be perfect, but I’d rather selectively buy the bonds of companies with business models we understand rather than blindly invest solely based on their yield.
There are signs in the market that suggest many investors fear underperforming a short-term benchmark more than suffering permanent losses of capital. Many are reaching for yield and bonds that are priced to perfection are simply not incorporating a change in the current environment. We believe it’s more prudent to value investments based on a variety of scenarios. History has proven that business cycles and competitive environments often challenge a company’s success, leading us to focus on what could cause a company to default, its probability and potential mitigating factors. If we don’t feel the bond’s pricing includes a more realistic variety of scenarios, we will not invest.
While we always strive to outperform, we won’t reach for yield. We recognize that this may lead to short-term underperformance, but we’re confident it’s necessary for long-term outperformance. Capital preservation and the adherence to our investment approach will always trump benchmark risk in our Growth & Income Portfolios.
|Company A||Company B|
Since we purchased Company A’s bonds, you can guess what we find more attractive. It took a great deal of credit work to get comfortable with our investment, but we think that work will pay off and enable us to find unique credit investments with attractive returns in today’s low-return world.
Regardless of our operating environment, we’ll always focus on where we think we have an edge – thorough credit analysis. We continue to scour the globe to find ideas and remain confident that we structured our Portfolios to perform if today’s benign environment continues. More importantly, we built nimble Portfolios that can react should we see a correction and more attractive investment opportunities. The past year didn’t provide many bouts of volatility for us to take advantage of, but we must prepare as if the current levels of complacency can’t continue. We would certainly welcome a renewed level of skepticism in the market.
Thank you for your trust in 2017 and we look forward to continuing to earn it in the years to come.