Fructivore Investments

Every financial panic needs a good person to blame. This one can be blamed on securitizers and financial derivatives engineers; the one before on deluded dot-com investors, the one before (the junk bond collapse) on frenzied, ill-advised mergers, and the one before that (the Latin American debt crisis) on the oil crisis. I’ve skipped the savings and loan crisis since at least part of it was just bad timing. However, three of these four panics can be explained by the tendency towards yield hoggery.

A yield hog is, simply enough, an investor who is dazzled by high yield investments. A big fat coupon impresses investors and also serves to erase a few embarrassing mistakes. In fact, an investment that produces a large cash flow that is reasonably safe is the kind of low-hanging fruit that the investor should be seeking out. The emphasis, though, is on “reasonably safe,” whereas a yield hog sees “large cash flow” and stops reading. They are willing to reach for yield, and either get it by ignoring established standards of investing safety, or worse, they make up new standards that show that what they’re doing is now safe.

The central concept in yield hoggery is that risk can be made up for with a higher interest rate. I discussed that in the Capital One context, and in theory, it works as long as the risk premium does adequately capture the default risk and pays a premium to the holder on top of that. In other words, it works until it stops working. But worse for the sleepy investor, a risk that fails to materialize seems to fall out of the view of the typical market participant, and the risk premium narrows even as the risk becomes more and more likely. If, say, a certain class of bonds has a 4% annual default rate, this does not mean that 4% of them will default every year like clockwork; it means that they will see 1% default rates for years at a time and then suddenly get hit with a 20% default rate all at once. However, the investor that invested in those bonds will, until that happens, make more money than the more conservative investor who avoids them, and will also steal all of the latter’s clients. After all, clients pride themselves on not being cowardly and very risk averse–until the risk actually happens.

This was the view held during the Latin American debt crisis, wherein according to Nassim Nicholas Taleb, American banks lost, in nominal terms, all the money they had made in the history of American banking (which makes it kind of amazing they scraped together more money to lose so quickly in the subprime crisis). Latin America was growing at a fast pace and investors were naturally attracted to the higher yields available. After all, surely a government is safer than a corporation they could be lending to, and really, what are the odds that many countries would default at the same time? I mean, it’s not like defaults are likely to be correlated or anything.

However, at the very least they were following established financial standards rather than writing new ones, which is what they did during the junk bond explosion. The priests of the junk bond religion argued that since debt financing was generally cheaper than the cost of equity, it was entirely feasible to do leveraged buyouts, saddling companies with irresponsible levels of debt.The traditional corporate financier looked at the money a corporation could spare for debt service in terms of earnings, or at least EBIT, but the new method was to expand it to EBITDA, on the theory that capital expenditures could be delayed and so depreciation and amortization were basically “free money.” Of course capital expenditures can be delayed for a time, but not indefinitely and almost certainly not for the entire term of a junk bond. The switch to EBITDA provided a justification (i.e. excuse) for all manner of crazy, ill-advised mergers, and formerly solid companies were even pushed into borrowing large sums of money and distributing it to shareholders to hold off the acquirers.

Subprime securitizers had their own version of changing standards; the CMO structure allows investors in the lower credit tranches to absorb credit losses so that the higher tranches are not likely to be invaded by losses (again, what are the odds that many borrowers would default at the same time?). Their safety also depended on the availability of refinancing and and the ability of the housing markets to continue producing the ridiculously high returns they had been, and, although it went unmentioned, they also depended on the health of the foreclosure market. At least the Latin American debt investors were honest about the risks they had taken; junk bond and subprime investors just reached for yield and rewrote the rules in order to get it. The yield hog was absent during the triple-digit-PE craze of the dot com era, since with that kind of PE it is more profitable to reinvest any earnings into the company. (Is there such a thing as an appreciation hog? I think so.).

Since I seem to be in the habit of raising problems and not solving them, I suppose I should mention a holding that a yield hog can get behind. Windstream (WIN) is a rural telecom company that as of this writing sells for a little over $8 and pays $1 per share annually in dividends, which is dramatically impressive in a time of low interest rates. Their earnings have been stable over time, true, but have been stable at just a hair under a dollar. Using the trick we learnt from Qwest (see below), we find that their depreciation exceeds their capital expenditures, which gives them some extra free cash flow. As a result, their dividend is covered by distributable earnings, but just barely. On the plus side, they have recently announced an acquisition that in the opinion of management (ha ha) will begin to enhance their bottom line by the end of the year, which will enhance the safety of their dividend. They also have a debt maturity coming up in 2011, and hopefully the financial markets will have recovered by then enough to make rolling their debt over reasonably cost effective. Obviously, the company is unlike to appreciate significantly since they are paying out every penny they earn in dividends, but given their stability in earnings it is not too likely to drop either. Of course, in the unlikely but not impossible event of a dividend cut, the company would probably would drop in price, but they would still be earning somewhere in the area of $1 a share, and that money is still the shareholders’ whether or not they have it in their hands.

So, good luck and remember that even hogs can be eating low hanging fruit if they’re careful about it.

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Investing by grocca