Author: the_red_deer

The Financial Times published a nice piece on the UK the other day. Its cheeky headline was memorable:

It’s no secret that the UK has suffered of late as measured by multiple traditional measures. In part, it lacks the growth names that dominate the US headlines and aid in elevating US indices ever higher.

One of the interesting things I’ve found the be at least partially true about investing is: puzzles that have no answer often result in little investor interest. We as humans like to know the road came from, are on now, and the ultimate destination.

As an example, a UK listed and UK based company has the following past with respect to earnings per share:

Over the past 10 years, it has roughly increased earnings by 12% annually with little fanfare with exception of Covid. A fine performance.

In 2021 it guided to a continuation, or rather an acceleration, of its performance by the end of 2024 and has largely met its promise to date.

But today it trades a roughly 6x annual earnings and pays roughly an 8% dividend, nominally cheap metrics. An astute investor (not I) could probably guess the industry and perhaps the company, but that’s not the point. If a company has a strong past and reasonable odds of a good near term future, shouldn’t it have reasonable appetite for its shares?

Alas, the long term future is unknown, as the company undergoes a CEO transition, has no strong comparables, resides within the flows or lack thereof of UK stocks, and is in an industry that is generally unloved at present. Said simply, there is good reason for statistical cheapness. Or more tangibly, there’s no clear catalyst today, for a turn in the narrative to reverse its cheapness. And thus the lack of investor interest.

Perhaps therein lies opportunity. Certain investors have success investing behind defined catalysts. Event driven investors make their hay doing exactly that. But what of companies that get priced in a manner that you do “alright” for an individual investor (not a performance fee gathering investor) if nothing happens? I tend to like such situations and believe certain businesses, including one or more that reside in the UK, offer modest returns with unknown odds that for some reason, the buyer pool changes.

Alas, key to such an approach is diversification: an acknowledgement that accumulating such upside options do not offer certainty in upside. Just odds that the narrative may change at some undefined point.

One of the nearly certain truths about investing is that the proverbial sandbox is shifting all the time. A value investment may turn into a growth profile investment, or vice versa. A long-term play may turn into a short-term special situation, etc.

Yesterday, Jackson Financial reported earnings. It’s an odd duck for many reasons, not limited to focusing on the VA sector, terribly confusing accounting, and a lack of comparables. A variable annuity (VA) is kind of like a mutual fund with an insurance policy. You’ll capture equity upside, but if things go south, don’t worry, we’ve got you covered.

Jackson is the market leader in this space, a niche that has been plagued by bad consumer sentiment due to high fees and product opacity. It likely wouldn’t exist but for the tax efficiency, as gains within a VA policy are generally sheltered, much like a 401(k). Alas, Jackson tends to perform well when equity markets go up more than usual, thereby reducing the likelihood that they will have to pay out on the downside insurance they provide. In contrast, they perform less well when equity markets underperform, and the burden they shoulder in guaranteeing certain minimum levels of returns/income increases. The trick is underwriting the right level of conservatism so that the company can pay out on these guarantees in bad times, but not so much conservatism that the pricing is uneconomical or unappetizing for the policy buyer.

Jackson is in a unique position at present as its current book of policies is deeply in the money. In other words, equity performance has exceeded what the company hoped for when it underwrote the policies. And not by a small amount.

As of the end of June, almost all of the 10,000 scenarios used in VM-21 were floored at the cash surrender value, which is further into the tail than we have ever experienced. 

In simpler terms, this generally means that even in the worst equity outcomes, Jackson generally isn’t paying out on its downside guarantees. However, the accounting regime it operates under from a regulatory perspective does not seem, at face value, to be designed for the situation Jackson currently finds itself in. Under the regime, Jackson is not receiving regulatory credit for rising equity markets and the decreasing likelihood of paying out on guarantees. In fact, the regime requires Jackson to put up more capital. The net result is the company having to uneconomically hedge against the scenario that the market continues to rise, something that logically should actually be what the company wants to happen (because it will have fewer guarantees to pay out).

Jackson revealed that it is in discussion with its home regulator about changing the accounting regime to better align with the economics of the business as it stands today. Conversations with regulators can notoriously drag on for years without producing any results. But one set of words has me thinking that perhaps there is an expectation that there will be some measure of capital relief as a base case:

So what we’ve been looking at is while we definitely want to provide as much insight and help others get the greatest amount of insight into the business, we do think that the best time to update those will be just after we get our solution in place with respect to the cash value floor so we have a clearer picture of how we think capital will emerge as we move forward under that solution. I think that will be a lot more meaningful, and it will be a good opportunity to refresh that information.

Essentially, they are delaying investor disclosure due to the expectation that there will be an updated accounting regime. While far from guaranteed, I personally view this probabilistically as a real scenario. In that vein, what can come of it?

Jackson has spent $500 million per year on hedging in the past when the book was in a similar state. They mentioned on the call that hedge spending is currently below guaranteed fees of roughly $750 million per quarter. Therefore, I would presume that since the level of moneyness in the book is at an all-time high, hedge spending is higher than $500 million and less than $3 billion. Any measure of regulatory relief that reduces the need to spend this uneconomical capital on upside protection to generate reserves is meaningful. With a market cap of $2.7 billion, saving half of the low end of $500 million in hedge spending is nearly 10% of its market cap annually. If hedge spending is $1 billion, one can ponder the potential amount of capital redirected to an excess bucket versus hedge spending.

As such, to return to the beginning, I view this situation as a value investment that has morphed into a hybrid special situation. Will something come of it? I don’t know for certain, but a new upside scenario has emerged with unknown but meaningful odds. As the company has guided for approximately $700-900 million in annual capital generation paired with roughly $500 million per year in capital returned to shareholders, one doesn’t have to make that bet, but rather just tuck it into a set of upside options.

In conclusion, most of this message has focused on the details of a medium-term event. It should go without saying that the trajectory of the core business is more important than any of this in the long term. Will Jackson’s anemic VA sales gain traction again? Will Jackson make a significant impact in the RILA market compared to its initial 5% share? These are the most important questions, but they are for another day.

While I dislike Josh Wolfe, he has a saying which has stuck with me.

It’s something along the lines of: in investing, “you want people to agree with you…just later.”

Recently it seems, the narrative around one of our larger investments has turned from one of pessimism to one of envy. A sample from early 2021:

But here we are in mid-2023, and Bloomberg delivered this to my inbox this week:

And this:

In most cases, I see people engaging in victory laps and back slapping, among other things. It seems so obvious, doesn’t it? The company itself stated its plans, and now it’s delivering on them. Investing must be easy, right?

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What I personally find more intriguing is looking back and making an effort to identify what the market was accurately discounting that I failed to appreciate due to the narrow perspective I had, driven by a desire for a positive outcome.

In that vein, a couple of thoughts:

The Credit Default Cycle: When I initially invested in the stock, my understanding of credit was weaker than it is now. I lacked the insight to recognize that a portion of the price was simply based on the anticipation of a default cycle. This wasn’t exclusive to this particular stock; it was a pattern seen across numerous similar companies, including insurers, BDCs, and other credit-related equities.

Insurance Multiples Pose Challenges, for Good Reason: Only later did it become clear to me that Apollo functions more as an insurer with an attached asset manager, rather than the other way around. Insurers have been trading poorly for some time now, largely due to underwhelming performance over the past two decades, particularly in the life insurance sector. While insurers have seen some improvement recently, and Apollo has participated in this upturn, the initial and current undervaluation is to some extent due to skepticism regarding lifecos’ ability to truly enhance shareholder equity.

Regulation Can Sneak Up on You: Although it’s abundantly evident today, I didn’t fully grasp in the past how significantly regulatory decisions could impact a business’s trajectory. Rowan’s comment about his gray hair resulting from dealing with current and potential regulations is quite telling. This statement gains significance considering the challenges already inherent in successful investing, which are at the core of the business.

Execution is Challenging: It’s easy to overlook the difficulty of implementing a business plan from within the organization. Financial experts often make statements as if achieving success in business is as straightforward as allocating capital wisely. “Just allocate to the highest and best use…” Having experienced various difficult situations, I can attest that it’s never that simple. Execution is often disregarded because it happens behind the scenes, away from public view, making it challenging for outsiders to understand, let alone quantify. Yet, it’s likely one of the most tangible risks. Assessing it externally is complicated, and it’s easy to tell oneself that Apollo succeeded due to Rowan’s exceptional abilities. However knowing the difference between a skilled salesperson versus a capable organizer, motivator, and talent scout, beforehand, is difficult.

Moving forward, one of the trickier aspects of considering this investment is determining how to manage risk. Each of our other investments currently contributes a significant yield. When we initially invested in Apollo, it contributed meaningfully to portfolio yield. However, at today’s price, its role in terms of generating income compared to principal value is the lowest in the portfolio.

I’ve often emphasized that real estate investors excel at focusing on their figurative cash-on-cash returns. After all, you can’t use net asset value gains unless you decide to sell. I’m now pondering a question in my free time: what would constitute a wise rotation of this position to strengthen yield further? Would I end up regretting the decision? The answer won’t be clear beforehand, but part of this journey involves refining a process that suits us. In this fortunate scenario, whether due to fortunate chance or a modest accumulation of skills over time, we have the opportunity to practice risk management in a favorable outcome rather than the opposite.

I’ve really enjoyed reading Bridgewater’s commentary throughout this unique interest rate cycle. Reason being is they are probably one of the best-equipped investors to make commentary on a macro basis. They also simplify dramatically to make their commentary digestible. Alas, as I previously wrote in May 2022:

My opinion is, unfortunately, while Greg is not absolutely wrong in what he is saying, he likely speaks so eloquently and simply that the listener tosses out the hardcore fact that the economy is far too complex to simplify and make accurate predictions on. There are likely 25+, maybe 100, legitimate economic inputs whose relative importance vary by the day / month / year. In hindsight, it becomes obvious which few factors drove certain outcomes, but looking forward at the potential performance of a complex and constantly adapting system is somewhat futile to do with any accuracy (and precision).

In this case, Jensen (CIO of Bridgewater), returned to Odd Lots just over one year later to relay that he was right for a period of time in 2022 (namely when stocks went down and yields peaked in October), but has been very wrong over the past six months. I appreciate how he said “we have been wrong…I mean, I have been wrong.” There’s humility in that conclusion versus socializing blame. He continued on to say that the view hasn’t much changed and he expects deterioration in the economic environment again.

Relying on other people’s analysis tends to be futile because you’ll never have the confidence to stay the course nor the mental flexibility to know when to change your mind. However, few have the proper resources that folks like Bridgewater have, let alone the time. So understanding alternative views is a great way to diversify the powerful pull of authorities like Bridgewater.

Renmac is a group with a very different makeup than Bridgewater. They focus on technical analysis, macroeconomics, and politics. Contrary to Bridgewater, they have been very “right” in their upbeat view since November. That isn’t to say they are the star and one should listen to them going forward. Look no further than Mike Wilson, CIO at Morgan Stanley, who was very right about the rate cycle but has been dead wrong since. Just that it’s worthwhile to listen to opposing views versus latching on to one view.

All told, despite the discussion of various macro views, I continue to find that the only real strategy for a small punter like us is one of the old “richest guy and best investor around,” whom I generally dislike mentioning. That is, to stay overcapitalized and wait for the market to serve up opportunity versus predicting it.

Estimates for inflation have changed materially since March, and even May:

Investment income was up 40% from the prior year quarter, once again on the back of timing mismatches from the prior year and rotation from lower yielding investments. I estimate gains in income from the prior year to quickly level off to 19% for 3Q23 and 0% for 4Q23. Overall this year is trending to be 22% higher than the prior year, and it likely 2024 ends nowhere near such gains in income. The hope is to outpace inflation.

Certain moves were made to trade away from hospitality and alternatives towards insurance and consumer credit. Adverse M&A pushed us out of one prior red list position. Of the other three prior red list positions, one is a private shopping center that is in a marketing process, one is a hotel with no real timeline on exit, and one was a financial that has now since moved off the red list.

While there are still plenty of pockets to find yield in today’s market, even on a tax adjusted basis, the combination of an upward trending market paired with the recent home purchase make debt pay down above the $750K mortgage interest deduction cap, attractive.

In a previous post, one could surmise that I was trying to gather my thoughts on what to make of the housing market from a personal perspective. The simple math didn’t make sense to me. If interest rates had moved the average price of a mortgage from, say, 3.5% to 7%, how was it possible that the prices of homes I liked were priced at 20-30% more than pre-Covid? This kind of simple thinking is often good as it keeps you out of potential trouble brewing with an uncertain catalyst. As I’ve often preached to myself, true chaos is hard to predict but obvious in retrospect.

However, it’s often useful to not stop there and understand the other side of the proverbial coin. In doing so, it became blatantly obvious that I either didn’t understand or, perhaps more importantly, refused to accept the state of the US housing inventory. I most definitely had a mental block around the idea that I wanted to move to a mountain town pre-Covid, started the process, got derailed by Covid, and the dream was subsequently shared by millions of others like me, pushing pricing for this sort of home to the stratosphere.

Perhaps I’m not old enough to be a stubborn curmudgeon, or a past life as a derivatives trader has stamped mental flexibility as a means of survival, but quickly accepting the facts and moving on enabled us to move forward with life. Life is often a set of compromises, and while we certainly had to make some compromises in light of this unhealthy housing market for buyers, we can move on with a portion of life that had been put on pause for years and enjoy the new place we’ll call home.

Being an investor prioritizing current yield simplifies the process of portfolio management by encouraging rotation out of assets that are currently favored in favor of less favored assets. Two of the names we own(ed) are driven by factors related to infrastructure assets and hospitality, both yielding about 4% based on current stock prices. I have liked and held both of these names for years.

Distinct from the above mentioned factors, two factors (among many) that investors dislike today are sensitivity to equity prices and unemployment. Based on the economic commentary I’ve recently encountered, the consensus thoughts revolve around the stock market being overly optimistic given the potential “higher for longer” rate environment. Many people on TV or in print suggest that the Fed will follow through with higher rates through ’23, contrary to futures predicting rate cuts later this year. Additionally, they argue that in light of higher rates persisting, equity prices must decline – “it’s just math.” I find it hard to disagree with this reasonably simple and logical analysis.

However, it also strikes me that all the chips have been placed in the bet that equity prices will decrease significantly on this basis, with few being placed in the concept that prices might not decline dramatically or might even go up. Personally, I tend to favor situations where the reasons for such outcomes are unclear, but because everyone has invested heavily in one side, you can earn modest returns if the high probability scenario materializes, but substantial gains if it doesn’t. We have purchased a modest position in a business that will generate modest earnings if equity markets remain stagnant, while having the potential for elevated capital generation if markets rise or fall. Furthermore, it yields well above 4% and is a qualified dividend to boot.

Moving on to unemployment, names that are sensitive to consumer credit are trading at levels that anticipate a significant increase in unemployment. There is a strong correlation between unemployment and losses in consumer credit because when individuals lose their jobs, they often struggle to service their credit. However, to paraphrase Jeffries analyst John Hecht, we have likely already experienced the steep climb of an interest rate cycle, inflation, rapid capital market disruption, and the delinquency cycle. The only cycle that has yet to experience a significant climb is unemployment. And as previously mentioned, the relationship between unemployment and losses is well known and predictable.

Therefore, consumer credit names, both bank and non-bank, that are underwriting to 5-6% unemployment today and have already reserved (due to CECL) for those figures on the back book, may have less to worry about regarding credit losses compared to the market’s projections. The positive aspect of this situation is that these names have been priced accordingly, at least until the market’s recent jump in early June, meaning you don’t have to bet against things getting worse. You can still do well if things do indeed get worse, and you can thrive if things don’t turn out to be as bad as feared.

While I may have digressed a bit, the original thought behind this article was that in the search for yield, I naturally am encouraged to shift away from factors where there is an explainable positive outlook and move toward factors with less clear positive outlooks, as of today. And while it is an unoriginal thought, yield prioritization makes the old adage “buy low, sell high” a much more simple exercise versus assets that don’t pay you.

The recent Milken conference was a masterclass in herd behavior, as the “masters of the universe” were asked about their investment preferences in today’s environment. There was near-unanimous consensus that private credit is the most attractive option.

The reason for this is straightforward. Most argue that banks have reduced lending due to deposit flight and a significant increase in the cost of capital. Additionally, Dodd-Frank regulations provide long-term tailwinds. However, amidst the promises of pristine underwriting and a golden era for the asset class, few discuss the specific financial factors at play.

Private credit primarily consists of floating rate loan instruments, although the discussion mostly revolves around corporate loans rather than asset-backed loans, which often come bundled at a fixed rate. But I digress.

In my opinion, a floating rate loan has two crucial factors, when aggregating some of the underlying sub-factors: long benchmark interest rates and short credit default rates. The goal is to have higher interest rates and lower defaults. Low interest rates reduce the gross yield of the floating rate loan, while high default rates erode the principal. Although credit spreads may compensate for higher defaults, it is reasonable to assume that during times of disruption, unexpected events lead to higher defaults than were previously anticipated.

Looking ahead, what can one expect from this asset class? Milken attendees promise “equity returns with fixed income risk.” As a side note, these attendees don’t seem to consider the tax burden of ordinary income in that comment. But again, I digress. A significant increase in interest rates, say 2% more, would result in substantial defaults. That seems fairly certain. Furthermore, it is unclear whether inflation would necessitate rates that high, at least based on today’s data, and there is uncertainty regarding whether the Fed has the stomach to raise rates to that extent.

There are at least two possible paths to lower rates: inflation could slow down due to higher rates via a mild recession, or there could be a severe recession. In a mild recession, we would see lower rates with slightly higher defaults, while in a severe recession, rates would be substantially lower with correspondingly high defaults. Both of these scenarios would be detrimental to private credit, as they would lower both the benchmark rate component of the gross yield and increase the default rate.

In my view, the best scenario for private credit is for nothing to change. Moderately elevated inflation would nominally increase earnings and reduce corporate leverage. Rates would remain moderately high, impacting equity layers but not significantly increasing defaults. A European credit fund CEO, who managed a portfolio of floating rate credit during the global financial crisis, mentioned (I cannot find the exact quote) that his worst year of returns was in 2009 not due to defaults in his portfolio, but because benchmark rates cliff-dove to zero.

However, everything in the market indicates lower rates in the future, despite the near-unanimous sentiment at the Milken conference that inflation will persist at higher levels. In such a scenario of lower rates, forward private credit returns may deteriorate, and one might wish for greater stickiness in the gross yield.

So, what can one do in this situation? Personally, I believe that locking in duration at higher yields is worth considering instead of investing new funds in floating rate instruments. This does not necessarily mean duration in fixed income; it could involve owning equity on the cheap that generates cash. In a world where rates gradually decline over time, we may find ourselves nostalgically longing for the yields of the past.

The Economist’s Money Talks podcast had a nice discussion on housing both in the US and internationally. It wasn’t groundbreaking, just summarized what is already well known. If you’re anxiously waiting for home prices to cool off from the +20% bump vs 2021 in our area, like me, it may be helpful. It won’t be helpful in reassuring that housing prices will correct, it will be helpful in understanding why they may not correct.

The conclusion of the podcast is that, given:

• The size of owners locked into low mortgages who have no interest in moving and taking out a new high rate mortgage
• The largest generation ever (millennial) deciding to join the ranks of homeowners post-covid
• The low volume of supply, lack of subprime mortgage volume
• The generally very strong economy, with unemployment at ~3.5%

…it is unlikely that home prices will fall materially. The only chink in the armor of that thesis is the last point on the economy – as most believe some sort of recession is coming.

I remember what the GFC was like; I simply characterize it as somewhat terrifying. Stepping out on big purchases, whether a home or any asset, seemed like you were alone in the pursuit. I remember buying $25K of Bank of America at just under $7 / share, and thinking “I may never see this money again, why am I doing this?” And this was in late 2011, not 2008/2009. The economy, despite headlines, is so incredibly far from that feeling of despair and battening down the hatches. Air traffic is making record highs, hotels are full, and most telling after taking a breather late last year, housing is picking up again (at 6%+ mortgage rates, no less).

So to conclude, as this is mostly a missive to myself, don’t bet on pending distress in the housing market. It likely won’t come without an unpredictable major economic dislocation, something one can’t reasonably plan life around occuring.

Diversification to reduce correlation within the portfolio, is one of the holy grails of investing. The issue with diversification is correlation tends to rise, often times dramatically, during times of stress. But over a longer time horizon, like watching paint dry, it tends to do its job. AQR recently put out a piece advocating for international equities, arguing the international diversification factor won’t save you in the short term, but likely will save you from painful longer term bear markets:

However international investing often can’t pass my own screen for investing because of my yield test. Simply put, I want and need durable longer term yield, and international index investing doesn’t get me that. Sure, the Brazil ETF (EWZ) has a double digit yield today, but that’s on the back of high concentration in resource companies doing major dividends on due to high commodity pricing. If I want big exposure to Vale, PBR, etc. – I can just do that directly.

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Asset managers are another way to get broad exposure to factors by taking different risks. The increase in risk is single name exposure, a material risk versus indexation. What one gets in return is exposure to a cash machine that generates its earnings from a diversified set of products, underpinned by a track record of positive value for its clients.

I’ve likely mentioned Vinci Partners in the past. It’s an asset manager whose business comprises of 50% private capital and 50% publicly marked capital. Since its 2021 IPO, the stock price is off from $15 to $8 / share due to a major slowdown in AUM growth. Its balance sheet generates $20M of current earnings and the asset manager does about $30M, annually. Market value of the equity is about $425M, and it pays out about 35M in dividends at its current trough level of earnings on the back of a decimated Brazilian liquid assets market. In 1Q23 alone, 4% of the BRL public equities market redeemed and the market is trading at the lowest relative valuation to developed markets in decades, according to the company.

Earnings likely rise when interest rates in Brazil come off their near 14% level, which may bring flows back in some form to public markets and accelerate private markets flows. If rates don’t come off, the business is has roughly flat net flows in its public markets business, a feat in this market, and modestly positive flows in its private markets business. It likely continues to muddle through, growing slowly, and paying a healthy dividend. One never knows when cycles turn, but getting international exposure through this venue, with a shot at a bad market getting slightly less bad, is interesting.

As always, while the above commentary is about a single name, I personally don’t take concentrated exposure, and we own it as a small part of a diversified portfolio.