When does Distressed Debt get cheap again?

About 6 weeks ago I posted a graph on the amount of distressed debt outstanding according to Bloomberg. Here is that post: Amount of Distressed Debt Outstanding as of April 2010

Here are those two graphs today, from index inception:

Distressed Debt Issuers Outstanding:

And now Distressed Debt Bonds Outstanding (again from inception)

All in all, it looks like bonds are marginally cheaper.

In his recent interview with Seth Klarman, Absolute Returns magazine,

"And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market's surge from its March 2009 bottom. "The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years," he says.

I fully agree with that assessment. That doesn't mean I am sitting idly on the sidelines. We still sharpen our pencils as investment opportunities come our way.

That being said, one thing that is UTTERLY TERRIFYING: the vast majority of the major sell side firms are telling clients in their published reports that this pull back should be viewed as a buying opportunity.

Look at those charts above one more time. Does that look like "blood in the streets?" I do not think we get back to the peaks of that chart (one reason: a lot of those bonds never really traded there in size combined with Lehman's prop book selling everything at any bid) but I think its hard to classify this market as "full of opportunities."

A few months ago I posted one of my value screens on Bloomberg - These are not mechanical screens. They are simply idea generators. The screen doesn't do the work; but it points you in the right direction. On March 30th, 2010, 5 companies passed the test. Today, 13 companies pass:

Post Properties

Hovnanian

YRCW

Standard Pacific

Alon USA

Blockbuster

K-Sea Transport

Eastman Kodak

Delta Petroleum

Poniard Pharma

HRPT Properties

Cohen & Steers

Jackson Hewitt

So, at least we are moving in the right direction. Post Lehman filing (it takes some time for the sell side to downgrade stocks when the world is coming to an end), the list had nearly 100 names on it. There wasn't enough time in the day to look at it all. It was glorious. It still does not feel that way unless you are an oil analyst, and that might even be stretching it (full disclosure: I have purchased RIG for my personal account).

All in all, stocks and less so bonds are cheaper. But they aren't cheap yet in size. The 60 day redemption window (most hedge funds have a 60 day redemption window) passed at the end of April for a lot June 30th withdrawals. Things were pretty rosy then. If performance continues even remotely close to what it did in May, we could see lots of redemptions coming for the 3rd quarter which funds will begin preparing for in late summer when no one is around. Bid/Offer spreads will widen and things could get ugly.

Yes - There are some pockets of value and event driven opportunities we have dabbled in, but nothing en masse. We steadily try to deploy capital with a bottoms up perspective in situations where the margin of safety is so great that our capital investment will be protected in all conceivable scenarios and where we can earn an adequate return on that capital. We want the market values of businesses and capital structures to become cheaper. We want the press to have front page articles of newspapers and magazines with graphs of the Dow and S&P going down with headlines like "Financial World Reels...", "Dow Tumbles...", and "Are you ready for the next bear?". We want the sell side to come out and say, "Ok clients, it is time to start selling..."

Does this make us filthy capitalists? Of course it does. But I'd much rather be patient and wait for the fat pitch than take a stab at a fastball away and at the knees. Tough pitch to hit in my opinion...