Thank you for taking the time to do an interview with our readers. Before we start, can you talk about the genesis of Aegis and its value and high yield funds?
When I was at Wharton getting my MBA, I ran across the academic research of Eugene Fama and Kenneth French, which demonstrated that small companies trading at low multiples of price-to-book value were delivering impressive, market-beating historical returns. I was already a Benjamin Graham convert, and was very interested in screening the market to find stocks trading cheaply based on historical fundamentals. My research helped convince me that it would be really interesting and potentially profitable to build a firm focused on exploiting underpriced small company value stocks. After working the summer of 1996 for Donald Smith, a talented deep value institutional investor, I got together with a couple of guys who had recently split off from New York value investing shop Kahn Brothers. We started the Aegis Value Fund in 1998 to invest in a variety of deep value small-cap stocks I had researched and selected. Later, we realized that many of the companies we were looking at for the Aegis Value Fund also had high-yield debt trading at attractive levels. We started the Aegis High Yield Fund at the beginning of 2004 in order to take advantage of these kinds of debt opportunities.
We know many value investors talk about using screens for idea generation on the equity side. Can you talk about your idea generation process for Aegis High Yield fund?
We initially screen for bonds with above market yields across a variety of industries, looking at basic cash flow and leverage ratios for various credits within industry groups to find anomalies. Because screens are not typically well-adapted to pick-up on subjective or complex indicators, the process of delving further into the fundamentals of potential credit candidates is research intensive.
We typically assess items such as management intent and discipline, covenant protection, and collateral valuation and quality. We also have a universe of particular credits we know and understand well given the work we’ve historically done researching the underlying issuers in our equity analysis.
One of Aegis' core beliefs is "Market inefficiencies can be found and exploited through intense fundamental research" - Describe how your research process is different than other buy side shops? Do you find as more and more funds get in the game, the opportunity set of "inefficient opportunities" is getting smaller?
Overall, our approach has generally been focused on smaller issues of companies with material tangible assets. We believe that selective smaller debt issues can often have better collateral and covenant protections as well as higher yields when compared to conventional large high yield issues. We generally look for small company debt that is either secured, or unsecured without any net secured debt outstanding. As a result, we tend to avoid subordinate issues of leveraged financial players. We also avoid technology or health-care issues where success is predicated upon predicting future technological growth or government regulatory reimbursement trends. In our approach, we attempt to model future cash flows over a variety of economic scenarios in order to assess the likelihood of default. We also approach our investments from an asset perspective, and work hard to assess underlying collateral or firm asset values to protect our downside in the case of default. Because our team is always evaluating investments across the entire capital structure, we often uncover possible catalysts for credit improvement, and may have resulting insights that may not be readily apparent to pure credit investors.
With regard to high yield market efficiency, after witnessing the last 3 years it is difficult to conclude that the high yield markets are in a long-term trend towards greater and greater efficiency. More funds have gotten into the game as the market has recovered from the financial crisis, but we must remember that many high yield investment vehicles employing financial leverage were wiped out in 2008. While the markets are clearly more fully valued than in 2009, the rising high yield market valuations are more likely driven by Federal Reserve monetary policy than any move towards greater market efficiency. The current Fed monetary policy itself is likely to be destabilizing over the long run, leading to significant future inefficiencies.
After a year like 2010 of torrid issuance in the high yield space, do you begin to approach the high yield opportunity set more cautiously? Where are you seeing value in the credit space today?
As we look at overall yield spreads rapidly contracting and approaching the lows seen during previous bull market peaks, we are maintaining a very cautious stance when committing new capital to high-yield bonds. While we continue to see one-off opportunities and special situations in the smaller issue space of the debt markets, you do not see the systemic undervaluation that existed from 2009 through the summer of 2010. I noticed recently that only four industries out of 20 in the Credit Suisse High Yield Index have witnessed a 100 basis point widening of yield spread since the end of 2007, Aerospace, Energy, Food & Drug, and Utilities. Energy probably remains our favorite space as a whole, but uncovering investments is certainly getting more difficult. High-yield bonds may continue to deliver reasonable performance for a period of several years if default rates remain low, but we think the tailwind of spread compression is likely finished. In the Aegis High Yield Fund, we are holding higher levels of cash (15% at 12/31/10), keeping our durations short in order to offset both interest rate and longer-term company refinancing risk, and investing in select convertible issues that should do well in a scenario of economic recovery and interest rate pressure.
How much of your analytical time is spent on business fundamentals versus understanding indentures and covenants in assessing the potential risk / reward of a particular situation?
We are primarily business analysts, and spend the majority of our time trying to get the credit call correct. While we think we are skilled at covenant and indenture evaluation, we typically don’t have attorneys skilled in bankruptcy resolution involved in our process of security selection. As such we generally focus our investment attention on stressed credits as opposed to distressed and bankrupt credits, where legal probabilities begin to dominate the process of security selection. When evaluating high yield credits, since most financial covenants for bondholders simply consist of incurrence (and not maintenance) tests, we place a big emphasis on tangible asset based fundamental analysis to establish a margin of investment safety.
Do you use street research and desk analysts in helping you generate ideas or get up to speed on a new situation? Do you have value this type of color?
We have not typically found street research helpful in generating ideas. Although some research can be quite good, generally we have not found the majority of sell-side research adequately devoted to establishing underlying collateral and firm asset value. However, we do follow street issuance of smaller company issue debt that may be disregarded by larger investment firms.
Do you hedge treasury rates in your fund? If so, which vehicles do you use? If not, how do you evaluate and position yourself for changes in the curve?
Although we have the ability to do some hedging through options on equity and index securities, we have not focused the fund on managing our interest rate risk through the use of options, derivatives, or futures contracts. The Aegis High Yield Fund has historically been a long-only, “plain vanilla” type of product. We currently are focused on mitigating the risk of rising interest rates by keeping bond durations short and identifying convertible debt opportunities that can deliver good returns in a rising rate environment.
In your marketing material you note that you "seek out issuers actively engaged in deleveraging/recapitalization of the balance sheet" - Does that still apply today given how low the after tax cost of high yield capital is and how little corporations have spent on capex in the past three years?
There is no doubt that as the public debt markets have made a near full recovery and management attitudes towards leverage are growing more liberal. However, we’ve also seen that the substantial rise in equity prices has allowed companies to use their stock as currency to acquire other assets on an unleveraged basis or refinance existing high coupon debt issues with equity or substantially lower-yielding convertible debt. We certainly take the probabilities of these kinds of corporate actions into account when evaluating bond ideas. Additionally, we see many smaller issuers who do not have the name recognition and broad appeal in the public markets maintaining a conservative attitude towards debt, with many using internally generated free cash flow to deleverage their balance sheets.
Many credit investors struggle with the balance between liquidity and the higher yields of smaller issues in the credit space. How do you balance this tough divide?
This balance is definitely a challenge given our desire to invest in the most inefficient segments of the debt markets. The illiquidity of smaller issues in general is a risk that our firm has decided to accept, despite the price volatility. As a result, we can get superior bond yields in safer credits with superior collateral coverage and covenant protections by investing in smaller, less liquid issues. In order to manage liquidity and redemption risks we tend to maintain a little higher cash balance than many of our peers and invest a portion of the portfolio in more liquid securities. We also try to manage this risk with an open and direct dialogue with clients, so they will understand and be mentally prepared for the near term price volatility that can accompany our strategy. We think the superior long-term excess returns possible are generally worth the volatility.
Long or Short: Rating agencies?
Probably short. Credit ratings are really a non-factor in our investment evaluation process, although we do seek to take advantage of what we perceive to be inherent biases or errors in rating agency analysis by buying or selling securities that are inefficiently priced off of these credit ratings. Downgrades can also drive non-fundamental selling pressure on credits that can sometimes be profitably exploited.
Can you talk about a few of your favorite investment ideas in the credit space?
One area we are heavy in is oil and gas exploration and production (E&P). One of the issues we like are the Black Elk 13.75% Secured Notes Due 12/1/2015. The issuer is a privately owned E&P company with proved, developed reserves in the Gulf of Mexico. We estimate the company’s net debt to trailing EBITDA to be at a very low 1.3 times. At recent oil and gas prices, the company’s net debt is covered by discounted PV-10 cash flows by an estimated 2.7 times. While the bonds, trading today at 102-103, have exposure to Gulf of Mexico drilling catastrophe risk, the private company focuses primarily in the shallow waters of the Gulf. Given that similarly situated larger public Gulf E&P shallow water producers with debt outstanding have single digit yields, we believe we are more than adequately compensated for the market perceived smaller, private company risk.
Another E&P issuer we like is RAAM Global Energy (12.5% Secured Notes due 5/1/15). This company has shallow water production in the Gulf of Mexico, as well as on-land production in Louisiana, Texas, Oklahoma, California, and New Mexico. The $150 million issue is well covered, as the company has only approximately $68 million of net debt, compared to approximately $600 million of primarily mature shallow-water and onshore proven reserves. Net debt to LTM EBITDA is only 0.4 times. The issue currently trades in the 103-104 range.
Thank you so much for sitting down with us.
Thanks again to the wonderful team at Aegis for providing thoughtful answers to our questions. If you are a portfolio manager with assets less than $500M and would like to be profiled in a future edition of the emerging manager series, please shoot me an email: hunter [at] distressed-debt-investing.com
Looks like AHYFX is very heavily concentrated in the O&G sector.
ReplyDeletehttp://quicktake.morningstar.com/syndication/holdings.aspx?cn=GLG117&symbol=AHYFX