Takeaways from SVP's Recent Investor Conference Call

Victor Khosla's Strategic Value Partners is one of the more well respected funds in the distressed debt universe. It's Strategic Value Restructuring Fund has returned over 13% annually since inception (September 2002) with less than 50% correlation with both the S&P 500 and Merrill Lynch High Yield Bond Index. They are fantastic investors that play up and down the capital structure, with a focus on senior tranches both domestically and internationally.

Last week, SVP hosted its Quarterly Market Call. While I will not post the presentation, here are some takeaways from the discussion:

• The three fold pressures facing the market right now are: 1) A slow down in the general economy in both the United States and Europe 2) The EU Sovereign Crisis 3) Japan - It's in a recession. Because of these pressures, we've seen a sort of mini crash in the equity markets
• This equity mini crash has extended to the high yield market with significant spread widening in both high yield and bank debt driven by substantial outflows
• With a weaker secondary market, primary markets have all but dried up
• With that said, the distressed market is down substantially more than you would expect given the underlying moves in the equity markets. This goes across senior, sub, and equity structures of the distressed universe
• This compares to the high yield and leveraged loan market being down essentially in line with expectations given the equity moves
• SVP compares recent price moves to the distressed cycle of 1998 (post LTCM / Russia default) which was not nearly as bad as the 2002 and 2008/2009 cycles. With that, SVP warns the market are "still playing out"
• SVP notes that while the distressed market has broadened (see my earlier post: http://www.distressed-debt-investing.com/2011/08/having-fun-yetpart-ii.html), this market needs to be navigated carefully given all the headline macro risk
• Emerging opportunities in the US: Shipping, infrastructure, commercial real estate debt, some large cap distressed names
• In Europe: lots of supply and lots for sale and few buyers

This squares exactly what I've seen in the past few weeks. I got a listing of big moves in the past month in bank debt land as of last week. Here are some notables:

• Quiznos Second Lien: Down 69 points
• Cinram First Lien: Down 43 points
• Buffets Term Loan: Down 28 points
• Lightsquared Term Loan: Down 25 points
• Marsico Term Loan: Down 20 points
• Idearc Exit Term Loan: Down 20 points
• Etc. Etc.

In the U.S., I do agree that shipping is shaping up to be an interesting opportunity (tomorrow's post). The large cap distressed names continue to leak as redemptions seemingly hurt those credits the worst (most liquid, overly concentrated in a number of high yield funds). And the primary market, effectively shut down save for a few bank loans that got launched before the mini crisis, isn't helping things either (i.e. the option for a hail mary capital raise to extend maturities is deeply out of the money right now).

Many distressed investors have been spending lots of hours working through some event driven opportunities that have popped up. Specifically, PMI is one that many people are working / wading through (both bonds trade 26/27 context). The CDS curve is a fun one on that one:

Sep11 8/12

Dec11 44/48

Mar12 56/60

Jun12 61/65

1yr 63/67

2yr 66/68

3yr 67/69

4yr 68/70

5yr 69/71

7yr 69/71

10yr 69/71

The numbers on the right are expressed as points up front for those interested. To buy protection for the Dec 2011 contract, you would have to put up 48 points initially and then pay a 500 bps running spread. The recovery market for PMI right now is 21/25. The PMI Group is in the on the run CDX HY Index (Series 16).

So, things are definitely MUCH more interesting than they were 2 months ago. It really does feel like night and day. One of these days, I am going to do a comprehensive review of Howard Mark's fantastic new book "The Most Important Thing". Chapter 9, entitled "Awareness of the Pendulum" is probably one of the greatest chapters written on investing since Chapter 8 in Intelligent Investor. In the book, Marks writes:

"Thirty-five years after I first learned about the stages of a bull market, after the weakness of subprime mortgages (and their holders) had been exposed and as people were worrying about contagion to a global crisis, I came up with a flip side, the three stages of a bear market:

• The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won't always be rosy
• The second, when most investors recognize things are deteriorating
• The third, when everyone's convinced things can only get worse"

To me, it felt like the melt down in August was the investing public moving from the first stage to the second stage. I do not believe, in the aggregate, we are at the third stage. Maybe in certain pockets and sectors (i.e. shipping / tankers - seriously, when was the last time you heard ANY good news about the tanker industry), but definitely not in the aggregate. That is why you have to selectively pick your spots focus on the opportunities where risk of permanent capital loss is the lowest, fear is rampant, and thus expected return (given the risk) is the highest.

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Why Buying Back Stock Isn't Always the Best Use of Capital

A year of so ago, we analyzed Reader's Digest post reorg equity, which trades on the distressed desks. At that time, the equity traded at 20 dollars a share. Today the equity trades for 9 dollars a share. Reason: Poor management capital allocation skills and weaker than expected results.

In January 2011, Reader's Digest, under the leadership of Mary Berner, announced a tender to repurchase up to $50M of stock via a Dutch Auction tender between $22 and $25/share (representing 8.3% of outstanding shares). This tender was later amended to increase the purchase price to $27 - $29/share. In the end, $43M worth of capital was used to repurchase shares at $29/share, retiring 5.4% of the outstanding shares (1,494,134 shares tendered).

We will never know if Berner thought it would be a good idea to tender for the share herself, or if she was pushed by her stockholders or board to buy back stock. Given the lack of liquidity of the stock, I'd guess the latter. We do know that in April, the company put out a press release: "RDA Holding Co. today announced that a majority of its shareholders have appointed a new Board of Directors, effective April 18, 2011. Mary Berner, President and Chief Executive Officer will continue to hold a Board seat." - You do not often here about an entire new board of directors. Soon after (i.e. a week after), this new board of directors appointed a new CEO.

Net / Net, the company deployed $43M of capital in the first quarter. Then, last week, the company put out its press release for its fiscal results for the 2nd quarter ended June 30th, 2011. In that press release, the company announced a new capital raise (my emphasis added):

"On August 12, 2011, the Company entered into and borrowed the full amount under a term loan and guarantee agreement, providing the Company with a $45.0 million secured term loan, and an unsecured term loan and guarantee agreement, providing the Company with a $10.0 million unsecured term loan, each with Luxor Capital Group, as administrative agent; the Guarantors (defined in each agreement); and the lenders thereunder (who are affiliates of RDA shareholders). The secured term loan matures in November 2013 and bears interest at the rate of 7.00% per annum. The unsecured term loan matures in May 2014 and bears interest at the rate of 11.00% per annum. The new credit facilities contain substantially the same covenants and limitations as our existing senior revolving credit facility, although in certain cases they are more restrictive. The proceeds of the new credit facilities will be used for seasonal working capital and general corporate purposes. In addition, in connection with the unsecured term loan, the Company issued two tranches of warrants to the lenders under the agreement. The first tranche of warrants provides the holders with the right to purchase up to 1.125 million shares of the Company’s common stock at an exercise price of $17.50 per share. The second tranche of warrants provides the holders with the right to purchase up to 1.25 million shares of the Company’s common stock at an exercise price of $15.00 per share. Both tranches of warrants expire two years after the issue date. Previously, the Company had drawn down the balance of its senior revolving credit facility."

Wait. Let's get this straight. 4 months ago, you spent $43M to buy back ~1.5 millions shares at $29/share and now you issue warrants at $15 and $17/share for 1.25 million and 1.125 million shares respectively? Hold on; and you drew down the balance of your revolver? Let's go to the conference call and see if we can find some answers.

Tom Williams, New CEO: "This past week, we entered into two term loan agreements that provided $55 million of incremental cash. The new $45 million secured facility was originally contemplated under the structure of the debt agreement that we put in place at the time we emerged from Chapter 11. Recognizing the need for additional seasonal working capital, given the peaks and troughs of our business, the company conducted a thorough process to raise new capital. After speaking with multiple potential lenders, we entered into serious negotiations with several parties and we are very pleased that we're able to close the financing last week, in light of the challenging capital markets environment.

In the end, we entered into a transaction with lenders that are affiliates of two of our shareholders. The agreements call for $45 million of secured loans with a term of 2-1/4 years and an interest rate of 7% and $10 million of unsecured loans with the term of 2-3/4 years and an interest rate of 11%, which also provides for warrants to be purchased of 2.375 million shares of Class A common stock.

The primary use of this new cash is for seasonal working capital needs."

Two things I take away from this:

• Someone forgot to carry the 1 when they were projecting working capital draws apparently. That $43M you spent for shares at $29/share looks pretty precious right now if you ask me. (Especially considering they also drew down on their revolver!)
• Luxor is getting an extremely attractive deal. This is essentially 2.5 year paper, senior secured, with a healthy rate, AND warrants.

I am only singling out Reader's Digest as it is topical to the site. Hundreds of management teams bought back excessive stock in 2006 only to see their stock price drop 50% in the ensuing 2 years. Unfortunately, management teams rarely think like owners and instead listen to their shareholder base on when it makes sense to buy back stock. Many times this has to do with incentives: I.E. Keep the shareholder base happy so the board doesn't kick me out. And because a buy back may increase short term potential of equity valuation, management teams benefit if they have options or if they themselves want to sell shares on the open market at a higher valuation.

Management teams should think like value investors: Buying back stock only when there is a substantial margin of safety in the purchase using prudent assumptions. If management thinks the stock is worth $20-30/share, they should buy back stock in the mid teens, not if its trading in the fair value range. I always love it when management teams are buying back stock significantly less than intrinsic value: Not only is it good for me as a shareholder, but it also shows me that management gets it. Henry Singleton, arguably one of the greatest capital allocating CEOs ever, tendered for 90% of Teledyne's stock over a 15 year period. He waited until blood was in the streets, and bought back loads and loads of stock and shareholders were dutifully rewarded over time.

In the future, when contemplating an equity investment, take a look at the company's history of buying back stock (and frankly issuing debt - a good capital allocator at the helm will be issuing bonds when rates fall ... see Warren Buffett last week). Were they buying back stock at peak multiples of earning and cash flow? Were they then issuing stock at the lows? While that might not preclude me from buying a certain security, it will require me to have a larger margin of safety in the purchase price to counter the off chance management makes a capital allocating mistake in the future.

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Advanced Distressed Debt Lesson: Implied Valuations

Last week, Sbarro filed its disclosure statement and bankruptcy plan in the Southern District of New York. For reference, here is the bankruptcy docket for Sbarro:

Sbarro Bankruptcy Docket

While this case has had its back and forth, the background of the case and the developments of the plan started with an April 2011 Chapter 11 filing by Sbarro with an agreement with junior creditors (second lien and 70% of note holders) to own the equity of the company by backstopping a rights offering while giving first lien lenders a new term loan. This term loan was supposed to be ~$173M which would lever the company between 5-6x, depending on your estimates of cash flow. When I first saw this, I had two concerns:

1. The agreement did not include first lien lenders. While the argument can be made they would be paid in full (with the new term loan), not including them felt like poking a hornets net with a pointy stick.
2. This would be awfully high leverage for a company experiencing hefty operational difficulties. Well run QSRs were being levered 3-4x through the bank debt, adding 2 turns to this seemed excessive.

In May, Sbarro terminated this pre-petition plan to explore other strategic options, including a possible sale of the company. I would assume, from news reports, that this decision was partly driven by first lien lenders that shared my aforementioned concerns.

In July, it was announced that the Sbarro had received a plan from the first lien steering committee. Last week the details of that plan emerged and was filed with the court. The essentials:

• Assuming the company can not find a bidder for its assets, the DIP and 43% of the first lien facility will be converted to a $110M exit facility
• The remaining 57% of first lien claim will be converted into equity, with first lien lenders owning the entire company
• Certain first lien lenders have agreed to also place a $18.6M new money term loan to provide the company with liquidity
• The second liens and unsecured notes will be canceled

This is in essence the stalking horse bid for the company, and indeed the second liens, unsecured note holders, or a third party could offer more for the asset.

As of this morning, Wells Fargo was making the Term Loan B at 92-93. The question then becomes: What does this imply about the valuation of Sbarro?

While the financial projections were not filed with this most recent disclosure statement, there is a statement in the disclosure statement that reads (in the discussion of potential business improvement):

"The Debtors expect to realize the full benefits from these initiatives and anticipated capital expenditures over their five-year business plan horizon, which forecasts an

improvement in adjusted EBITDA from approximately $28 million in 2011 to more than $45 million by 2015"

We know that the contemplated plan will have $110M of debt as a baseline. In addition, there is a possible $18.6M in additional debt, but this debt, should, in theory, bring a similar amount of cash on the balance sheet. So at a price of 92, what equity value is the market implying for Sbarro?

According to the disclosure statement there is: "approximately $176.2 million outstanding under the Prepetition First Lien Credit Facility (including accrued and unpaid interest and approximately $3.5 million in issued and outstanding letters of credit)". Because L/Cs will surely roll, I assume the claim for the first lien $172.7M. From here:

1. Using the average of 2011 EV/EBITDA comp of 6.5x and our $28M in 2011 EBITDA, we come up with a TEV of $182M
2. The implied equity value is then $182M less the $110M of pro forma debt on the balance sheet or $72M
3. First lien lenders are thus receiving 100% of the $72M + $75M of the exit term loan or $147M of value divided by their $172.7M claim for a market price of 85 cents on the dollar

To me though, a better way to think about the problem is what multiple is being implied by the current 1st lien price. To do this, you just work backwards:

1. The current price of 92% * total claim of $172.7M = ~$159M of "market value"
2. You then subtract the $75M exit term loan first lien lenders are receiving to determine the value of the equity award. This gets us to $84M of value. (Note: You do not add $110M of total exit debt as first lien lenders are only receiving $75M of the exit term loan - remember we are determining the value they receive relative to their claim)
3. You then add $84M to the total contemplated exit debt of $110M and divide by the 2011 EBITDA forecast ($28M) for a value of 6.9x to get an implied cash flow multiple.

Here are some other forward looking comps (FY+1 EV/EBITDA)

• CRBL: 5.7x
• BOBE: 4.8x
• RT: 5.7x
• DENN: 6.7x
• BAGL; 6.1x
• KONA: 6.5x

Seems like 6.9x is high relative to these comps. Of course, you could forecast EBITDA moving substantially higher. The average of the subset above is 5.9x. Using our implied valuation technique again, this would mean Sbarro would need to do $33M of EBITDA to justify today's first lien price of 92. Given the history of Sbarro (which used to do upwards of $50M of EBITDA) this seems achievable given the right management team in place to turn the operation around.

There is definitely a bit of optionality in the bank debt with a cash buyer coming in and taking the bank debt out at par + accrued and this may be one of the reasons the bank debt is trading at a higher implied multiple than comps. I think a purchase at 80-85 cents on the dollar makes sense here to allow for more margin of safety if a turnaround does not go as planned.

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Distressed Debt Weekly Links of Interest

What we're reading this weekend at Distressed Debt Investing:

David Merkel's fantastic chart on where we are at in terms of the volatility historical range [Aleph Blog]

Weil's Bankruptcy Blog discusses new legislation in the House that could limit forum shopping by Chapter 11 debtors (forum shopping is essentially choosing whichever bankruptcy court you'd like...Delaware for instance is VERY debtor friendly) [Weil Bankruptcy Blog]

Interview with quant and blackjack legend Edward Thorp [found via Abnormal Returns]

Harry and David's [HNDUS] Memorandum of Law regarding their emergence from bankruptcy - specifically the pension related discussion [HNDUS Bankruptcy Docket]

Fantastic commentary from Kramer Levin's bankruptcy blog on the application of the Second Circuit's recent decision in Enron regarding settlement payment [Kramer Levin Bankruptcy Blog]

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Having Fun Yet...Part II

John Hempton wrote today that he believes the current rout in the global stock market can be partially attributed to margin calls. And I believe him.

Below is a chart of the Bloomberg designed index MARGDEBT, which tracks the amount of debt balances in margin accounts at the NYSE. Here is the chart going back 20 years:

You will notice that margin balances decrease dramatically in market downturns and increase dramatically in market run ups. This chart runs through June 30th, 2011 - You may notice we were veering into bubble territory at that point.

More to Hempton's point: Large liquid names were moving like people HAD to get out. Forced and uneconomic selling is a gift to value investors. While playing in large cap, high quality names may not give you the BEST returns in a market correction to the upside, the risk to the downside is minimized, and some of the valuations out there are very very compelling. If you want a place to start looking, look at the Dividend Aristocrat Index which is made up of companies in the S&P 500 that have increased their dividend for each of the past 25 years. With the 10 year bond at 2.3% and the DJIA dividend yield at 2.8%, it's where I'm sticking capital in the face of the abyss. I also find some merger arbitrage deals (LZ for instance) fairly compelling despite only an 8% annualized spread - feels like some of these names are also getting the boot b/c of the out performance (essentially flat) relative to a down 15% market.

I also think certain areas of the market just have not corrected enough. Buying protection on a basket of defense names that are still trading ULTRA tight given the outlook for defense spending in the medium term is an interesting hedge with asymmetric upside / downside characteristics.

And distressed is coming back folks. Here is the Bloomberg chart, that I love to show, with the number of issuers trading at 1000 basis points over the benchmark treasury:

Unfortunately, let's put a little context to this. The chart above only goes back through 2010. Here is the chart going back 4 years:

It still feels like to me that high yield credit just hasn't felt near the pain of equities on the aggregate or on a single name basis. To be honest, I do not know why that is. Here are some opinions:

1. High yield bonds are relatively illiquid - real money sellers are tapping the more liquid equity markets to fund margin calls and fund redemptions
2. Demand for high yield paper was incredibly robust from 1Q 2010 through seemingly a few weeks ago - accounts that never got filled on deals are topping up positions making a more reasonable two sided market relative to equities
3. Corporate balance sheets are stellar and given the maturity schedule of high yield bonds and levered loans, no large default spikes are imminent
4. HY returns is still positive on the year - retail flows will start allocating towards the better returning asset classes.

None of these could be right - I just don't know. I think everyone has an opinion; and my opinion is there is better value in equities right now than credit. When on the run bank debt trades into the 600s and 70s (avoid buying in the low 80s / high 70s because the CLO rule of 80 really hurts technical around the 80 price level), I'll definitely find some value there.

Thought and opinions are always appreciated. Looks like tomorrow (futures down 270 points at midnight) will be another wild ride.

One final note: Warren Buffett, in his Annual Letter for Fiscal Year 1987, recounted Ben Graham's analogy of Mr. Market first outlined in Intelligent Investor. I think it offers some perspective on the current market:

"Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can

see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-

depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day

in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr.

Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

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Who's Having Fun?

In his 2006 Annual Letter, Seth Klarman wrote:

"The old saw reminds us never to confuse genius with a bull market. Anyone can become 'expert' at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into 'buy anything'; a rising tide that is lifting all boats often proves irresistible."

And then, a favorite of mine: In an interview with Becky Quick, Warren Buffett said:

"You get more excited when there's a lot going on, you can't help it. And frankly, it will probably present more opportunity to us because when dislocations occur, things get more mis-priced and that sort of thing...So it can be a time of opportunity. It won't be for sure, but generally speaking, when there's a certain amount of chaos in certain sections, the fallout, and it's unpredictable where the fallout will be, but the fallout sometimes offers some real opportunities."

I put these two quotes together purposely. While the Klarman quotes heeds caution, the Buffett quote points us to the fact that market sell-offs provide value investors the opportunity to buy assets on the cheap.

Security prices falls, and most of the time, they fall further. Our job as investors is not to pick the bottom. Our job, rather, it to purchase securities with minimal risk of permanent capital impairment loss that offers adequate returns on that capital. We want a return of our capital and ON our capital. To better guarantee the return OF our capital, we require a margin of safety on our purchases.

Unfortunately, a 500 point drop in the DJIA does not constitute a margin of safety. Yes, stocks are cheaper today than they were last week. That does not make equities a buy - it simply makes equities more compelling.

What I find most interesting about today's market is the sheer magnitude that individual securities have fallen on bad news. Three months ago, I believe you'd see 1/2 these sorts of moves. But because, as pointed out in the last post, the tails are fatter, and the chance of zeros are increasing across the board, investors are selling first and asking questions later.

The list goes on and on: PCS, Leap, the long term care providers, CLWR, the mortgage insurers, HUN, DNDN (one of the largest moves I've ever seen), HOV, post-re org equities (slaughter), etc.

JPM's Peter Acciavatti sends out a Daily High Yield Update each morning. On it, he has a list of the dollar price changes for widely held securities. Obviously these are levered names, I'm going to strip out of the list all companies that do not have public equity, and show you how hard these name's stock prices have been hit over the past 5 days:

• Cablevision: -10.5%
• Charter: -12.8%
• Chesapeake Energy: -8.7%
• CIT Group: -9.9%
• Community Health: -13.8%
• El Paso: -13.8%
• Ford: -11.0%
• Frontier: -11.1%
• HCA: -14.2%
• Lyondell: -15.1%
• Sprint: -11.5%

What about the "Distressed" names that still have tradeable equity:

• Eastman Kodak: UP 3.75% (miracle?)
• Hovnanian: -27.1%
• PMI: -59%
• CEDC: -32.5%

This compares to the S&P return in that period of about down 7%. Levered names are definitely feeling the pain. Do these moves make these securities cheap? Absolutely not. Instead, and especially for the "distressed" names, a sense of reflexivity begins to take hold in that suppliers and lenders will view the stock price as a statement on the company's credit worthiness and will tighten terms which pushes these companies closer to a Chapter 11 process.

In high yield land, nothing really feels washed out except for a few of the shipping names like CMA CGM and GMR and more stressed names (HOV, Hawker, etc). Bank debt has held in really well. When CMS came out with their reimbursement changes for skilled nursing, SUNH, KND, SKH saw their equities down 30-50% with bank debt only moving 2-3 points. That doesn't feel right.

So sharpen your pencils folks, because things have gotten a lot more interesting in the past few weeks - and the jobs number tomorrow is the icing on the cake as it were. Know that you can't catch the bottom, but don't let that stop you from doing the hard work, collecting your facts, and doing your due diligence. The worst thing you can do right now is type WEI GO all day long, sit on your thumbs, and watch the red.

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What Concerns Passport Capital

Last week, I received Passport Capital's quarterly letter. I have remarked in the past, that I believe Passport Capital's John Burbank is one of the most creative thinkers and investors in the hedge fund world. While macro is definitely not my specialty, Passport brings a level of expertise to various regions of the world that are simply unparalleled. The results speak for themselves: Since inception in August 2000, the fund is up ~22% net on an annualized basis.

While I will not post the entire letter, I found Passport's thoughts on the risk factors currently in the market very relevant to the current environment:

Dan Loeb in his recent investor letter commented the difficulty of the macro environment is having on investors:

"Generally, we are "bottom-up investors." However we are living in a climate where these economic and political considerations are at least as - if not more - important than underlying fundamentals in forecasting investment outcomes. Given the great uncertainty described above and sentiment levels that reflect it, I can foresee scenarios where securities could trade much higher - or much lower. Happily, as Warren Buffett has pointed out, we operate in a "no strike" game, which is to say that we can let many pitches pass us by before swinging at the ball that comes right to our sweet spot."

Last week, every single investment bank had conference calls and numerous pieces on the debt ceiling legislation and a US downgrade. While interesting water cooler talk, the big takeaways were a lot of uncertainty, with the assumption a deal would get done. The CDS leveles reflects the sentiment last week:

This is the chart of the 1 year CDS spread of the U.S. Government. You can see the collapse today as a debt limit deal was reached. The run up was spectacular to watch.

While I will not pontificate on macro environments, I will say this: The range of outcomes has increased dramatically. And the tails are getting fatter. Seth Klarman has always advocated putting on cheap hedges to hedge against tail risks (he once spoke about sovereign CDS which has to be a home-run trade at this point). While this is getting more and more difficult as investors across the board are looking for cheap hedges (volatility, whether it be interest rates or equity risk, has increased dramatically) a prudent investor should understand that to win the race, you must actually finish the race. Overlaying the portfolio with well out of the money puts or buying protection on senior tranches of high grade and high yield credit indices (a post coming will discuss these in detail), may marginally detract from performance, but will allow you to survive if one of those tails comes to fruition.

In the meantime, you wait for the fat pitches and bet when the betting is good. Like any good poker player, you wait until the odds are significantly stacked in your favor, and then you bet when you have the best of it. You can only have an edge on so many investments - the human capital required to know more about every company out there is impracticable and uneconomical. Stick to those areas where you have an edge, hedge against tail risks, and in my opinion, you should make out just fine.

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